by Gary North
It is important that you do not take too seriously the financial media's explanations for rising or falling stock markets. If the explanation is "inflation," pay little attention.
When you read about "inflation," be aware of the fact that this means "the most recent data on price inflation." These figures are far less relevant than the most recent data on monetary inflation. This is why I keep reminding readers with money on the line to monitor the monetary charts published by the Federal Reserve Bank of St. Louis.
Last week, Asian stock markets tumbled by close to 15%. You can see the charts of several Asian nations here.
Click on any country's name on the left column.
Asian bond markets also fell.
The Dow Jones Industrial Average got close to its 2000 peak two weeks ago; then it fell. Gold and silver have also fallen. What is going on?
We are seeing the clash of two inflations: price inflation and monetary inflation.
TWO DEFINITIONS OF INFLATION
Monetary inflation is the basis of price inflation, except in rare occurrences, such as a war or an earthquake, where unexpected falling supplies are the cause: "The same number of currency units chasing too few goods."
In the United States and around the world, monetary inflation is the norm. But, very occasionally, central bankers decide almost simultaneously to put on the brakes. They stabilize money. Then we see the clash of the two inflations.
The St. Louis Federal Reserve Bank publishes a chart of the four major currencies: U.S. dollar, Canadian dollar, Japanese yen, and British pound. This chart tracks the reserve money data, which reveal central bank monetary policy. It's worth printing out.
You can see that there was parallel policy in 1999: inflationary. The Canadian central bank was creating reserves at an astronomical rate: 25% per annum. The other countries were creating reserves in the 10% to 15% rate — high.
Then, without warning, the central bankers reversed their policies in 2000. Canadian reserves fell like a stone at minus 7%. The Bank of Japan's rate of reserve creation fell to 0%. So did the Federal Reserve System's. That coincided with the collapse of the Nasdaq and the general U.S. stock market.
Then, in 2001, all four banks reversed policy again: back to monetary inflation. The Bank of Japan expanded reserves at a 28% rate, or close to it.
Ever since 2005, all but the Bank of England have been reducing the rate of monetary inflation: under 4%.
Ever since the final week of January, 2005, the Federal Reserve has almost stabilized the adjusted monetary base.
This is monetary disinflation. When monetary disinflation hits price inflation head-on, there is a crash in the equities markets. The stock market boom, fueled by rising monetary reserves, threatens to become a bust.
Ludwig von Mises described this boom-bust phenomenon as early as 1912 in his book, The Theory of Money and Credit. I have written a short book on Mises' monetary theory, for those of you — in addition to my mother — who are interested.
THE BANK OF JAPAN OPTS OUT
To the question, "What happened to Asia's stock markets?" — there is an answer. It may not be the best answer, but it makes sense to me. The Bank of Japan is in the process of abandoning its policy of zero interest rates.
This policy has subsidized Japan's ailing commercial banking system, which is still sitting on a pile of bad loans left over from the 1990s. It has kept equity prices higher than would otherwise have been the case. The same goes for property prices. Yet both markets fell substantially in the 1990s.
The legend of Japanese deflation is inaccurate. Japan's retail prices had slightly down years and slightly up years through the 1990s. See the chart, "Inflation."
As you can see, price deflation was low whenever it existed, which was infrequently. From 1990 until 1995, the consumer price index was positive except briefly in 1995. It moved up in 1997 to about 2%. Then it moved down in the aftermath of the Asian currency crisis of 1998. In this decade, price deflation never got more than about 1% per year.
This should warn you: Do not take seriously the headlines of roaring price inflation as the cause of the recent fall in the U.S. stock market, any more than you should take seriously stories of roaring price deflation in Japan.
Ambrose Evans-Pritchard's article in the May 29 issue of The Telegraph reported on a shift in policy by the Bank of Japan.
Governor Toshihiko Fukui has bled more than $140bn from his banking system since March 9 to reduce a menacing overhang of liquidity left from the battle against deflation. He is halfway through.
No longer buying fistfuls of US Treasuries with printed money to hold down the yen, the Bank of Japan has been the silent force pushing up global bond yields this year by 0.8pc — the jump that really lies behind the market rout.
It is possible for the bond market and the stock market to rise or fall together. They rose together in the United States from 1982 until 2000. They are now falling together in Asia.
Japan's central bank is now selling dollars.
Japanese holdings of US Treasuries have fallen by $74.5bn since December. "We are reaching an inflection point in monetary policy," said Mr. Fukui.
In other words, the subsidy provided to the U.S. government's debt market by the Bank of Japan has ceased for the time being. Yet this has been the most important subsidy for this market for the last decade.
This has ominous implications for the yen carry trade. For almost 15 years, the Bank of Japan has subsidized large-scale speculators, who borrowed yen at almost 0%, bought foreign currencies, and then bought debt obligations, especially bonds. This was easy money on a massive scale. When you can get free money, you are tempted to do it again and again. But then comes the day of reckoning. As Evans-Pritchard puts it,
Hedge funds that had borrowed for zilch in Tokyo, to lend for a fat premium to overheating Iceland and New Zealand, began rushing for narrow exits.
The storm has since swept up much of the globe, setting off the steepest falls in emerging market stocks and bonds since the Russian default in 1998.
"Most people underestimated the effects of monetary tightening in Japan," said Phillip Poole, an economist at HSBC. "The liquidity that has driven these markets is being withdrawn."
This policy of Japan has an acronym: ZIRP (zero interest rate policy). This policy is now coming to an end.
Few investors lose sleep worrying about life after zirp, but our guardians at the Bank of International Settlements view it as the greatest imminent risk to global markets.
Adding to the threat of worldwide recession, the European central bank is also tightening money. The European housing bubble has created concern over rising price inflation, which is driven by rising real estate prices.
Judging by the apocalyptic tone of the Bundesbank's May report, Europe is on the brink of a monetary shock going far beyond the mincing half-measures trickled out until now by Jean-Claude Trichet, ECB chief and French "soft euro" inflationist.
Evans-Pritchard refers to the German central bank (Bundesbank) as Buba. It reminds me of that mythical American redneck, Bubba.
Germany is back, and a reawakened Buba is snorting with the same bloody-minded determination it displayed before causing the 1987 crash and the 1992 bust up of the ERM [European Exchange Rate Mechanism].
This threat of rising rates threatens the U.S. dollar. If Japan allows rising short-term interest rates, and Europe allows rising short-term interest rates, the dollar will come under selling pressure. To keep the value of the dollar high, the Federal Reserve will have to retain its present flat-reserves policy, thereby letting short-term interest rates rise.
This is bad news for the ARM [adjustable rate mortgage] market and the housing market generally. Evans-Pritchard's analysis is spot-on.
Ben Bernanke was back-peddling fast in a letter to Congress last week, pleading that core CPI inflation "overstates" price rises. "Monetary policy must be forward-looking," he said.
Has the Fed already gone too far, baking a recession into the pie? Will the delayed effects of past tightening kick in, with mounting ferocity, just as the housing boom plummets into bust?
"Housing mayhem seems unavoidable. The US hard landing begins now," said Charles Dumas, global strategist at Lombard Street Research.
Mortgage applications are down 17pc in a year. House sales are down 5.7pc, and inventories of unsold new houses are at their highest since 1996. The central prop holding up the US consumer boom is crumbling, leaving behind record household debts equal to 127pc of disposable income.
[Note: This article was removed or else the link died on Tuesday, May 30.]
Evans-Pritchard is not alone in his analysis. William Pesek wrote a piece for Bloomberg, published the same day, May 29, as Evans-Pritchard's article.
In Mumbai in January, I asked India's No. 2 central bank official the same question I pose to every policy maker these days: What does Japan's revival mean for Asia?
Without a moment's hesitation, Rakesh Mohan replied: "The yen-carry trade will make things interesting." . . .
Over the last decade, the trade — which exploits the gap between ultra-low Japanese interest rates and higher ones elsewhere — has become a staple in markets. In many cases, anyone borrowing for next to nothing in yen and parking the funds in, say, higher-yielding U.S. Treasuries or higher-returning Indian stocks found it to be a sure bet.
That's about to change as Japan's recovery leads to higher rates in the world's second-biggest economy.
I find it interesting that the financial press has finally figured out what I wrote about two years ago, in May, 2004. The carry trade is the Achilles heel of today's boom.
Short-term rates and bond yields in Japan have been negligible for so long that investors take them for granted. Japanese recoveries tend to fizzle faster than they emerge. The Bank of Japan hasn't built much credibility in markets, having failed for some 15 years to stabilize growth and avoid deflation.
Yet Japan's long-awaited return to the economic plus column is here. And even if the country doesn't grow 5 percent a year, there can be little doubt that the BOJ will raise rates from zero percent. The central bank is keen to return some normalcy to Japan's monetary policy.
Global markets have been slow to grasp the specter of higher Japanese rates. In recent weeks, though, surprisingly large moves in markets from Iceland to Turkey to India have been partly attributed to the unwinding of yen trades. And where yen-volatility is concerned, we probably haven't seen anything yet.
The worldwide housing boom has rested on the Bank of Japan's monetary expansion and the parallel expansion by the other major central banks. Now this is ending: in Japan, in Europe, and in the United States.
Today's financial press wailing about U.S. price inflation will be replaced by wailing about a worldwide recession. What happened to Gerald Ford's 1975 WIN program (Whip Inflation Now) should remind us: Recession can follow the next year. That reversal cost Ford the Presidency.
Pesek worries in print that no one knows how big the yen carry trade is.
What makes the yen-carry trade so worrisome — and easy to dismiss as a potential problem for markets — is that no one really knows how big it is. It's not like the BOJ has credible intelligence on how many companies, hedge funds or mutual funds borrowed in yen — or how much — and put the money into assets elsewhere.
It would be more comforting if the Bank for International Settlements, the International Monetary Fund or the Federal Reserve Bank of New York had a better handle on all this. Who really knows how many purchases of Shanghai properties, Google Inc. shares, Zambian treasury bills, bars of gold or derivatives are related to yen borrowings?
The American investing public has not yet got the message. Few investors have heard of the carry trade. Few fund managers are prepared for its potential negative consequences. The central banks are now reversing a decade-old policy.
I don't think they will maintain this disinflationary policy, once it becomes clear that the carry trade is unraveling and taking the equity markets and the real estate markets with it. But whenever the major central banks pursue the same policy, there is going to be simultaneous trouble.
Cash is not trash. Foreign currencies are not trash.
But it's safest to hold them in the form of short-term CDs. Bonds are possible as ways for speculative profits. But rising long-term rates are likely because of the unwinding of the yen carry trade. When speculators sell non-Japanese currencies to repatriate yen in order to buy yen and unwind their positions, they will sell non-yen bonds first. That will put upward pressure on long-term interest rates.
I see a continuation of bad news for all stock markets. I also see trouble ahead for the U.S. dollar.
I also see what the slogan will be for the Democrats in 2008: "It's the economy, stupid . . . again!"
June 2, 2006
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