It's a central bank world--we just live (and invest) in it

04/09/2013 8:30 am EST


Jim Jubak

Founder and Editor,

Friday’s market action on the very weak U.S. jobs number—just 88,000 jobs created in March—put worries about U.S. economic growth on center stage.

At least in the short term.

What with earnings season highlighting companies’ growth for the first quarter and projected growth for the second quarter, and what with the Commerce Department set to release retail sales figures for March on April 12, I think it will be easy for the market to get caught up in growth worries and for the bulk of investors to start behaving as if growth were the most important issue facing the market.

Don’t go with the crowd. Recent numbers casting doubt on U.S. growth rates shouldn't be ignored, but they haven’t changed the basic forces driving global financial markets.

This is still the central banks’ game. And currencies—the relative price of the dollar, the euro, and the yen—are still the most important mechanism for transmitting messages from the central bank to the markets.

If I’m right and this remains the central banks’ game, I’m looking for a strengthening dollar (and a weakening yen and euro) to continue to put downward pressure on the price of oil, copper and other commodities—and to continue the rout in gold.

U.S. economic growth does figure into this equation since weaker than expected U.S. growth will temper the boost that the dollar might otherwise deliver to Japanese and U.S. equities. Decent growth in the U.S. economy is likely to give the current rally more room to run.

But growth is really a sidebar to the main story.

Which isn’t to say that the story hasn’t changed at all. Now it won’t be just the huge flood of cash from the central banks that sets the terms of market behavior—as it has for the last two years. Now the timing of individual central bank policies counts for as much as the net direction of those policies when it comes to determining the moves of individual global financial markets.

Right now the most important market “fact” is the increasing difference in timing between the U.S. Federal Reserve, on the one hand, and the Bank of Japan and the European Central Bank on the other.

The Fed has started to talk about cutting back on its monetary stimulus in 2013 and maybe even ending its monthly purchases of $85 billion a month in Treasuries ($45 billion) and mortgage-backed assets ($40 billion) by the end of the year. The Fed is still a long way from actually raising interest rates—Bernanke & Co. have pledged not to raise rates until unemployment falls to 6.5% or less and that looks like 2014 at the earliest and quite possibly 2015. But with rates effectively at 0%, the Federal Reserve isn’t going to be cutting rates either.

Contrast that to the Bank of Japan, which just week announced that it would double its current stimulus effort and buy $80 billion a month in bonds. That brings the Bank of Japan’s program of bond buying into rough equivalence to the Fed’s $85 billion a month—until you take account of the much smaller size of the Japanese economy. Japan’s $80 billion in bond buying, if you correct for that size difference, is equal to $279 billion a month in the U.S. economy. The effort will expand the Bank of Japan’s balance sheet by roughly 1% of GDP a month. In contrast the Fed’s massive program of bond buying expands the U.S. central bank’s balance sheet by 0.54% of GDP a month.

We’re talking a huge effort. Which is exactly what you’d expect from a central bank that is trying what may be Japan’s last chance to blast itself out of a long-term deflationary trend that, combined with the country’s rapidly aging population, will result in a steady decline of the standard of living in Japan.

Will it work in the long run? I hope so but I have my doubts. Severe doubts.

Massaki Shirakawa, who was replaced as governor of the Bank of Japan by Haruhiko Kuroda last month, has defended the central bank’s efforts to battle deflation by arguing that much of Japan’s deflation was structural. Globalization had produced lower price for Japanese consumers and companies—a process dubbed the Wal-Mart effect for its power to lower U.S. inflation. And deflation has gone on for so long in Japan that its now engrained in the minds of Japanese consumers and companies—everyone expects prices (and demand if you’re a corporate manager) to be lower tomorrow than today. And that influences buying decisions.

In the short-run the Bank of Japan’s new aggressive policy will produce a cheaper yen, which will make Japanese goods more competitive in global markets. Japanese companies will get a second boost to revenue and profits from the weak yen as revenue is translated back from strong dollars, yuan, and other currencies. I think this will lead to the yen falling to 102, or 105 or even 110 to the dollar. And I think it will continue the current rally in Japanese stocks. Many estimates of earnings for the first and second quarters of calendar 2013 are based on company estimates of 90 yen or so to the dollar. On Monday, April 8, the yen was at 98 to the dollar in early trading.

In the slightly longer but still short-run—let’s say 6 months or so—this policy threatens serious potential problems.

First, if the yen sinks fast enough and far enough it will lose its status as a global safe haven currency. Currently when some crisis threatens, in say, the EuroZone, money flows into the yen. It’s a deep and liquid market and the cost of borrowing yen is very low. But if the yen comes to be seen as a falling knife, forget about the currency as a safe haven and forget the bounce the yen gets whenever there is a crisis somewhere in the world. That means the yen will have fewer bounces to slow its decline.

Second, if the speed of that decline rises high enough or the dimensions of that decline get large enough some of Japan’s huge pool of domestic savings will start to move overseas. Buying a U.S. Treasury bond would only get more attractive to Japanese retail investors. That development would be extremely important because it’s the willingness of domestic Japanese savers to buy Japanese government bonds, despite almost invisible yields, that has enabled Japan to support the world’s highest debt burden as a percentage of GDP. If some of that money starts to flow overseas in search of better yields and a more stable currency, then Japan’s ability to self-fund its debt becomes an issue. Once doubts about self-funding start to rise, the momentum can easily get out of hand as credit rating companies and institutional investors jump on the band wagon.

Total effect: A weaker yen and a stronger dollar

Shift to the EuroZone and the picture isn’t as dire but the trend points in the same direction toward a weaker euro and a stronger dollar.

When the European Central Bank met last week, it left interest rates alone at 0.75%. But with economies across the EuroZone slowing into recession and that slower growth threatening to increase budget deficits above targets in Portugal, Greece, Italy, France, and Spain, the consensus is that the bank will move on rates at its June meeting. Data from Eurostat, the European Union’s statistics office, showed that unemployment in the EuroZone climbed to a record 12% in February. That’s up from 10.9% in February 2012. Unemployment in Greece reached 26.2% in February. Spain was actually somewhat worse at 26.3%. Portugal somewhat better at 17.5%.

The political imperative to throw EuroZone economies an interest rate cut seems to be building too. The government of Francois Hollande in France is reeling. Portugal’s government has just faced a vote of no confidence. Italy looks headed to a new round of elections that don’t hold much more promise of a government than the last round.

Central bank interest rates in the EuroZone are the highest among developed economies. An interest rate cut seems a given.

Which is one reason that the euro has been falling against the dollar. Remember that the Federal Reserve is closer to raising rates than cutting them again so any interest rate cut from the European Central Bank will close the gap between U.S. and European interest rates that has helped sustain the euro.

In addition, the brave talk from the European Central Bank of just a few weeks ago that the bank would be able to reduce the size of its balance sheet now looks like wishful thinking. Post-Cyprus the projections are that the EuroZone and the central bank will have to fund more bank bailouts rather than fewer and that rescue programs for countries such as Greece will need yet more funds.

The European Central Bank is also the only game in town until September’s elections in Germany. German Chancellor Angela Merkel isn’t likely to put more taxpayer money at risk in a bailout—in that sense the Cyprus debacle is a template for deals in the near term—and her government isn’t likely to muster the huge energy that would be needed to advance projects such as European deposit insurance in the absence of domestic enthusiasm and the lack of effective partners in France, Italy, or Spain.

The pattern in the euro debt crisis has been that the embattled currency has been able to rely on press releases trumpeting big EuroZone reforms in order to stage periodic rallies. Those seem likely to be in short supply through September.

Total effect: A weaker euro and a stronger dollar.

You’re entitled to ask how the U.S. dollar can possibly strengthen against any currency given all the political and economic problems faced by the United States. My answer, again, is that in the short to medium run a currency doesn’t have to be a good currency. Better than the alternative currencies is enough. In the longer run the genuine absolute weakness of the U.S. dollar is moving the world financial system faster than it might otherwise move. China is signing more bilateral financial agreements such as last week’s deal with Australia that allows the two countries to settle their trade accounts in renminbi. But the Chinese currency is still years away from providing a global replacement for the U.S. dollar. (And it may never reach that goal given the very real problems in China’s own economy.)

So in the short term the world is stuck with the U.S. dollar and in the short term financial markets are stuck with an appreciating dollar.

Which isn’t exactly good news for the price of any commodity that trades in dollars—such as oil and gold. When the dollar is strong, it takes fewer dollars to buy a barrel of oil, an ounce of gold, a pound of copper, or a ton of iron ore. That drives down the market price—in dollars—of these commodities and of the shares of the companies that produce them.

In another global economy the world might be generating enough growth to make up for the strength of the dollar and, for example, the price of oil and oil stocks would be rising on increased demand. But this isn’t that economy—see my April 5 post for more on the supply demand problems in the commodity sector—and I don’t think we can count on economic growth to make up for an appreciating dollar. That’s especially the case in commodity sectors where costs are rising—as in most of the Australia’s mining industry—and where costs are frequently denominated in U.S. dollars.

If you’re wondering when the decline in gold or oil or coal or any other commodity might be about to end, the strength of the dollar is another reason to think the pain could still have months to run.

Not forever, in other words. But long enough to hurt.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own positions in any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at
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