The Bank of Japan Fires a Pop-Gun
By The Daily Reckoning Australia | January 26, 2013 2:24 PM EST
Question: Who wins a currency war?
Answer: Those holding the currency not involved.
And there's only one currency that's not involved in the escalating currency wars. That currency is gold. So why is it continuing to lounge around, pretending that nothing is happening? We have a few ideas on that, but first let's look at the latest happenings in the currency war saga.
So what did the pop entail? We've become so accustomed to Japanese stimulus announcements we really don't know what this latest effort means. So let's break it down.
OK, so the BOJ has now officially adopted a 2% inflation target and committed to open ended asset purchases to make it happen. Sounds impressive, but what does that entail?
Well, it has committed to buy around ¥13 trillion (about US$150 billion) in Japanese government bonds (JGBs) and treasury bills EACH MONTH until it reaches the 2% target. But the purchases are aimed mostly at the short end of the yield curve, with targeted monthly purchase of ¥2 trillion in JGBs (longer term bonds) and ¥10 trillion in shorter term treasury bills.
Lest you think this is economic madness even beyond the Fed's idiocy, the BOJ and Japanese government have it covered. We found this statement in the press release TWICE:
Taking into consideration that it will take considerable time before the effects of monetary policy permeate the economy, the Bank will ascertain whether there is any significant risk to the sustainability of economic growth, including from the accumulation of financial imbalances.
But the BOJ is right about one thing...it will take time. They do not plan to get this insanity underway until January next year, a timeframe that clearly disappointed a market which has rallied for weeks on expectations of Japanese monetary largesse.
That is, the falling yen vis-à-vis the Aussie represents short term speculative Japanese funds moving into the Aussie market. As you can see the weakness in the yen (or strength in the Aussie) has been much more impressive than the market, but still, the correlation is obvious.
But now, it looks like the yen might be due for a rally, especially given the weak announcement from the BOJ. This could be negative for the market over the next few weeks. And check out this article, which says there is nothing to be worried about. Time to get bearish?
Click here to enlarge
Anyway, let's just ignore for a moment the short term market reaction to the announcement and think about the mechanics of what is actually going on. The Bank of Japan's targeting of the short term treasury bills market seems weird.
Quantitative easing is all about changing the market's liquidity structure. Creating 'overnight money' (cash) and buying government bonds with the proceeds simply takes a longer term security out of the market (because it moves to the CB balance sheet) and replaces it with cash.
Treasury bills are pretty much an accepted form of cash in modern monetary markets so buying this cash substitute with 'new' cash seems like a strange way to generate inflation.
Perhaps it's the BOJ's way of delivering the government the action it wanted without being as hardcore as the government wished. But that seems like a long shot. More likely it's a way of holding the short end of the yield curve down, keeping the cost of money low while hoping inflation kicks in.
Whatever. What's interesting to think about is what happens if Japan is actually successful and they hit their 2% inflation target? The JGB market, the largest capital market in the world with about 1 quadrillion yen in bonds outstanding (that's not a typo), enjoys the lowest interest rates in the world. It costs the Japanese government around 0.75% to borrow for ten years. How they maintain this advantage with a 2% inflation rate is anyone's guess. Our guess is that they won't and their interest expense will jump sharply.
And when your interest expense on 1 quadrillion in debt outstanding doubles, it is game over.
The BOJ can't buy enough bonds to muffle the impact of the jump in expenses. When you have to print just to pay your interest bill, it really is the end of the road. That's because it's different from actual debt monetisation, which is what they are practising now. When you monetise debt, you buy an asset from the private sector (usually banks) and create cash in return. That cash takes the form of an increase in bank reserves.
But when you have to print to pay your interest bill, what do you do? The BOJ will have to buy JGB's not from the private sector, but directly from the government itself. When the market sees this happening (and it looks like it will sometime around 2015 based on this latest announcement) then the private market will DUMP that quadrillion yen hoard onto the BOJ so fast they will barely have time to utter the word hyperinflation.
Which is probably why you saw a rush to take out some insurance in the last few weeks. As you can see in the chart below, gold priced in yen just broke out to a new high. Not an all-time high though, gold in yen is yet to break-through its 1980 super-spike peak. But still, the yen-based gold bull market is alive and well. And as more and more Japanese investors get their heads around the calamity that awaits the JGB market, it could be the most bullish thing for gold yet.
But all in good time. For the moment, this gold bull market is taking its sweet time in most other currencies. We were going to go into some reasons for that, but the more we think about it the more complex the explanations become. It's a story for another day.
In the meantime, watch and wait for Japan's coming hyperinflation. It looks like becoming the first major industrialised economy since Germany's Weimar republic to experience a complete monetary breakdown.
for The Daily Reckoning Australia
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