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For
the past decade, prices in Japan have been stable or fallen, in an economy
where the central bank has pegged its overnight loan rate near zero-percent,
and where 10-year bond yields haven’t climbed above 2-percent. Between
1991 and 1995, Tokyo spent $2.1-trillion on public works, in an economy
that’s less than half the size of the United States, in order to lift
its economy out of a severe downturn caused by the bursting of a real estate
and stock market bubble in the early 1990’s.
By
1996, Japan’s economy started to rebound, growing at a +3% clip, but it
was stymied by premature spending cuts and tax increases, due to concerns
about ballooning budget deficits. In total, Japan spent $6.3-trillion on
construction-related public investment between 1991 and September 2008. But
while spending remained high, Japan never escaped its recurring bouts with
deflation and recessions. Instead, Japan accumulated the largest public debt
in the developed world, equaling 180% of its $5.5-trillion economy, - while
failing to generate a sustainable recovery.
The
size of America’s $820-billion stimulus plan is far less than what
Japan spent, and now that various programs are being phased-out, traders in
the G-7 bond markets have begun to fear that the US-economy could stumble
into a “double-dip” recession, leading to a Japanese style
deflationary trap. As of May, Japan’s year-over-year core
deflation rate stood at -1.6%, and in August, its 10-year government bond
yield briefly slipped below 1%, for the first time in seven-years.
If
deflationary psychology takes hold among consumers, they’ll wait for
still lower prices, before buying, adding to the deflationary spiral. And as
Japan’s experience suggests, deflation can increase the financial pain
of a traditional recession. When deflation strikes, lower sales prices cut
into business profits and in turn, prompts companies to trim payrolls. That
undermines consumers’ buying power, leading to a vicious cycle of more
pressure on profits, jobs, and wages, - and cutbacks in purchases of new
equipment. Likewise, bond yields can stay unbelievably low.
The
Fed has vowed not to make the same mistake as the Bank of Japan, which waited
too long to ease its monetary policy in the early 1990’s. Taking note
of Japan’s experience, the Fed pledged in
March 2009, to buy $1.45-trillion of mortgage securities backed by Fannie Mae
and Freddie Mac, and $300-billion of long-term Treasury bonds. During the
Great Depression, the Fed allowed the money supply to fall rapidly, and
consumer prices fell 10% between 1929 and 1933.
On
Sept 1st, Philadelphia Fed chief Charles Plosser said he would be open to
further bond purchases if he saw deflation as a real risk. “I would
certainly entertain the solution if I feared deflation, and if expectations
were coming unglued in that direction. Then we would have to take
actions,” he warned. Treasury bond traders should be careful for what
they wish for. Soon after the Fed launched QE-1 in March 2009, the
US-Treasury’s 10-year yield turned sharply higher, climbing from 2.60%,
to as high as the impenetrable 4-percent level, just two months later.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07421.png)
Unleashing
QE-1 ignited fears in the T-bond market of “too-much” money
chasing “too-few” goods, that would unleash good, old-fashioned,
– Inflation, - the magic elixir for debtors, but injurious for lenders.
Sure enough, following a time lag of about four-months, the Rogers
International Commodity Index, (RICI), containing a basket of 36-commodities,
began to surge sharply higher on a year-over year basis, climbing from a
reading of -54% in July 2009, to as high as +37% in Q’1, 2010.
The
upward surge in global commodity inflation and Treasury bond yields converged
in Q’1, 2010. The RICI peaked at +49%, while the ten-year T-note yield
peaked at 4-percent. At about the same time, the Fed was winding down QE-1,
buying its last batch of MBS’s in March 2010. Since then, shockwaves
from the Greek debt crisis, and a stoppage of the Fed’s money
injections, helped trigger a sharp downturn in Treasury yields, and also
knocked the commodity inflation into negative territory.
For
all the smug confidence about a sustainable economic recovery this year,
sentiment turned upside down by August. The flavor of the month shifted
180-degrees to talk about a “double-dip” US-recession and a slide
into a Japanese style deflationary trap. As Mark Twain used to say, “It
ain’t what you don’t know that gets you into trouble. It’s
what you know for sure that just ain’t so.”
When
it comes to judging the true rate of inflation, an investor can choose to
rely on government statistics, which are often fudged by apparatchiks, for
political purposes, or an investor can observe the dollars and cents that
move the commodities market, for real-time clues about the future direction
of inflation or deflation. Using this simple rule of thumb, the RICI is now
trading near a zero rate of inflation, signaling that the bond market’s
fear of a deflationary trap is overblown.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07422.png)
In
Japan, the central bank and the ministry of finance (MoF) manhandled the
JGB’s 10-year yield within a narrow range between 1% and 2%, for the
past seven years. Massive overdoses of liquidity injections over the years
have left the $8.5-trillion JGB market dysfunctional. Still, it was of great
interest, when 10-year JGB yields briefly slipped below the psychological
1%-level, in late August.
The
historic slide in Japanese bond yields mirrored the US-dollar’s slide
to a 15-year low against the Japanese yen. Every time the US-dollar falls by
1-yen, it reduces Japanese exporter profits by about 0.90%, and weakens the
Nikkei-225 index. The yen has risen 11% against the dollar so far this
year, driven by safety-seeking flows lately on fears the US-economy may be
sliding into a “double-dip” recession, and worries that Greece
might ask for a restructuring of its debts.
Yields
on Japan’s 30-year bonds briefly fell below the 20-year yield, -
projecting a flat yield curve, and sliding to the fault line of a highly
dangerous inverted curve. “Currency rates have come to a critical
juncture,” warned Japan’s deputy banking chief Kohei Otsuka on
August 11th. “A rapid yen rise would boost deflationary factors, so the
government and BOJ must act as one in considering our commitment to act
against deflation,” he said. On August 27th, Japan’s
Prime-minister Kan vowed to take strong measures to stop the dollar’s
slide against the yen.
On
August 30th, the BOJ tried to stop the US-dollar’s slide, by boosting
its deposits in the local banking system to 30-trillion yen ($350-billion),
up from 20-trillion yen previously. Increasing the supply of yen briefly
boosted the US-dollar to as high as 86-yen. The Fed’s decision to delay
QE-2 for awhile longer, also gave the US-dollar some respite from bearish
currency speculators. However, the intervention effort fizzled, and within a
few days, the US-dollar tumbled to 83.50-yen. On Sept 7th, Japanese Finance
chief Yoshihiko Noda said Tokyo would take decisive steps to cap the
yen’s rise, including intervening in the FX market to weaken the yen.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07423.png)
Ironically,
the biggest reaction to the BoJ’s injection of an extra 10-trillion
yen, was in the JGB market, where ten-year yields boomeranged, and spiked
upwards to as high as 1.20%, marking a 30-basis point jump from a low of
0.90% hit in late August. Traders have long memories of the bursting of the
JGB bubble in the second half of 2003, that saw yields ratchet upwards from a
record low of 0.53% to as high as 1.65% within four-months. Already,
investors who locked-in JGB 10-year yields below 1% last month, have suffered
a 2% capital loss over the past few days.
Trying
to push ultra-low JGB yields even lower is like trying to push a helium
balloon under water. In order for JGB 10-year yields to stay below 1%, the
deflation rate in Japan must average a negative 2-percent. There is an
absolute limit to how far long-term bond yields can fall, and with the
BoJ’s overnight loan rate pegged at 0.10%, the probability of an
inverted yield curve is near zero-percent. Only foreigners can still make
money in JGB’s if the yen continues to climb higher the Euro and
US-dollar. But the yen’s potential gains from here would be much
tougher, if Tokyo’s financial warlords are prepared to engage in
full-scale battle.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07424.png)
Fears
of “double-dip” recessions in Japan and the US couldn’t
dent summer rallies in key industrial commodities, such as copper, rubber,
and steel - traded on the Shanghai Futures Exchange. In each case, the
rallies were supported by a reduction in supply. Orders by Beijing to Chinese
steel mills to trim output by 25-million tons annually prompted a rally in
steel prices across Asia. That equals 4% of China’s record crude steel
output, and a quarter of the nation’s excess supply.
China,
the world’s largest natural rubber user, is expected to boost imports
10% this year after “robust demand” from tire makers depleted
inventories to the lowest level in seven-years. Natural rubber prices climbed
to 26,200-yuan ($3,850) /ton on the Shanghai exchange, the highest level
since July 2008. Rubber stockpiles tracked by the Shanghai Futures Exchange
declined to 14,770-tons on June 24, the lowest since Feb 2003, and fell
sharply from 24,700-tons last week.
About
half of the world’s rubber supply is used for making tires.
China’s tire exports jumped 30% in the first six months from a year
earlier to 87-million tires as demand from developing countries outweighed
lost sales in the US, which levied a 35% tariff on China-made tires. Total vehicle
sales in China were 56% higher compared with a year ago to 1.22-million
units, boosting the demand for rubber.
Copper
futures in Shanghai rebounded 20% over the past ten-weeks, tracking gains on
the Shanghai red-chip index. Global copper miners put a floor under the
London copper market at $6,000 /ton, by cutting output 6% in the first half
of this year. Copper stockpiles held at the London Metal Exchange were
whittled down to 395,000-tons, down 28% since mid-February levels of
555,000-tons. In Shanghai, copper stocks dropped to 105,200-tons today, from
185,000-tons in April.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07425.png)
Still,
when viewed from a longer-term perspective, the Rogers Int’l Commodity
Index, and the Baltic Dry Index, are far below their bubble highs of 2008,
and little changed from levels that prevailed 5-years ago. Chinese imports, a
key driver of the “Commodity Super Cycle” in earlier years,
rebounded to new all-time highs, yet the commodity indexes were left behind
in the dust. China is taking advantage of the lower commodity prices, by
restocking iron ore, coal, crude oil, and soybeans, from Australia, South
Africa and South America, as it braces for the winter season, with droughts
and floods across the globe causing a shortage of grains.
The
US-government aims to keep inflation under wraps through greater regulation
of commodity traders, in the event the Fed decides to unleash QE-2, and
boosts the money supply. The CFTC began eyeing position limits after oil and
other commodity prices soared to record highs in 2008, on signs that
investment banking firms were dominating trade. The commodities market was
valued at $2.9-trillion in December 2009, and US-investment banks held
one-third of the contracts.
Wall Street Oligarchs, JP-Morgan Chase and Goldman Sachs, are closing their
proprietary trading operations in commodities, in conformity with financial
reform, after more than five-years of rapid expansion. Yet other legions of
commodity speculators are entering the game, and in recent weeks, commodities
such as oil, copper, cotton, grains, and gold had strong trading volume.
Chinese and Indian demand for commodities is also expected to grow in the
years ahead.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07426.png)
Interestingly
enough, while fixed-income speculators are touting the illusion of a
deflationary trap, the price of Gold is climbing to new all-time highs,
hitting $1,260 /oz this week. The gold market is thriving in a world of
ultra-low interest rates, and is squarely focused on the burgeoning size of
the US-Treasury’s outstanding debt. On August 19th, the non-partisan
Congressional Budget Office (CBO) forecast the US-budget deficit will hit
$1.34-trillion this fiscal year ending Sept 31st.
CBO
also predicted the budget deficit for fiscal year 2011, which begins on Oct
1st, would reach $1.15-triilion, bringing the Treasury’s debt to a
record $14.55-trillion, and greater than 100% of the nation’s GDP. As a
general rule of thumb, the price of gold climbs about $140- /oz for every
$1-trillion increase in the amount of US-red ink. If correct, Gold could
reach $1,400 /oz over the next 12-months, and could exceed this bullish
forecast, if the Fed unleashes QE-2, as is widely expected.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07427.png)
In
Europe, the gold market is buoyed by widening yield spreads between 10-year
German bond yields and those of Irish and Portuguese debt, which climbed to
all-time highs this week, while the German-Greek yield spread increased to
+990-basis points, exceeding the May 7th high. A Wall Street Journal report
said its analysis showed bank stress tests published in July had understated
some European banks’ holdings of risky government debt. The
Irish/German 10-year government bond yield spread hit a lifetime high of
+390-bps, or 40-bps wider on the day. The equivalent Portuguese yield spread
hit its widest since May 10th at +360-bps.
The
deepening crisis in Greece has resulted in near-record levels of
unemployment. Official unemployment now stands at 12%, but hardest hit are
younger workers, with 32.5% of all workers between 15-years and 24-years
unemployed in May. Euro-zone bond traders are worried that Athens will
eventually seek a restructuring, which could mean a 50% haircut for its
lenders. Banks’ worldwide exposure to Greek debt in the first quarter
of the year was $297-billion. The IMF foresees Greece’s debt topping
out 150% of gross domestic product in 2012.
![](http://www.24hgold.com/24hpmdata/articles/2010/09/img/20100909CLA07428.png)
The
amount of money flowing into US-bond funds is poised to exceed the cash that
went into stock funds during the internet bubble, stoking concern that
fixed-income markets are ripe for profit-taking. Investors poured $480-billion
into mutual funds that focus on debt in the two years ending June, compared
with the $497-billion received by equity funds from 1999 to 2000. American
banks plowed $500-billion into Treasury bonds - stealth monetization of the
government’s debt.
A widespread
exodus of baby-boomers from the equity market is behind the mania. However,
investors should consider that during the past six-years, long-term
US-Treasury notes have lost two-thirds of their relative market value, when
compared to hard-money, - Gold. Beijing has made a tragic mistake, by
investing two-thirds of $2.5-trillion FX stash into US-bonds. Trying to
figure out how Beijing and other central banks, will invest their FX-stash in
the months ahead, is the topic of the Sept 8th edition of the Global Money
Trends newsletter.
Gary Dorsch
Editor, Global Money Trends
www.sirchartsalot.com
This
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Mr Dorsch worked on the trading
floor of the Chicago Mercantile Exchange for nine years as the chief
Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures
Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.
As a transactional broker for
Charles Schwab's Global Investment Services department, Mr Dorsch handled
thousands of customer trades in 45 stock exchanges around the world,
including Australia, Canada, Japan, Hong Kong, the Euro zone, London,
Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts,
ADR's and Exchange Traded Funds.
He wrote a weekly newsletter from
2000 thru September 2005 called, "Foreign Currency Trends" for
Charles Schwab's Global Investment department, featuring inter-market
technical analysis, to understand the dynamic inter-relationships between the
foreign exchange, global bond and stock markets, and key industrial
commodities.
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