The Uncanny Correlation Between Yen and Gold

Japanese Yen - Dollar relationship

Did you hear the latest about the Japanese economy? Y’know, the one that has far and away the largest government debt-to-GDP ratio in the world? The one whose central bank is now intent on monetising a large part of that debt pile to create inflation and boost economic growth?

Before I tell you, have a quick squizz at Doug Nolan’s latest Credit Bubble Bulletin from Friday, with my emphasis:

From the perspective of my “Financial Sphere vs. Real Economy Sphere” analytical framework, inflating the contemporary Financial Sphere [asset markets] in hope of spurring sustainable economic recovery is an absolute fool’s errand.  It’s nothing short of reckless.  To inflate Financial Sphere excess based on Real Economy Sphere indicators (i.e. GDP, the unemployment rate or CPI) is lunacy.

Back to Japan (with Doug’s comments in mind). Its economy shrank by 1.6% in the three months to September, defying expectations of a 2.2% expansion. Falling inventory levels accounted for some of the miss, but weak household consumption and business investment were also blamed.

In other words, trying to pump up your economy by inflating asset markets is a fool’s errand, reckless, and an act of lunacy. Be that as it may, it won’t stop Japanese officialdom trying ever harder from now on.

Chances are they won’t go ahead with a planned consumption tax increase from 8% to 10% next year. The latest jump in the tax, in April, when it went from 5% to 8%, is already getting the scapegoat treatment for the weaker than expected growth numbers.

And why wouldn’t it? The government wants to create inflation and economic growth…so they make a plan to double the rate of consumption tax! Pure genius.

Perhaps you’ll see the annual target to expand the monetary base now increase from 80 trillion yen to 100 trillion? Pump enough cash into the markets and it must eventually make its way into the real economy, no?

Keep a close eye on Japan, dear reader. It’s a history lesson in real time. The difference is that in the history books, national bankruptcies play out reasonably quickly, sometimes in a matter of pages.

In real life, it takes many years. It took Germany, already on its knees, five years after their defeat in the First World War before they blew their currency up, ruined a generation and changed the course of history. But Japan’s leaders are doing their best to speed things up. The way they’re going, this could all be over in a couple of years’ time.

The one defence Japan has against a rapid demise is its vast hoard of capital, thanks to running years of post-Second World War trade surpluses. These surpluses build up as excess capital and find their way into global capital markets and direct investments (factories, businesses, etc.) in all corners of the world.

At the end of 2013, Japan had a net international investment position of around US$2.8 trillion dollars. That’s a lot of moola, and means that when Japan’s foreign assets and liabilities are added up, it comes out at $2.8 trillion in the black.

About $860 billion of that is ‘directly invested’, meaning that it’s invested in operating businesses around the world.

The largest net asset component by far sits in foreign debt markets. That is, Japan has a net investment of nearly $2 trillion in various debt securities around the world, including government and corporate bonds.

That makes sense given it’s one of the world’s largest creditors. And it makes sense especially as the yield from Japanese government bonds has been so low for so long. Japan’s savers have always been risk averse, and investing in bonds is, according to conventional finance, less risky than investing in equities.

Well, you’ll get a chance to see whether conventional finance theory gets it right in the next couple of years.

Because if Japan continues down their current path, they will, in Ernest Hemmingway’s memorable phrase, go broke slowly at first…then all of sudden.

As their currency collapses, they will need to draw on their accumulated capital to maintain their living standards. This means they will start selling their hoard of foreign bonds and other assets. The Bank of Japan (BOJ) will do their best to keep up by monetising assets, but the market will always be one step ahead of them.

Of course, the BOJ could pull their head in and put pressure on the government to bring about genuine reform, but that’s not going to happen. Once you set out on an inflationary path, you tend to keep going until you blow up. Because stopping halfway brings about a deflationary collapse.

How will you know when Japan gets close to the tipping point? Here’s a wild guess, but there may be something in it. Take a look at the chart below. It shows the gold price (in yellow) over the past three years plotted alongside the YEN/USD exchange rate.

Yen/Gold correlation

Yen and Gold Correlation

That’s some correlation, huh? My guess is that when this correlation breaks down (presumably with the yen continuing to head lower against the dollar, while gold rises or at least remains stable), it will be an important warning sign that the market sees serious cracks in the yen.

I don’t know why the correlation is so tight. I suppose it’s because gold trades like a currency…an anti US dollar currency. And because the yen/dollar is one of the world’s major currency pairs, just like XAU/USD (XAU is the currency code for gold), when the yen weakens, it means the US dollar strengthens. And as you know, a strong US dollar means a weak gold price.

But at some point, gold and yen will go their separate ways. When that happens, you need to be on guard…because things could get weird in the financial world.

We’ve lived with Japan being the world’s largest exporter of capital for decades. When that dynamic changes, EVERYTHING will change.

It matters for Australia because we are a major capital importer. I don’t know how much, but I’m guessing Japan supplies a lot of our capital needs. It helps keep our interest rates low.

The best we can hope for is that the Japanese people reject Abenomics and its inflationary policies. But history suggests that rarely happens. Inflationism is always an easier sell than austerity and reform.

As Doug Nolan wrote last week, ‘Regrettably, this era’s sophisticated inflationism is even more seductive than its predecessors.   

Indeed it is. Everyone mistakes it for genuine wealth!

Until Thursday…Callum is in the driver’s seat tomorrow.

Greg Canavan+
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Greg Canavan

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing.

He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’.

Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors.

Greg Canavan

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slewie the pi-rat
now, it looks like Abe is gonna rev up the chopper and do a “gift card” drop to low income Japanese citizens. slewienomics applauds this. this is the correct solution: if you ARE gonna have ZIRP, NIRP and QE, put it in the hands of the struggling people and they WILL spend it! in this case, the “state” is supporting an asset class known as “people”. imagine that! given the current state of “economics” in the fiat world, and the ponzi-nature of the can-kicking, the antidote to the dis-ease of wealth concentration at the top is to aim the freaking… Read more »
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