It seems like forever ago, when central bankers were at the height of their powers. Back when Draghi could save the EU from the depths of destruction with a single phrase and Kuroda could devalue the Yen at will. But alas, those days are over.
The truth is, since 2011, the primary force in the world has been deflation not inflation. The central banks of the world were fighting not just a losing battle but a losing war of attrition. In essence, they were doomed to fail, and now that the BoJ and the ECB are out of ammo, the deflationary forces will crash their respective economies.
To make matters worse, people actually believed the BoJ and the ECB would actually win. Which is why there are such large short positions in the Euro and Yen. But now these short positions are blowing up as the currencies rally on top of a crashing economy.
Over the coming months the word “contained” will be thrown around a lot. Despite what central bankers would have you believe, nothing is contained. The markets are all connected and levered up more times than anyone can possibly conceive. Never in history have our markets been so interconnected and at the same time so fragile.
It’s why a sell off in US equities can lead to a fall in the dollar, a rise in the yen and a drop in the Nikkei, which leads to further a rise in the Yen and another drop in US equities. There are deadly feedback loops in place to guarantee the shock waves are NOT contained.
I’m not saying the game is over just yet, but we are moving to the final stage. Draghi and Kuroda are not likely to go down without a fight. Which means, more NIRP and maybe threats of more QE, but the world doesn’t need Yen or Euros. It needs dollars. Any of the BoJ’s or ECB’s attempts to stabilize their economies without the Fed’s help is a moot point.
Which brings me to Janet Yellen. Before the Fed’s last meeting in January, I discussed the market’s dire need for more dollar liquidity (QE4), but the Fed didn’t listen. They kept their hawkish bias and betrayed their ignorance all at once.
For whatever reason, the Fed wants to keep tightening. Now I will bring up the fact that a strong dollar is good for Europe and Japan, our two allies, and bad for China, our enemy.
Maybe it’s not that simple, but I think Yellen is missing the point that, as bad as the ECB and the BoJ need a stronger dollar, the rest of the world needs a much weaker dollar. In order to accomplish that, we’d need to see massive additional easing programs from the BoJ, ECB, and Fed simultaneously. That way, the EURO and YEN still fall or maintain their current position against the dollar at the same time the global markets are flooded with cheap dollars to artificially inflate demand.
I don’t know if that’s going to happen. I don’t think Yellen and the Fed truly understand the magnitude of the situation. And even if they wanted to launch QE4, the US government is in no shape to run a massive deficit in Obama’s last term. Politically that is a very ugly situation, which leads me to believe, barring a 50% draw down in the US stock market and or a systemic global banking system collapse we won’t see QE4 till 2017.
Which means the Fed is left with negative rates. But as some people have pointed out, negative rates may not be possible, with the addition of the reverse repo facility and the Fed’s own laws. Perhaps the Fed is aware of how little ammunition they have left and that is exactly why they are hiking.
Which leaves the Fed pretty empty on ammo for the rest of the year as well. The only way they get more ammo is to make it themselves via rate hikes. With the Euro and the Yen much stronger the Fed has the leeway to continue with its hiking cycle and build itself some more ammunition. Thus the market may get a rather rude surprise tomorrow when Yellen comes out on the hawkish side.