Since the beginning of the month, equity markets have moved higher, although progress has been choppy. Last week saw two strong days on Tuesday and Friday and lacklustre days on Wednesday and Thursday.
On Friday, the US announced its September non-farm payroll data, which was significantly weaker than expected. In the event, the data was interpreted as being more likely to tip the US Fed Reserve’s hand towards greater monetary ease. Although private sector payrolls rose by 64,000 and the equivalent number for August was revised up by 26,000, government payrolls are falling. The US government in its various forms reduced its employment by 159,000 and the losses for August were revised to 150,000 from 121,000. July was also revised up and now shows a loss of 183,000 from a previous loss of 161,000. The key point, of course, is that this is just not about temporary census workers leaving their posts but individual US states shedding workers. It is worth bearing in mind that 40 of the 50 states of the union are technically bankrupt.
The world must be a very frustrating place for policy makers. Some of those frustrations were on display at the IMF annual meeting over the weekend in Washington. Big international gatherings of finance minsters, of course, are not the best place to resolve policy issues. The tendency is for participants to restate entrenched positions. And a lot of that was on display at the weekend. When the problem is too knotty the matter may not even be mentioned.
Apparently, US Treasury Secretary Geithner and Japanese Finance Minister Noda met on Saturday evening and failed to comment on the elephant in the room – the likelihood of further Japanese currency intervention, suggesting that the US may be willing to look the other way while Japan pursues currency intervention designed to push the Japanese yen downwards. Noda, however, had stated his position “quite elaborately” over dinner on the Friday evening before, providing a slightly lacklustre rationale for Japanese intervention. Noda apparently stated that the Japanese goal in intervening was merely to counter excessive exchange rate moves, not to achieve a particular level for the yen or to conduct prolonged or messy intervention. It is hardly surprising that the yen reached another high on Monday.
One must surely have some sympathy for frustrated Japanese officials. After all, the yen has appreciated by 11% against the US dollar since mid June. This puts Japanese exports at an even greater disadvantage compared with the Chinese or the Koreans whose currencies are more or less explicitly tied to the US dollar. It must have been slightly galling to the Japanese authorities to have seen those responsible for investing Chinese official reserves reverse their earlier policy of accumulating Japanese government paper following the first Japanese intervention into the foreign currency markets on 15th September.
The Chinese swagger and Japanese exporters suffer.
Japan’s latest moves to stimulate its economy, frankly, are likely to have a limited impact on its currency. For the trend of a rising yen to be halted in its tracks a number of things need to happen over which Japan has little control. Inflation needs to re-emerge in the US and US long-term interest rates need to rise again. For the time being, this is unlikely. Deflationary not inflationary pressures are increasing in the developed world. The biggest reason for this is the undervaluation of emerging market currencies, notably the Renminbi.
As China refuses to allow its currency to appreciate, inflation in China and deflation in the developed world are likely to intensify and the correction of exchange rates in real terms will continue. The yen is overvalued against the Renminbi and other emerging market currencies. However, as long as China or Korea reject the appreciation of their currencies, a rising yen is hard to halt. Any time Japan tries to do this, it is seen as an intervention against the US dollar. Inevitably, since the Renminbi and other Asian currencies are more or less pegged to the US dollar, the US dollar is left as the only key currency against which Japan can intervene to produce the stability it desires.
It would suit the Japanese more if the US Federal Reserve stopped talking about another round of quantitative easing – after all, from a Japanese point of view, this is a merely policy which is aimed at US dollar devaluation. Even hints that such action is likely have been enough to weaken the US dollar. There are two problems. As the US dollar weakens, the Renminbi also wanes against the yen, euro and other currencies, giving China, Japan’s biggest competitor, an added advantage. The US Federal Reserve has created an unintended but effective China export-support policy. By extension, a weaker US dollar and Renminbi force the Bank of Japan to further ease monetary policy, posing many undesirable domestic dangers for the Japanese banking system. Intervention pushes down long-term interest rates, thereby narrowing the yield spread, which constitutes most of the Japanese banks’ profit margin.
Frustrations also produce absurdities. Those responsible for managing Chinese foreign exchange reserves must be among the most frustrated individuals.
In the last few weeks, China has sold off virtually all the Japanese government bonds it purchased in the first seven months of 2010, when it was desperately looking for a replacement for European bonds and an escape from a falling euro exchange rate. There has been, of course, no reaction in the Japanese government bond market – after all, foreigners only own 5% of all Japanese government bonds. Chinese selling was probably a response to both the Chinese government’s unhappiness with the trawler collision on 7 September as well as Japan’s decision to intervene to stop the yen from rising on 15 September. Other foreign investors happily bought the bonds the Chinese were selling.
China is also one of the biggest foreign investors in US government bonds but in the 12 months to end July it has cut its holdings by about 10% to $846.7 billion, according to the US Treasury Department. If Mr Yu Yongding, a former advisor to the Chinese central bank is to be believed, “US Treasuries fail to provide safety or liquidity”. According to him, “China should reduce its holdings of US dollar assets to diversify risks of sharp depreciation”, Yu suggested in July that “The nation should convert some holdings in US dollars into assets denominated in other currencies, commodities and direct investments overseas.” All this is easier said than done. The Chinese have been buying Korean bonds, driving yields in that market place still lower.
The Chinese policy preference is clear and was expressed by Premier Wen Jiabao in Brussels last week. China would like the world to “intensify macro policy co-ordination, manage with caution the timing and pace of an exit strategy from economic stimulus and keep the exchange rates of major reserve currencies relatively stable”.
None of this is very likely. Over the last 10 days, it has become clear that a consensus is developing on the US Federal Reserve’s Open Market Committee in favour of further easing of US monetary policy. The key speech was that of William Dudley, New York Fed President. His view was supported in speeches by the Boston and Chicago Fed Presidents. The remarks of these three men over shadow contrary views expressed by the Philadelphia Fed President, Charles Plosser. Dudley, Vice Chairman of the US Federal Reserve Open Market Policy Committee and the only regional president with a permanent vote, on 1 October, suggested that the outlook for US job growth inflation is “unacceptable” and that “further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident”. The latest non-farm payroll figures can only have leant weight to this argument.
In the face of unilateral US action, the question that investors face is where to hide. In recent months, US equities, the Swiss franc, Japanese yen, euro and sterling have all strengthened – not to mention the more freely floating currencies of the emerging markets, such as the Brazilian real and the Malaysian ringgit and the commodity related currencies of Australia and Canada.
Specifically in respect of the euro, there was weakness during the course of the financial crisis in Europe from mid April through late June. In that period, the euro weakened unilaterally and, in particular, weakened against sterling. Now, of course, it is recovering.
We believe that the European central bank will likely seek to avoid quantitative easing even if this reduces the rate of European growth for a period. Since its June low, there has been a 7% rise in the euro’s trade-weighted value, which this has probably reduced the Eurozone’s real GDP going forward by 0.5% and its nominal growth by 1.0%. The prospective rate of growth of earnings per share in Europe has probably fallen by up to 8% as well. A strong euro inevitably increases deflationary pressures there and may raise sovereign risk questions fears in peripheral Europe again. Analysts are continuing to downgrade the profit prospects for Spanish banks.
By contrast, the US and the UK are likely to implement some form of QE2 by year-end with Japan already at work in this direction. The UK, along with other major developed European countries, is putting in place a significant fiscal austerity package. In the case of the UK, the details of that package will be announced on 20th October. This fiscal austerity package is likely to be greater in magnitude than the packages in either France or Germany. This is already helping the perception of UK creditworthiness but will slow the UK domestic growth prospects for 2011. At its party conference last week, the Conservative Chancellor, Mr Osborne, was given a rough ride over proposed reductions in child benefit. It is hardly surprising that he has also indicated that he would be happy for the Bank of England to enter into another round of quantitative easing.
For the stock market, quantitative easing is potentially a powerful stimulant. In the year after the Bank of Japan did quantitative easing in 2003, the Nikkei increased +40% and real GDP went from +1.3% year-on-year to +3.9%. In the year after the Bank of England did QE last year, the FTSE increased +50% and real GDP went from -5.5% year-on-year to -0.3%. In the year after the US Federal Reserve did QE last year, the S&P increased +50% and real GDP went from -3.8% year-on-year to +2.4%. In the year after the 1994 midterm elections, the S&P increased +30%.
The real object of all this extra ease is to get banks to lend more. Over the last few weeks the US Federal Reserve’s H8 report has showed a steady continuation of the themes that have been in place for the last two years. US Commercial Banks are continuing to favour holdings of US Treasuries and mortgage backed securities over either Interbank loans or lending for Commercial and Industrial purposes. US holdings of US Treasury and Agency Securities have continued to grow over the past quarter with the volume increasing by approximately $66.54 billion since the start of July 2010.
Over the same period, US Commercial banks have reduced their lending to Consumers by more than $28.2 billion, and generally continued to consolidate and manage down credit risk as time passes. The ratio of loans for Commercial and Industrial purposes compared to the amount of cash assets that the banks are holding sits at 1.09x, close to the all-time low of 0.93x seen in February of this year. This ratio stood at 4.98x in August of 2008, just before the financial crisis plunged into its darkest days. At that time, US commercial banks had almost five times as much in C&I loans on their balance sheet as they held in cash assets. Today the two numbers are almost equal.
Even more startling over the past two years are the changes in comparative holdings of US Treasury & Agency Securities over C&I lending. Back in the halcyon days of 2008 US Commercial banks couldn’t get enough of C&I lending, shunning the 3.75% yields available in 10 year Treasuries in favour of lending to the Commercial and Industrial sectors of the US economy. At that time, C&I lending exceeded holdings of US Treasury and Agency debt by almost $472 billion. Today the banks favour Securities over C&I loans by almost $400 billion. This is an extraordinary reversal and must be very frustrating to US officials.
Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.