What the hell is happening in the Japanese markets?

Outlook:

We return to normal data release and response this week, starting with personal income and spending today and the all-important PCE inflation number, and ending on Friday with payrolls. The Energy Dept report on crude inventories will be a day late, as usual after a holiday. PCE could rise a little more to 1.8% but the fixed income and the FX markets seem to be going into the data with a bias toward thinking the Fed is not going to care much about the data one way or the other—the data on which it is supposedly dependent is not this data, mandate or no mandate.

Some analysts worry that the Fed knows something the rest of us do not, including worries about a spectacular rise in repo fails reported by Bloomberg and other measures pointing to a possible liquidity problem in the US banking system. In a nutshell, money is flowing from the US to the overseas Eurodollar market even as some spreads go deeper into negative territory. Loss of liquidity in the eurodollar market is how the Lehman crisis got started…. Most of this analysis is arcane and complicated, including basis swap spreads that don’t line up with actual FX rates and negative yield curve swap spreads. We don’t understand most of it but we do understand that simplicity counts, at least in FX. If the return on swapping a 5-year note for a 30-year bond is negative, that’s historically abnormal. Normalization of rates at the short end may not be the answer, but it can’t hurt—can it?

Fed chief Yellen speaks at the Economic Club of NY tomorrow. Maybe somebody will ask her.

The most worrisome thing in FX is not whether Yellen has a secret deal with Draghi to postpone hiking until he gives the green light, but rather what the hell is happening in Japanese markets? The FT notes the dollar/yen is now up for 7 straight days and on track to match the last rally from July, when it ran for 10 days.

Today the Nikkei rose as the yen fell some more, as usual, but we don’t get why the yen is not falling off a cliff after the introduction of negative rates and the prospect of another economy-choking sales tax hike next year. Reuters reports that ever since the adoption of negative rates on Jan 29, the bond market has been a volatile mess. “The average daily trading range of the benchmark JGB futures rose to about 0.44 point after the BOJ's shock decision to adopt negative interest rates, more than double the average of 0.20 point in the preceding one-year period. Trading in longer-dated cash bonds became even messier as about three quarters of JGBs, or up to 12 years to maturity, have negative yields, prompting investors to rush to buy 20- and 30-year bonds in panic.

"As investors fight to secure some of the rapidly declining float of investable bonds, the market is trading like a department store's going-out-of-business sale," said Neale Vincent, strategist at Nomura Securities.” Another analyst says "The JGB market is really in a bubble, when you think about it as an investment vehicle," said Takuji Okubo, chief economist at Japan Macro Advisors in Tokyo. "Their prices have moved away from fundamentals, and people don't have a traditional way to measure their value." Nobody knows how the BoJ can ever begin tapering once it has killed the normal liquidity-providing mechanisms. And meanwhile, the BoJ—which is listed on the Tokyo stock exchange—is buying assets that return a cost, not a yield. We continue to lack guidance on whether rates can go more negative.

Some official statements seem to say no while others seems to say “never say never.” For negative rates to work, banks have to be able and willing to lend and enterprises have to need to borrow to expand production. Japan seems to have neither. We get the Tankan on Friday, expected to reveal a drop in capex intentions. It’s the same problem as Japan has faced over the past two decades—you can’t push on string.

One thing you can do to put some starch in the string is to devalue—by a lot. Instead, the yen hit 125+ last June and has been firming ever since. We are not going to discuss the currency war story, which is 99.9% fantasy, but honestly, if you were running the BoJ, that’s exactly what you would want. The problem is how to get it. The FT writes “Mr Abe cannot afford further yen strengthening. In the weeks that followed the negative rate announcement — a move widely judged to be an attempt by the BoJ to remind markets of its ‘all-in’ resolve to support Abenomics and to hold the yen below Y115/$ — the yen challenged the Y110/$ level in spite of heavy asset outflows as foreign investors fled and domestic funds sought higher yields overseas.”

But Japan is a good G7 and G20 citizen and not likely to start a war with outright intervention or even much jawboning. The more likely approach is to arm-twist domestic investors into foreign markets, something already started with the pension fund but capable of vast enlargement. But until a confused Abe administration gets more focused, we can expect the trend to continue. This is what traders always do—test a line in the sand, even if the line is mostly imaginary. The dollar high overnight was 113.69, closing in on the presumed 115 worst-case level. Something might be brewing. But the BoJ can be cagey and would probably let the market get its nerves fried at (say) 117 or 119, and see if the market doesn’t correct all on its own. See the monthly chart below. A run to 107, the 38% retracement, looks likely.

Finally, on the political front, Cruz is nearly as personally repulsive as Trump (to women, at least) and not any the less dangerous. For someone who went to Yale and Harvard, he is spectacularly uninformed about economics and finance. Or else he knows perfectly well that his ideas are bunk but they appeal to the ignorant and ideology-addled. In other words, it is more likely he is lying to them than to us. The latest is a revival of the promise to return to the gold standard.

This is somehow a promise of a return to a golden age of stability and prosperity that never, of course, existed. From financial writer Desmond MacRae, we get this interesting tidbit: If the US went on the gold standard and all the major countries followed, the price of gold would have to be $23,356,000 per ounce (and that’s to accommodate global GDP, not global money supply). Needless to say, gold at $23.6 million/oz would set off everybody digging in his back yard. The BBC points out “Ted Cruz would turn out to be a far worse environmental ninny than his critics say he is now.”

Keep your powder dry.