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This edition of Currencies and Markets is going to discuss the
Yen Bomb.
The Yen has been a sister currency with the USD for at least two
decades. As I recall, after around 1987 roughly speaking, there was concern over
the USD and Yen valuation and an agreement apparently was reached for the BOJ
to coordinate with the Fed to support the USD and carry on coordinated
currency policy. I don’t have the details here. Then in the 1997 Asian
crisis the Asians really dove into the USD for a haven after that for
stability.
We also know the Japanese started the Yen carry trade in the
early 90s to fight off the deflationary effects of their combined stock and
real estate crash about 1990 and began lowering interest rates to near one
percent. Welcome to QE zero.
Have you ever heard the term ‘patient zero?’
Since then Japan entered into now 25 years of stagnation and
deflationary forces which they fought off with huge sums of public money,
building lots of bridges to nowhere and basically supporting their banks and
stock markets. Their national debt became the world’s largest by GDP at
now near 300 pct. They will never be able to repay that.
Their economy is now saddled with huge debt and CONTINUING
zombie banks. It’s like trying to swim with an anchor around your
waist.
Right now, the Japanese government is caught in a fiscal crisis
where they cannot raise their debt maximums unless they form a coalition to
deal with this fiscal crisis. The clock is ticking and Japan is on the verge
of running out of money for its national government functions, covering
everything from pensions to the usual building projects to normal operations.
The bond markets have barely squeaked but they are going to
start reflecting this. If interest rates rise a mere one percent, Japans debt
service which is mostly interest will about double. And interest is just
about the biggest part of their budget.
Japanese savers will at some point become discouraged and if any
inflation rears its head, and this is possible, they will stop buying
Japanese debt. And if fact we can easily imagine capital flight FROM Japan.
If things get going bad enough.
Part two, the Yen carry trade in this
Now a weird phenomenon here is that if Japan has a fiscal crisis
spin out of control, they will find managing the Yen virtually impossible.
They will be able to hold wide ranges but the fluctuations will be massive.
Remember what happened to the world currency markets in the Asian currency
panics of 97/8 when the Yen rallied 30 pct. and caused utter panic across
Asia.
A Japanese fiscal crisis and any rebellion in the bond markets
would paralyze Japanese commerce, primarily from the standpoint that their
industry would have no way to carry on business profitably with wildly
gyrating Yen exchange rates.
At such a point, the trade partners will become reluctant to
accept Yen payments and demand immediate payment in other currencies, the USD
would be an example but there are lots of problems with that too now at this
point, because I said the USD and Yen are sister currencies in my view,
dating back decades with trillions of dollars’ worth of commercial and
banking and FX linkages and market linkages related to this Yen carry trade.
The USD is now the carry trade currency of choice in my view, but not
completely taking over from the Yen for example.
If the Yen begins to enter a period of FX chaos, and sees rising
interest pressures many results will follow like dominoes.
One, the major issue I am concerned with here, is the USD Yen
linkage will possibly be broken. That would ultimately cause wild unwinding
forces from the Yen and USD carry trades, which affect both central banks
will fight tooth and nail.
If the Yen and later USD exchange rates start to fluctuate too
much, many companies will do everything they can to minimize the FX risks,
which cost them a TON of money when rates go askew from their plans, by the
way.
Why do FX rates have such huge effects on companies?
Imagine that you build a Toyota vehicle, and your costs are in
Yen, but the Yen falls in relation to the USD, or rises. If the Yen falls to
the USD, then you get more Yen for that same $30,000. If the Yen rises you
get fewer Yen. In a currency crisis, rates skew wildly from one extreme to
the other, and your profits, which for cars is maybe 5 to 8 Pct. vanish. It
becomes impossible to pay suppliers and everyone else if exchange rates are
out of control. The ultimate effect is that every company in the supply chain
ends up using its cash flow to manage the currency losses gains, and not
running the company. This effect rolls all the way down the supply chain.
Big companies and small ones end up having to look months ahead
for deliveries, making months long deals and when the goods are delivered and
sold, maybe 5 months later, exchange rates have drastically changed.
It’s a crap shoot.
The net effect of a Japanese fiscal crisis could paralyze
Japanese industry. Especially if it lasts for even only one year.
The US would face the same issues on their side as well, but
would have some longer flexibility, but still would face the same pressures,
ultimately. If the US and Yen linkages break, and they are going to
eventually, the combined economies of the US and Japan would falter badly at
first, and possibly lead to a rapid deterioration of their bond markets and
huge interest rate spikes. Their currencies, both would fall drastically.
Such a scenario would speed up the ultimate demise of the USD
and Yen by years.
Since the USD and Yen are already faltering, one might say they
would merely fall together, however the big problem for both of them is they
are hitting a wall fiscally, and the bond markets are going to hammer them in
interest rates. In other words, the Yen and USD carry trade being used to
support their economies, support their stock markets, and support their
currencies and their fiscal deficits, that party is ending.
Economic contraction
If commerce is disrupted this badly, and FX rates become
erratic, the only outcome will be lower production as companies attempt to
stem the bleeding risks from the FX losses. More people will be fired. Even
though fewer units will allay this problem, ultimately the governments will
have to expand the safety nets to allay the unemployed. The cycle then shifts
more burden to the governments, as they take over the economy, and the end
result is higher fiscal deficits in an environment this time of RISING
interest rates starting from near zero. Their budget deficits from interest
alone will double then triple.
This is a recipe for a rapid currency collapse.
The question here is, will the Yen bomb blow up, and how long
can Japan hold up its faltering and if you look at their fiscal deficits,
running about Half, how much time do we all have before the Yen collapses,
first maybe by spiking and crashing the financial markets, then followed by a
fiscal collapse and bond riot in the Yen?
This is kind of like a supernova. First, the pressures of
collapse build as the final fuel of (in this case cheap money which is about
to end) is burnt faster and faster. Then implosion. But the implosion is a
stupendous logarithmic burning of the final fuels, and you get a stellar
explosion. It lights up the entire sky.
The currencies in question could rise rapidly, even as their
bond markets falter initially. The last hot money would flow for a while to
them. Ultimately, this supernova could suck in all the hot money on the
globe, followed by total economic paralysis (remember a rising currency
causes companies to burn cash in that country) and subsequent collapse of the
currencies involved, and the need for a new currency which is pan national.
This is the scale of what the Yen bomb can do. What this means is that all
savings are burned. All companies become insolvent, and bond rates ultimately
skyrocket putting a final clamp on the whole shebang.
In this scenario the entire FX complex of Asia, as well as with
the West will be totally disrupted. Now since most of the inter Asian trade
is manufacturing components for trade with the West, the FX chaos would clearly
cause all of those supply chain dominoes, large and small to burn their cash
too. IN short, total industrial bankruptcy in maybe a single year and
paralysis, those companies run on razor thin profit margins. Talk about
scaring China!
Gold would of course skyrocket eventually, albeit might be
hampered in the beginning but would rise steadily. It would be the only
metric out there that had any FX stability. Eventually gold would rocket. And
not in a long time after the initial start.
The resource currencies would be seen as a haven at some point,
but frankly as we stated this is a complex situation, and an economic
collapse which would occur here would absolutely hammer the commodity
complex. So this is dicey.
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