Widening Divergence Aids Dollar, but No Currency War

There are three elements to the investment climate:  The divergence between the US on one hand and Europe and Japan on the other, the drop in many commodity prices, including oil, and the slowing of the Chinese economy.  

Last week, the divergence was driven home by policy makers.  The contrast could not be starker. The FOMC ended QE, and seemingly began prepare investors for a rate hike next year, and the Bank of Japan, surprise of extending its asset purchases from JPY60-70 trillion a year to JPY80 trillion.  

The euro fell to new cyclical lows not only as a result of the yen's pull, but also from the general pessimism of the outlook for the region.  The ECB is still thinking on too small of a scale to be truly persuasive, and Germany is as determined as ever not to have its pocket picked.  Indeed, domestic political concerns, particularly electoral gains of the AfD, may limit Merkel and Schaeuble's already restrained desire to compromise.   Moreover, the Greek government needs to cobble together a super-majority to pick a new president.  Failure to do so would force a snap election, and polls show the anti-EU Syriza party running ahead.  

There is little on the near-term event horizon that will significantly change the investment climate.   There is some talk that the  ECB could follow the BOJ and spring a surprise on investors. We suspect not.  However, Draghi will likely confirm that there are other assets, such as corporate bonds, and the ECB could purchase if needed.  Draghi argues that the impact of the ECB's unorthodox monetary policy is constrained by the lack of sufficient structural reforms on the government level.  

With the FOMC statement acknowledging the improvement in the labor market, they may have stolen much of the thunder from this week's jobs data.   Weekly jobless claims are making new lows.  In the first nine months of the year, the US economy grew a net 2.5 mln jobs.  Job growth has been remarkably steady.  The 3-month average is 224k, while the 24-month average is 229k.  

The outcome of the US mid-term elections is unlikely to be a mover of markets. The Republicans are favored to extend their majority in the House of Representatives and take a razor-slim lead in the Senate. It will though provide a sense of who the key players will be in next year's fiscal drama in which the debt ceiling and sequester issues return.  Two other controversial acts come up for renewal next year:  the Export-Import Bank and the Highway Trust Fund, which funds the construction of an important part of the US infrastructure.  

While the ECB and the Reserve Bank of Australia meet next week, neither is expected to do anything, and last week's moves by the Bank of Japan may overshadow modest tweaks in the official language.   It terms of its asset purchases; the ECB has chosen a course that puts it in action immediately, but slowly.  With some economic data stabilizing, and the launch of the ABS purchase program in November, there is not immediate need to unveil new initiatives.  

The Reserve Bank of Australia is also under no compulsion to adjust monetary policy.  It has been saying that monetary policy was on hold for an "extended period" for some time, it is vulnerable to being tweaked.   The RBA would prefer if the policy was eased through a depreciating currency. The Australian dollar is the only major currency that appreciated against the US dollar in the month of October.  Between the statement following the RBA meeting and the Monetary Policy Statement proper at the end of the week, a call for a weaker currency should be anticipated.  

The Bank of England meets.  It is widely anticipated to stand pat, and if so, it will not issue a statement.  The combination of an economy losing some earlier momentum (which should be confirmed in this week's PMIs), easing inflation and negative real wage growth has seen the market push out rate hike expectations.  

Japan delivered not one but two shocks at the end of last week:  The BOJ's moved to expand its asset purchase program and a dramatic shift in the government's largest pension fund (GPIF, AUM ~JPY127 trillion or ~$1.14 trillion) allocation was announced Although officials have tried playing down the interconnection, but they need to be understood together.  

The increase of BOJ JGB purchases (~JPY30 trillion a year) largely, but not completely, offsets the amount of bonds GPIF is expected to sell as part of the more aggressive shift in its portfolio than expected.    Moreover,  other pension funds are likely to duplicate the GPIF strategy.   Already, before the doubling of GIPF's allocation to domestic equities was officially announced, Japanese trust banks, operating on behalf of pensions, aggressively stepped up their purchases of Japanese shares.  Reports indicate that after buying JPY79 bln of Japanese equities in September, the trust banks bought JPY543 bln in the first three weeks of October.  

The BOJ itself tripled the amount of equities it will buy to JPY3 trillion.  It will focus on the JPX-Nikkei 400, which includes companies that embrace Abenomics and the return on equity.  In addition to this ETF, the BOJ will increase its REITs purchases too. 

Perhaps more controversial, and also an unspoken driver of the yen's near free-fall before the weekend, was GPIF's decision to double its allocation of international equities (from 12% to 25%).   It also will increase the share going into international bonds (from 11% to 15%).   This amounts to something on the magnitude of $152 bln purchases of foreign  stocks and bonds.   

The extent to which the QE created funds leak out of Japan can be debated.  The diversification of its portfolio will require GIPF to sell yen and buy foreign currencies is unambiguous.  More than two-thirds of the MSCI World Index is accounted for by three countries, the US, the UK and France.  Whatever benchmark GPIF will use, it is unlikely to be significantly different than the MSCI benchmark which covers about 85% of the free-float adjusted market capitalization of 23 developed countries.

Some journalists, like Ambrose Evans-Pritchard of the UK's Telegraph and Michael Casey of the Wall Street Journal, have already claimed this to be a shot in the currency wars.   Casey focuses exclusively on the BOJ activity and does not even mention GPIF.  Evans-Pritchard spends most of his time talking about the bearish yen implications of the increased BOJ purchases, and mentions GPIF only at the very end of the his essay, and even then to dismiss it as "a clever way for Japan to intervene in the currency markets to hold down the yen."  

Why hasn't the world responded to the more than 30% depreciation of the yen under Abenomics?  Casey warns us it is just a matter of time, but offers no explanation for why, as he recognizes, that "the biggest players in the global monetary system have mostly resisted direct tit-for-tat responses to Japan’s yen-weakening moves over the past two years."  Evans-Pritchard suggests that the  QQE was launched when the yen was terribly over-valued, but this time it is not.

Casey and Evans-Pritchard are well versed in economic theory.  A weaker currency is supposed to boost exports, and squeeze Japan's competitors.  In practice, the situation is considerably more complex.  Japanese companies do not appear to be using the weaker yen to gain market share as economic theory would suggest. Indeed, Casey's colleague at the Wall Street Journal, Takashi Nakamichi noted at the end of July, "[Japan's] export volumes have hardly budged. Many manufacturers opted to keep their export prices little changed to enjoy inflated foreign earnings". 

In September, the most recent data available, China's exports were up over 15% on a year-over-year basis.  Despite the pressure on the yen-yuan rate that Evans-Pritchard notes, it is hard to make a case that the weakening yen has sapped Chinese exports.   Both Casey and Evans-Pritchard cite South Korea as another victim of Japan's attempt to drive the yen lower.  South Korean exports were up nearly 7% in the year through September over the comparable period in 2013.       Moreover, we note that in both of this year's US Treasury reports on foreign exchange and the international economy, South Korea was cited for not permitting more currency adjustment.  The OECD measures of purchasing power parity have the won some 25%.

In market lore, Japanese postal savings, like Kampo, was thought to time its purchases and sale of foreign currencies to assist MOF objectives. The long-discussed changes to the allocation of the government's largest pension fund cannot be regarded as intervention, regardless of appearances.  Motivations matter.  The movement of assets out of low-yielding Japanese fixed income market is aimed at enhancing returns and addressing the looming pension challenge in the aging Japanese society.   Similarly, if Calpers, (California Public Employees Retirement System) changes its allocation to boost holdings foreign assets, it too is not intervention. 

That neither the expansion of QQE nor the diversification of Japanese pension money reaches the threshold of currency manipulation does not mean that Japan’s strategy will not face objections.   This more aggressive monetary policy stance, and augmented by the diversification of Japanese savings seems to be instead of the kind of structural reforms that will boost Japan’s growth potential.   The first arrow of Abenomics, fiscal stimulus, was blunted by the sales tax increase.  The third arrow of Abenomics, structural reforms, have largely disappointed local and international investors. 

Japanese policy makers have resorted to the easy course, relying ever more on the second arrow.  The BOJ’s new measures mean that it will be expanding its balance sheet about 1.4% of GDP a month.  This is around three times Fed’s QE pace.   And even with this, the BOJ cut its forecast for inflation  in FY15 to 1.7% from 1.9% and left its forecast for growth unchanged at 1.5%.  The world needs a stronger Japan, and it is not clear that Japan has found that path yet.