June Hike? Things to Consider

It seems like so much has happened since the beginning of the year, where everyone in the world including the guys on CNBC were worried about China, falling oil prices, a surging dollar, widening US credit spreads, a slowing US economy, and global equities which were crashing like it was 2008.

Central bankers watched the event like bystanders observing a car crash in slow motion. The BOJ tried to step in with NIRP and was immediately slaughtered. Eventually the Fed, the only central bank with a reasonable amount of credibility left, stepped in and through forward guidance, they forced the dollar down.

And just like that, the storm cleared. The clouds parted. The fear that gripped the world vanished in an instant. Much like surviving a near death experience floods the brain with endorphins, the global economy has been riding a similar chemical induced high.

Energy prices were at decade low levels. The dollar fell from a multi decade high. China launched its largest stimulus program since 2009. Emerging Markets were rebounding off very low and beaten bases. Add all these things together and it’s not hard to explain the subsequent and historic rally.

On the surface of the global economy things appear so good that the Fed is desperately trying to hike interest rates and if we dig a little deeper we can see why the Fed is desperate to hike interest rates.

With over 600 rate cuts world wide since 2008, negative interest rates bogging down Europe, and sub 2% on the US 10 yr, inflation just might be the most mispriced indicator in markets today.

Funds are flowing out of the US stock market and flowing into the bond market, and yet rates won’t go lower and the stock market won’t fall. This is incredibly vexing and not just to me.

Druckenmiller, Gundlach, Icahn, the line of financial titans commanding the stock market to go down is almost as long as the market is tall. And I don’t disagree with them. I think this stock market should fall, especially given the state of the economy. I also think bond yields should fall but these are longer term objectives.

In the short term, inflation has rebounded from a very low base. Lumber, Corn, Sugar, Oil, Gold, Silver, Soy Beans, Lean Hogs, Coffee the list of commodities that have bottomed in the last 12 months is quite long.

The world is dealing with a very powerful and potentially destabilizing inflationary pulse. Western bond markets are not accounting for any sign of inflation whatsoever. This is why the Fed feels compelled to act, even if it means risking a stronger dollar.

In the US inflationary pressures are rising. The bottom in commodity prices in early Q1, higher rents, and rising medical costs will only add more stress on a very strained US consumer. To make matters worse, corporate profits have been in decline and in order to prevent them from falling even further corporations can either reduce costs, ie. fire workers, or raise prices.

Job gains have been slowing, and I expect this trend to continue if not accelerate as we reach the end of the year. Retail sales should also deteriorate as inflation accelerates and consumers have less money to spend, or at the very least we should see an acceleration of credit card debt.

Despite all this, I still believe in the short term (2-5 months) the US stock market could actually head higher, and break to new all time highs as the dollar strengthens and external shocks remain hidden from view. But of course a lot of this depends on the inflationary pressures, investor psychology and the dollar which all of course take their queues from the Fed.

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So before the Fed decides whether or not to hike interest rates here are some things to consider.

Will the impact of this rate hike be the same as the previous one? Or will it be more like the Fed’s tapering of its QE program where the first was the hardest but each subsequent reduction went practically unnoticed.

My thoughts on this are somewhat mixed. China’s Q1 stimulus wore off quite quickly. Most of the credit did not find its way into the real economy. This indicates that stimulus in China is no longer effective. That doesn’t mean they won’t turn on the taps again, but it does imply that China is not ready for tighter monetary conditions.

Structural reforms are slowly being implemented and China needs a smooth runway to continue down this path. A Fed rate hike COULD be the equivalent of a crashed jumbo jet burning on the center of the runway. In this case, China would be forced to unleash another massive stimulus package to clear the burning wreckage.

Now a counter argument, is that the PBOC has been successful in devaluing the Yuan to 5 year lows. usdcny20fixing205-30

The slow and steady devaluation of the Yuan has gone unnoticed by global markets so far.

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This has occurred on the back of rising stock markets and a strengthening US dollar. Unless there is an outside shock, I think both the dollar and US equities are going to be headed higher as a result.

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It should be important to note that a stronger dollar AND a weaker Yuan translate into deflationary forces. The Dow Jones Commodity Index his a multi decade low to start the year.

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There are a few ways to look at this. If you think that central banks have delayed an inevitable deleveraging then this can effectively be seen as a lower low in a deflationary cycle that has not yet finished. Thus sometime after this significant bounce, commodities will eventually head even lower.

The alternative is that commodity prices have indeed bottomed, and we should expect prices to continue to rise going forward. It seems less likely that this will occur now because the Fed will be forced to hike interest rates to combat the inflationary pressures that result from this bottom in commodity prices.

At the very least the short end of the treasury curve should get annihilated over the next few months as inflation rises and the Fed promises further rate hikes. I expect the long end of the curve to sell off a little bit as well, although rate hikes actually bring down long term inflation and will flatten the yield curve into a pancake run over by a steam roller.

I’m going to stop it here for now. My articles are getting longer than expected. I will try and make further posts more frequent and succinct, but as I’m am headed to Iceland for the entire month of June, like the Fed I will be forced to delay any short term adjustments.

IF there’s anything to take away from this post it is that the Fed is walking on an increasingly narrow tight rope. It will be incredibly difficult to placate both China and inflation. The former is not ready for tighter monetary conditions and the latter has not been priced into any developed bond market around the world. A stronger dollar combined with rising inflationary pressures could provide a temporary boom for the US stock market but not the US economy which I expect to be on its last legs. But remember, the higher we go, the risks to the downside will only increase.

 

 

 

The Magician’s Last Trick

The spotlight too bright,
The magician lost his sight,
Forced only to hear.
The shuffling feet betray their fear.
They head for the door,
Fully aware of what’s beneath the floor.
The bomb goes tick tick tick.
The desperate magician promises one last trick.
Drenched in sweat, shivering in fear,
The magician hears the crowd draw near.
The audience watching silent as the night,
The magician sets himself alight.

FOMC Tea Leaves: The Price Is Right?

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I find interpretations of FOMC minutes to always be an interesting affair. Like a Rorschach test for the financial community, interpretations of FOMC minutes can reveal more about the observer than the FOMC themselves.

I myself have been skeptical of the supposed power of “The Magic People” affectionately known as central bankers. And I suspect that even some of the Fed officials believe that this expansion is on its last legs. It’s why I’ve long held the belief that the Fed has desired since early 2015 to begin a tightening cycle but has been hamstrung by consistently disappointing data.

My fellow skeptics would happily tell them that this is what happens late in a cycle. The data continues to deteriorate until we hit a recession or worse.

Unfortunately, the members of the FOMC have no use for cycles in their forecasts. Apparently they wake up and go to sleep with the sun locked in the exact same spot in the sky ever day. Winter spring, summer, fall, these have no impact on modern financial markets which are completely detached from all things in nature.

But that’s beside the point. The Fed once again appears to be testing the waters. Two Fed governors (who have no say in rate hikes) came out the day prior and floated the possibility of a June rate hike. Then the FOMC minutes come out and you can see the desperation in their language.

I haven’t been reading these long and, I’m only got 30% of the way through Maestro before I misplaced my kindle last week, but this set of FOMC minutes feels like a shotgun blast to the face.

Almost every major macro concern from the freaking Puerto Rican debt crisis to China to US consumer spending to the accuracy of their own GDP calculations and finally to the market’s misinterpretation of the March minutes. They seemed very hurt by that last one. After all how could anyone misinterpret such a transparent and clear piece of communication.

Not lost in the barrage of pellets is the Fed’s desire FOR THE MARKET TO PRICE IN A RATE HIKE. Out of fear that the bold and underline may not be enough for that last bit to be interpreted as important I will state it again so that there is no March minutes style misinterpretation. The Fed wants the market to price in a rate hike.

The Fed wanted to maintain complete flexibility and at the same time communicate to markets that it should price in a rate hike. If the price is right they will hike.

My guess though, is the price will not be right. China devalued the Yuan this morning. The dollar surged even harder dragging commodities and inflation with it. Although the market’s initial reaction was a steeper yield curve, as I said back in December, a rate hike flattens the yield curve by dragging down long term inflation expectations while raising short term rates.

This is bad for banks which is bad for credit and since we live in a credit fueled world, it is bad for growth, which by the way according to the guys at Hedgeye are suggesting that Q2 GDP growth will be sub 1%. They have been much more accurate AND precise when it comes to GDP tracking than the Atlanta Fed whose Q1 GDP tracker ranged from 2.2% to 0.1%, and now is forecasting an unbelievable 2.8% for Q2.

With sub 1% GDP growth, rising jobless claims, slowing employment growth, declining retail sales, a rising dollar, and Chinese warning signs I find it very difficult to believe that the Fed will hike in June. These minutes were the Fed’s attempt to understand  how cornered they are. The market of course ran with it and perhaps in June the Fed will be talking about how the markets once again misinterpreted the Fed’s true intentions. Time will tell.

 

Bulls on a Tightrope

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Countless times have I stated that global leaders are operating on a very thin tightrope. The risks should they fall are asymmetric to the downside. But just because the odds are against them, doesn’t mean they will fail.

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I believe there exists a very particular albeit unlikely set of circumstances that could stabilize the global economy for the rest of the year. With market participants expecting a significant correction sooner rather than later (myself included in this group), this particular set of circumstances could be a nightmare for people like us.

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What are these “circumstances”? Well they certainly aren’t highly attuned reflexes, expert krav maga technique, next level marksmanship, in-depth knowledge of the criminal underworld and sheer determination to save his only child from the Albania mafia.

I believe that the world economy could stabilize if the following conditions are met:

  1. The Yen and Euro weaken against the dollar.
  2. The dollar weakens against commodities and EM currencies.
  3. Emerging markets rebound accelerates into sustainable growth.
  4. The US economy stabilizes on the back of a weaker dollar.
  5. China continues to delay any real adjustment.

As you can tell, a lot of this scenario depends on what the dollar does. The dollar has to strengthen against the Yen and the Euro to prevent a deflationary spiral from consuming their respective economies. At the same time the dollar must weaken against emerging market currencies to prevent a further unwind of the $9 trillion dollar denominated carry trade and a rebound in commodity prices as well as an deceleration of capital outflows from China.

So how does this actually happen?

Since mid 2014, the global economy has been over shadowed by the effects of a rapidly rising dollar.

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Commodities were pummeled taking emerging markets down with them. US growth slowed as credit conditions tightened and the strong dollar dragged down corporate earnings. China struggled under its debt and continued to slow down in the face of expanding credit growth. None of these events are positive for growth going forward.

However, a lot has changed. Since late January of this year, the dollar has fallen back to mid 2015 levels, allowing for a loosening of global liquidity and return to growth in emerging markets. As emerging markets rebound, we could see an increase in global demand. The result of which would be higher commodity prices. Higher commodity prices could alleviate stresses and deflationary pressures in China.

Most importantly, oil may rebound as well off the back of higher emerging market demand, large production cuts from inefficient producers and supply disruptions from various nations. Thus the seemingly mortal blow that oil producers thought was once dealt may now be finally healing leading to high paying job growth in the US and greater dollar liquidity as more petrodollars flow through the system.

As hinted above, the impacts for the US could be quite huge. With a weaker dollar, the US can export more to higher demanding EMs. The weaker dollar would also give US corporations a breather and perhaps stabilize the recent descent of earnings which peaked last year.

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With growth stabilizing in the US, the dollar could strengthen against the EU and Japan while their NIRP and QE policies continue to weaken their currencies. As I suggested in a previous article Japan may also increase its fiscal deficit allowing the BOJ to monetize this extra debt, which would help dispel rumors that the BOJ is running out of bonds to buy. This could also lead to a pick up in demand for Japan and perhaps finally with the help of higher commodity prices lead to the first real signs of inflation in decades.

The big themes here are higher commodity prices. Stronger EM economies and currencies. Weaker Yen and Euro. Stronger than expected US growth. All of these positions have rallied significantly off the February lows which makes going long any of them considerably less sexy. With everyone on oneside of the boat, one year call options on the S&P are quite cheap and offer an interesting way to play such a scenario. The market is certainly not anticipating this bullish scenario which makes it cheap and perhaps necessary to account for in a portfolio as bearish as mine.

My portfolio consists of the following positions (in order of size):

  • LONG – precious metals and their miners
  • LONG – cash (in dollars)
  • LONG – US treasuries
  • SHORT – US equities
  • LONG – A specific Uranium exploration company (NXE.cve)
  • LONG – Lithium miners
  • SHORT – Canadian Banks

It’s a simple portfolio that has worked quite well this year. I like to take the Stan Druckenmiller approach of putting a lot of eggs in one basket and watch that basket very closely.

I don’t have the luxury of 50 analysts and another 50 hedge fund managers and another 50 research firms that I can call at a moment’s notice to get their opinion on intimate details about specific economies around the globe. Neither do I have a Bloomberg terminal to get specific information on every little economic detail at the press of the button although I find their website sufficient.

The point is, I don’t the technical knowledge or access that the big guys do. I like to keep things simple, identify major trends, position myself early and wait. The bull case I outlined here is something of an unexpected surprise that may last 12-18 months and at the same time decimate most of the holdings in my portfolio.

Higher than expected inflation would kill my long us treasury and cash positions. Higher than expected EM demand coupled with a re-surging US economy would kill my short US equities and Canadian banks positions. Hard to say what would happen to gold, but if fears of a global recession faded the price of the yellow metal could take a heavy hit.

Needless to say, in a 6 months my portfolio could go from looking near genius to incomprehensibly stupid, and that is exactly why I decided to discuss the bull case today. Fear is a powerful motivator, and one should never be fully comfortable with their positions.

There you have it. A bull case for growth. That wasn’t hard. Now it’s time to rip it to shreds.

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If the Euro and Yen do not weaken against the dollar then their banking systems will be destroyed by the deadly cocktail of deflation, NIRP, a flat yield curve and over regulation. The EU aka Germany for better or worse will not allow on an expansion of fiscal deficits which could temporarily help stabilize the currency bloc via the expansion of more credit. Without the ability to generate new credit in the system, their economies will simply collapse on themselves.

Despite the best efforts of governments and central banks the world economy has never been more interconnected. The major European banks are vital to the system’s health. Their inability to generate credit growth and remain profitable is a systemic issue for the global economy that has yet to be addressed. And no I don’t count Italy’s $5B bandaid for a $100B bullet hole as addressing the issue. These weak institutions must not be allowed to fail. Thus the Yen and the Euro at the very least have to weaken against the dollar to stave off annihilation in the short term.

So the dollar must strengthen against the other funding currencies while paradoxically weakening against EM currencies. Although I outlined that as a possibility if EM growth picks up, I do not find it likely, and even if it does occur let me outline the dangers of such a scenario. If EM demand accelerates from here and successfully pushes up commodity prices as the Yen and Euro weaken, what happens to inflation in Japan and Europe?

Well inflation goes higher… much higher (on a relative basis). With spiking inflation what happens to all those wonderful government bonds with negative yields? Who in their right mind would pay a government to borrow money while that money is also losing value to inflation.

The idea of negative rates only seems less insane if the rate of deflation is higher than that of the absolute value of the negative interest rate (the bonds still generate positive real returns). But if you have negative yielding bonds in an accelerating inflationary environment (even if temporary remember most bull markets end with a spike of inflation followed by deflation) you should and probably will see a very large and possibly destabilizing sell off in European Sovereign bonds.

At the very least, the ECB and BOJ won’t have to get on their hands and knees and beg for someone to sell them some of these “safe” assets. In the end, volatility in the sovereign bond market will undoubtedly translate into volatility across all other asset classes. From equities to currencies to commodities. The end result being the very end of this central planning engineered low volatility environment.

Let’s not forget, in this scenario, the Fed is also behind the curve, just not as far as the ECB and the BOJ, but behind all the same. Hindsight is 20/20 and it’s clear the Fed missed the optimal window to raise rates back in 2013 or even in 2015. Fears of China and global fragility derailed any of the rate hikes necessary to keep the Fed ahead of the curve. And to be fair, the dollar is the world reserve currency and I believe if the Fed hiked in 2015 more than once we would have seen  serious financial cracks split wide open.

Now given the recent data and the upcoming BREXIT vote, I don’t expect the Fed to hike in June. Which means the Fed in this bullish scenario will undoubtedly fall behind the curve. By September, it would be apparent that the Fed made mistakes and then the big question is what happens next.

At that point the Fed may be forced to guide the number of rate hikes per year much higher. From the 0.5 per year the market is currently predicting to as high as four. This would represent a significant and sudden tightening that the world like back in January was not prepared.

Thus I think risk assets could be seriously capped on the upside. But that doesn’t mean they couldn’t rise sharply if we did see a BREXIT vote failure coupled with dovish Fed and a more robust US economy in Q2 and Q3 of this year. Which once again makes S&P call options an interesting hedge for this brief period.

I probably should get into the pitfalls of an emerging market recovery based on the health of China’s economy, but this article is getting long in the tooth and that isn’t my area of expertise (not like any area really is). Instead I’ll end it with some good hedging strategies that are either 1) relatively cheap and 2) can fit into my bearish bias. Firstly, I would like to reiterate the great risk reward opportunity S&P call options provide over the near term. No one thinks we will hit new highs on S&P which makes call options above that level so cheap and a great way to hedge this bullish scenario. Secondly Credit default swaps (CDSs) on European peripheral nations or outright shorting European sovereign debt seems like the most obvious choice. As bond yields rise, the governments ability to pay back their debt will be called into question and risks of default should sky rocket. It also happens to play right into the hands of my bearish perspective on the EU its banking system.

That’s it for now. This article has been incredibly trying to say the least. I’m going to dunk my head in a bucket of ice.

 

 

Golden Thoughts

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I’ve been rather quiet on the precious metals so far this year. I have enjoyed watching my precious metals positions rise on the back of various narratives whether true or not and now with large profits right there for the taking, I find it necessary to discuss and analyze my thoughts on the precious metals market.

Are we seeing a paradigm shift in the markets views on negative interest rates, central banks, and quantitative easing or is this something more mild? Perhaps we just witnessed minor panic that turned into a momentum trade which hedge funds and algorithms have ridden a little too far. Recall we saw a similar spike in both gold and oil in Q1 of last year. Neither of which lasted. However this time, everyone believes the recent gold rally is for real while the oil rally is false. It will be interesting to see how these two perceptions work themselves out over the next few months.

After hitting new and higher 52 week highs for the first time since 2012, a lot of people seem to think gold and silver have officially bottomed. And when looking at the Yen, Dollar and Euro, it appears that may have been in the case.

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XAU/USD is the gold line. source:Bloomberg

XAUJPY bottomed in mid 2013. XAUEUR bottomed in late 2013. It may be too early to say that XAUUSD has bottomed in late 2015. I still believe the dollar is going to be headed much higher relative to other fiat currencies. Depending on what causes the dollar to make its next move higher I think gold may be surprisingly resilient to the dollar’s strength. This could be pure foolishness and I’m certainly concerned about what any renewed dollar strength will have on gold and my positions but for now I find myself in the gold has bottomed camp.

Unfortunately to my contrarian nature it appears this is a crowded camp.  Speculative positioning in the silver futures market has never been higher.

Also, anecdotally it seems that a large portion of the precious mining industry is now starting to turn bullish. Whether or not that is a good thing remains to be seen, but it has been interesting to see how quickly the psychology has turned.

But it’s not just insiders psychology that has turned, investor psychology on a whole seems to have undergone a dramatic shift. This is evident in the valuation of the mining stocks. Just a few months ago, these stocks were trading at fractions of book value, now after a large move up in silver and gold, these stocks are trading at multiples of book value. Some of these stocks are trading at 50-100% premiums to where they were the last time gold and silver were at these prices.

The obvious conclusion is that investors and the market think gold and silver have finally bottomed and are heading higher. A contrarian by nature, I find this recent faith in gold miners to be a little uncomfortable to say the least, and although I am not ready to sell a portion of my positions yet, I am watching the precious metals market quite carefully.

As always you can’t talk about any market without talking about the dollar. Perhaps the biggest surprise this year is the dollar’s downward trajectory. The DXY shown below has broken down to new 52 week lows.

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Perhaps the most interesting aspect of this move is it fall against currencies that are being weakened by their central banks. In the face of falling rates and expanding central bank balance sheets the dollar has weakened considerably against both the Yen and the Euro.

Both currencies are fighting hard against their central banks to retrace 50% of their down moves against the dollar over the past few years. For EUR/USD 1.20 and USD/JPY 100 are the targets. I think if we hit those, it may be time to reconsider my sizable gold miner position.

 

 

Ding Ding: The Next Round of Currency Wars

The currency war that started as a result of the 2008 crisis has been in a cold period since the US agreed to accept a stronger dollar in 2014. The Euro and the Yen have enjoyed their periods of relative weakness, but unfortunately, the dollar moved too far too fast and it may have done irreparable damage to the commodities complex in the process. I have little doubt we will continue to feel the shock waves of the 2014 dollar move higher for years to come.

The US economy has also bared the brunt of this strong dollar resulting in a decline in corporate earnings, the loss of jobs via US shale, and a widening trade deficit. It is now quite apparent that the Obama administration isn’t going to tolerate this strong dollar any longer. The US put China, Germany, Japan on a watch list for FX manipulation. And if that wasn’t enough, President Obama AND Vice President Biden both met with Yellen after the Fed held an emergency meeting on interest rates just a few weeks ago. Once you add in Obama’s concern for his legacy for reviving America’s post crisis economy, and the picture becomes quite clear.

Unfortunately a weaker dollar translates into a stronger Euro and Yen. Unfortunately, both the Euro and the Yen never weakened enough to begin with and any move higher from here will be come at a great cost to their economies.

I believe that Japan will be the first of these economies to break ranks and head for a weaker currency through open manipulation which will most likely ring the bell for the next round of the currency war.

In our current currency war, the first round of competitive devaluations were done under the guise of “stimulus”, but now that QE has failed to stimulate the economies in both Europe and Japan, this excuse will no longer be acceptable both from a political and an economic point of view.

It took a while but now it seems the majority of people are ready to admit that monetary policy alone is not enough to stimulate growth. Governments must get in the act. Although this is foolish thinking, because one only needs to look at the failure of Abenomics’ three arrows to see that the problem is too much debt and the idea that governments aren’t doing their part to stimulate demand is misplaced.

Eventually, somewhere down the line, debt will need to be forgiven, but we are not there yet. I think we will need to have as Raoul Pal calls it “a bonfire for the central planning vanities” where citizens will cede complete control over economic planning to central institutions so that they can once and for all prove to the world and history that they are not capable of creating sustainable growth. Only after this final folly can we start to rebuild what was lost, and add another tally in the column of free markets which hopefully won’t be ignored next time.

Getting back to Japan, the point is that the BOJ has failed to stimulate the economy with its current toolkit. QE,  QQE and NIRP are no longer producing the intended effects. The BOJ cannot reasonably increase its purchase program because it will absorb too much of the remaining JGBs. The remaining JGBs which a large portion of them are trapped on bank and pension balance sheets due to regulations. Thus the amount of JGBs truly available for purchase are smaller than people realize, which magnifies the BOJs current conundrum: Where are they going to find the bonds?

The answer is the Japanese government should issue a poop ton of debt by expanding the deficit even further with the BOJ monetizing every last bit. Unfortunately with Japanese government debt to GDP at +220%, it seems silly to think that the answer to Japan’s problems are for the government to issue even more debt. But hey, logic be damned we are having a bonfire!

It’s hard to tell when people will start to worry about Japan’s ability to pay back its debt. Some time during the aforementioned bonfire would be my guess.

But let’s say, the Japanese government doesn’t have the power or leeway to rapidly expand the fiscal deficit in the short term. That would mean that once again it all falls on the unelected members of the BOJ who don’t have the current tools to devalue the Yen.

As stated earlier QQE and NIRP are not having their desired effects. The Yen has rallied in the face of collapsing bond yields – a deadly deflationary mix for Japan’s demographic depression. The only possibly way in my mind, for the BOJ to fight this deflation would be through direct currency intervention.

Using ball park estimates I’d think the BOJ should try and get the USDJPY to 120 by the end of the year on its way to 140-150 over the next few years. Do I think this is the sensible long term thing to do? No, but it’s what I think the BOJ should and would do if it wants to preserve short term stability regardless of the cost of stability in the long term.

The BOJs drastic intervention in the FX market could spark a similar response to NIRP, when the market responded with fear instead of jubilation.  And let’s not forget that the geopolitical responses to such a measure although unclear would most likely have detrimental effects to global trade and ring the bell for the next round of the currency war to commence.

The extreme and overt nature of currency manipulation is indicative of the challenges that central bankers are faced with. Forced to manage the world’s floating exchange rates at a time when currency volatility is hitting multi year highs, central bankers are like high wire artists pushed further out on an ever narrowing tight rope with no end in sight.