IMF is worried that low rates have driven investors insane

Outlook:

The IMF is worried that low rates have driven investors insane in the quest for yield and we have bubbles everywhere, while sovereigns are over-indebted. This can’t end well. Well, yes, and various people have been saying exactly this for some time. The problem is most obvious in Europe, where banks won’t lend as long as they are under the regulatory microscope but money is bursting out of savers’ mattresses with nowhere to go except sovereign debt, driving yields to ridiculous levels that bear no relationship to riskiness.

Here’s a guess: the ECB’s quest for securitized paper and collateralized bonds will work, albeit taking a long, long time and not starting until after the bank exams are done at end-Oct. The ECB will compete with private investors for the new securities. If they get a decent rating—not a foregone conclusion—the hedgies and the Asians will rush in. If there is any underlying basis for a euro recovery, this could be it, and to hell with deflation/recession. Demand for a currency can disregard fundamentals if the institution-al change is appealing enough.

One of the more interesting pieces we have seen in a while is a WSJ story last week on the true value of the yen. “The yen’s fall has seen the dollar rise from around ¥84 in December 2012 to as much as ¥110 earlier in October, but it still lies a long way from the ¥135 seen in 2002. In relative terms, though, the BOJ says the yen is now even weaker than it was at the time of the Plaza Accord in 1985, a landmark agreement among rich nations to help strengthen a yen that was seen as too low against the U.S. dollar.”

The BoJ comes up with the real effective exchange rate the usual way—weighting each of 59 trading partner currencies by the volume of trade. The bank also adjusts for inflation. “The BOJ calculations show that the real-effective exchange rate hit 74.91 in January this year, its lowest since 74.56 in No-vember 1982.”

Since the real effective exchange rate comes up with a number that the Japanese government doesn’t want to see, that gives it credibility, but we can find 87 things wrong with the trade-weighted and inflation-adjusted methodology. For one thing, China is a big trade partner for Japan and no one would imagine the yuan is properly valued. Other Asian countries have the same issue, and be-sides, much of the trade attributed to this country or that country is actually done in US dollars. Finally, the trade method ignores capital flows, which we know can be as important as trade, is not more so, at least sometimes.

Bottom line, the euro/dollar is the key benchmark and there we have no doubt about the eventual out-come—the Fed may lollygag and fret and postpone and otherwise impose unnecessary uncertainty on the market, but the economy is better than anyone else’s economy and the US will be tightening. The BoJ and ECB will not be tightening. The BoE is anyone’s guess, but on the whole, the dollar is the win-ner, if only on having less uncertainty than anywhere else.

Note to Readers: We have jury duty next week on Tuesday 10/21. If we do not get a message Mon-day night that we are excused, there will be no reports on Tuesday.