Japan’s Desperation May Push its Monetary Policy to the Depths of Despair

This week’s news cycle is brought to you by the US Federal Reserve. In case you weren’t already aware, the Fed wants you to know that it’s probably going to raise interest rates soon.

When ‘soon’ actually is, no one really knows. That’s because the next rate rise, for all the huffing and puffing, is still ‘data dependent’.

Overnight, data on US consumption growth was healthy, supporting the case for a strengthening US economy. Consumer spending rose 0.3% in July, after rising 0.4% in June. According to Reuters:

Monday’s report from the Commerce Department came several days after Fed Chair Janet Yellen said the case for raising rates had strengthened in recent months. Low inflation, however, suggests the U.S. central bank could wait until its December policy meeting before raising borrowing costs.

“This report is a mixed bag for the Fed. While the consumer sector is continuing to advance solidly, progress towards the Fed’s inflation mandate has stalled,” said Michelle Girard, chief economist at RBS in Stamford, Connecticut. “It strengthens the case for an increase in interest rates, but does not suggest an urgency for policymakers to act in September.”

As I mentioned yesterday, a move in September, just a few months ahead of a presidential election, would be very surprising. And something is bound to go wrong between the election and the December meeting, which means the next rate hike, in all likelihood, will be sometime in 2017.

Despite this, the market is adjusting to an increased probability of a rate hike before the end of the year. For example, prior to the Jackson Hole Symposium of central bankers, the odds of a September rate hike were around 20%.

In the few days since Yellen’s speech, the odds of a September rate hike have doubled, to 40%. That means, of course, there is a 60% chance of nothing happening; I think those odds seem about right.

But, as I said, the market has spent the past few days adjusting to the change in odds. It will continue to do so if US economic data remains strong and there are no other flare-ups (internationally) that would give the Fed an excuse to do nothing.

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Notably, the US dollar has been strong over the last two trading sessions. But as you can see in the chart below, the rally comes after a selloff in July and August, and is still well off the highs reached in November 2015.

Source: Optuma
[Click to enlarge]

Unless the US economy is much stronger than I think, I can’t see the US dollar index rallying back to those highs for some time, if at all.

Back in late 2015, the Fed raised rates for the first time in seven years. It spent the better part of two years prepping markets for that move. At the time, the thinking was that the Fed would follow up the December 2015 rate hike with a number of moves in 2016.

But that didn’t happen. As it turned out, the late-2015 positioning by currency markets was way too aggressive. Given the realisation that any interest rate moves will be at a glacial pace, it seems unlikely that the US dollar will rally too aggressively.

But…there are a few caveats. One is that poor old Japan may do something drastic. Let me rephrase that. Poor old Japan may do something even more drastic than it has ever contemplated before…which is certainly saying something.

Check out the recent fruits of Japan’s monetary insanity. If their aim was to weaken the yen, it’s been a dismal failure…

Source: Optuma
[Click to enlarge]

As you can see, since the start of the year (when markets realised the Fed wouldn’t undertake any rapid fire tightening), the yen has been relentlessly strong. That’s despite the Bank of Japan buying up every government bond and stock ETF it can get its hands on.

That’s got to be annoying Japanese monetary officials. It makes you wonder whether they might be thinking of doing something monumentally stupid to weaken their currency against the US dollar.

Haruhiko Kuroda, the Bank of Japan governor, hinted as much in his speech at Jackson Hole over the weekend. As Japan’s national newspaper, The Mainichi, reports:

Bank of Japan Governor Haruhiko Kuroda said Saturday the central bank has “ample space” for additional monetary easing to revive the country’s economy.

Kuroda also indicated the BOJ could cut interest rates further into negative territory, despite opposition from lenders to the policy, which has hurt their profitability.

The BOJ will “take additional easing measures without hesitation in terms of three dimensions — quantity, quality and the interest rate — if it is judged necessary for achieving the price stability target,” Kuroda said in his speech at a meeting of central bankers in Jackson Hole, Wyoming.

The BOJ could be bluffing, of course. But if they do try something bigger and dumber than they have ever attempted before, it would give the US dollar rally more impetus.

The other caveat is inflation. If inflation picks up more than expected, it would give the Fed cover to raise rates faster than expected. Don’t forget, real interest rates are the consideration here, not nominal rates. Real interest rates are nominal rates minus inflation.

Ideally, the Fed would like to raise nominal rates while keeping real rates low. It can only do this if inflation picks up. There’s no sign of an imminent pick-up in inflation yet, but that can change pretty quickly.

The comical thing about all this is that this latest ‘interest rate tightening news cycle’ could end abruptly with a poor employment report this week, or with some weaker than expected news out of China. Given that the big stimulus injection from the start of the year should wear off soon, it might not be too long before the China bears start growling.


Greg Canavan,
For Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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