After Friday’s rallies in world equity markets yesterday came as something of an about-face. The Dow Jones Industrial Average fell some 140 points to lose nearly all of Friday’s gains. The feeling of well-being engendered by better than expected US growth figures and a relatively optimistic speech by Ben Bernanke does not appear to have lasted for long. I guess as I pointed out yesterday markets started to think of the implications for the future of the US economy in the trend for GDP figures who have gone 5%,3.7% and now 1.6%. Perhaps also they began to wonder about the limit to the powers of the Federal Reserve and the four options outlined by Mr. Bernanke. After all he has deployed the resources of the Federal Reserve to the order of US $1.3 trillion and cut rates to just over zero and yet we still face a situation where the US economy is plainly slowing.
Personally as time passes and more perspective is gained I feel that option 2 as described by Mr. Bernanke actually looks rather unwise to say the least. “Better communication” is likely to be of no use when it is communication about the Fed. keeping rates lower for longer. After all if markets have not taken that on board with the rush to reduce US government bond yields along the maturity spectrum I do not know what they have been doing recently. The US two-year government bond yield is 0.5% and the five-year is 1.37% so really option two is already in the markets.
US Personal Income and Personal Consumption
These figures give us in one sense a clear signal about the state of the US economy and that is how many people are interested in them this time around! Over the years they have been issued to a fair bit of indifference whereas now they are much more widely debated and analysed, and this is because every little rune and signal from the US economy is being poured over to try to find out where it is going. The actual numbers themselves showed personal income rising by 0.2% which was less than expected and also less than personal consumption which rose by 0.4%. So spending rising at a faster rate than incomes at a time the economy is slowing is not entirely reassuring if you think through the likely implications. The savings rate which has improved since the credit crunch dipped back to 5.9%. So not inspiring figures but not in themselves enough to cause the equity market drop on the scale that occurred, in my view.
The Japanese economic and indeed cultural problem
After the turnaround in US equities one might reasonably have expected falls in Japanese equities too overnight, particularly as I recorded yesterday that the initial response to the so-called policy easing by the Bank of Japan had been for markets to push the Yen higher against both the US dollar and the Euro. However there were in fact quite substantial falls with the Japanese Nikkei 225 index falling some 325 points to 8824 which is 3.55% and the wider Topix index fell by 2.96%. So in spite of a solid fall in the Dow Jones the spread between the two indices widened substantially again to 1185 points which is 13.4% of the value of the Nikkei. This is a large relative underperformance and leaves the Nikkei solidly in bear market territory if you use the definition of a 20% drop being the boundary.
There are two main problems in Japan in terms of official economic policy. The first is that most if not all policy options have been tried. The second is that the Bank of Japan is usually at loggerheads with the government. So political pressure builds up from time to time on the central bank which in my view responds with a policy move which involves as little as it can get away with. This is why I called Monday’s move a so-called policy easing as it is a new variation on a scheme introduced last November which has already been expanded once and has shown no real signs of helping Japan’s economic problems. The government is invariably cautious about using fiscal policy because the size of the national debt in gross terms is over 200% of GDP and looks on its way to 250% by the middle of this decade. Just to add to the caution about fiscal policy the new government of Mr.Kan had set reducing the deficit and the national debt as a main policy goal. Rather unfortunate timing for him as I am sure the contradiction between policy and possible reality has contributed to the leadership challenge he is suffering from.
I wrote last week that I felt it would be better if the Japanese authorities stayed out of any intervention for a while to see if markets settled down. In the end pressure for action led to the move on Monday which so far has made things worse. Against the Euro the exchange rate has moved back towards the recent highs and is now at 106.86 whilst against the US dollar it is at 84.29. At least they did not make the mistake of foreign currency intervention but I guess that needs the caveat of so far. This morning the Ministry of Finance is suggesting that Japan could have an inflation target and that the Bank of Japan could cut rates to zero. I would forgive the Governor of the Bank of Japan if he bashed his head against the wall at this point as his institution has been battling Japan’s deflation and disinflation for years and interest rates are at 0.1% so the gain would be 0.1%. What is needed is new ideas and not headline grabbing.
Whilst all this is going on Japan’s population is ageing and her national debt is rising so these two trends are pointing towards insolvency. Now this is a slow-moving influence but in a country where the lost decade has now extended into two lost decades a lot of ground has already been lost. I was reading a report recently which pointed out that even in the relatively good years in this period Japan’s fiscal position has declined. Her government bond market has yields which are domestically driven due to Japan’s high savings rate and are as low as they are partly because Japan’s disinflation means that real yields exceed nominal ones for the domestic buyer. But even so an interest rate of 1.7% on a thirty-year government bond is completely mispriced in my view if you look at a thirty-year timescale and likely economic events for Japan. It is by no means inconceivable that she could be forced into some sort of default over this period if current rends persist and remember many of these pre-date the credit crunch. It is tempting to add the level of disinflation to the nominal yield to raise the real yield but I doubt even Japan can keep that up for thirty years without some sort of economic collapse. In some ways Japan resembles a dam which is starting to creak under pressure. From the other side of the dam there is no problem until it goes but then you get flooded and probably drowned whereas a second before you were dry. Yet to an engineer there would have been signs and signals.
The Swiss Franc and Hungary’s problems
Looking at the strength of the Japanese Yen has made me think of her twin the Swiss Franc. She too is surging as a currency and all of the problems for Switzerland and her central bank are back again to say nothing of the economic woe this rise will cause in Eastern Europe and particularly Hungary as they borrowed in Swiss Francs on a large-scale. Today the Swiss Franc has rallied to 1.292 versus the Euro a new high for a currency which was steady at just over 1.5 a year ago.
The implications of this are bad enough for Switzerland who finds herself saddled with an uncompetitive exchange rate. They are even worse for the Swiss National Bank which has spent much of this year intervening to try to stop this rise. Before this recent further rally the SNB was estimated to be sitting on losses of 7.5 billion Euros because of this failed intervention and these are mounting as I type.
Hungary and Eastern Europe
Many countries in Eastern Europe borrowed in Swiss Francs and I wrote about the problems caused by this on the 10th June and the 19th July . They did so because the interest rate cost was lower in many cases much lower, but the risk is that the currency you borrowed then rises. To look at the numbers and concentrating on Hungary where this was and is a big factor some 1.7 million mortgages were taken out in Swiss Francs and the total sum borrowed is estimated at around half of her GDP. At the opening of this year the exchange rate between the Hungarian Forint and the Swiss Franc was 182 and right now it is 222 for an increase of 22% in eight months. Imagine that being applied to your mortgage debt and I hope everyone gets the idea of the economic drag this situation is likely to cause if it persists.
So bad for Eastern Europe’s economies and also bad for the banks in the euro zone which loaned the money. Shareholders in the banks who loaned this money may well be getting nervous and as ever we come back to the state of Europe’s banks. Officially according to the stress tests they are fine, unofficially problems continue.
The International Monetary Fund
The IMF has announced a “Crisis Prevention Toolkit”. Of course the title suggests something which might more usefully have been applied some four or five years ago rather than now! In a nutshell it has extended its Flexible Credit Line and created a new Precautionary Credit Line for those who do not qualify for the FCL.This leads me to a reply I made to a question about the Triffin Dilemma yesterday. The work of Mr.Triffin led to the existence of Special Drawing Rights and laid the bedrock for an expansion in the role of the IMF.
The second is that his work led to the construction of Special Drawing Rights at the IMF, it is not clear to me that they have turned out to be an improvement as they are in effect a creation of fiat money but by who? Put this another way do we have the right number of SDRs?
If we put aside for a moment the question of whether the world economy has ever been in equilibrium and remain with the IMF.It’s role is expanding and yet whose voters elected it? Personally I would question its authority as it is too easy for usually weak politicians to encourage or allow it to create yet more fiat money. I think Quis custodiet ipsos custodes is relevant here.