Less stability, more surprises
CENTRAL BANKS love stability...and hate surprises, writes veteran FX trader Andy Krieger for Bill Bonner's Diary of a Rogue Economist.
Like it or not, though, they're about to see less of the former, and a lot more of the latter.
The currency market has been jammed into ever-narrowing trading ranges over the past five years. This compression is both unnatural and potentially dangerous.
And there's evidence it's about to break loose, which means a lot of the old themes dictating today's market action will fly out the window.
The best way to describe market behavior in recent years has been to categorize it as either "risk-on" or "risk-off".
In a risk-off scenario, traders buy Japanese Yen, Swiss Francs, and gold – the ultimate store of monetary value. They also buy Dollars – the king of safe-haven currencies (as long as the risk doesn't originate in the US) – while selling currencies like the Australian and New Zealand Dollars. They also tend to sell stocks and buy bonds.
In a risk-on scenario, traders do the opposite. They sell Yen and Swiss Francs, sell gold, sell bonds, buy stocks, and bet on strength in Australian and New Zealand Dollars against the US greenback.
The cycle we're now entering, however, may be entirely different – a kind of hybrid where old patterns and relationships break down. A "new normal" that's anything but.
Here's just one example: We may soon see an era of Dollar strength against the Yen, with a persistence and magnitude that many won't see coming.
The Yen has been slowly weakening over the past 10 days and just last week, it broke through several significant technical levels. This move in the Yen was fierce, and it is likely just the start of a major trend that will continue for months.
Japan posted awful GDP numbers for end-2019. Based on the old, risk-off paradigm, one would expect the Yen to strengthen on this news.
You see, over recent years, when conditions in Japan turned sour, Japanese investors repatriated some of their massive overseas holdings and converted foreign currencies into Yen in order to prop up the system.
The recent move, however, was different. Things in Japan are so bad that Japanese investors accelerated their purchases of overseas assets, selling Yen for US Dollars.
This is the opposite of what many expected, and is so unusual that it may be among the early warning signs that the old paradigms are breaking down. The economic challenges in Japan are only going to get worse.
Japan's largest export market is China. Last year, Japan sold about $140 billion worth of goods into China. That market is going to take a hit this year. It isn't yet clear how bad it will be, but China's problems couldn't be coming at a worse time for Japan.
China's economy has shifted in recent years, becoming far more reliant on consumption. More than 60% of the Chinese economy is consumption-based, and the coronavirus has had a massive, negative impact on consumption.
The problems in China will send shockwaves through the global system. We certainly shouldn't be surprised to see some of these shockwaves result in a stock market correction at some point in the future.
Japan will initially do the same thing they've done for the past 30 years – pump lots of fresh money into the system and hope the economy can recover. The central bank playbook is nothing if not consistent.
This time, however, I suspect it may be different.
Instead of just printing money and buying assets, Japan may ultimately be forced to take some extreme steps to ward off a crushing deflationary spiral. Just buying assets won't be enough. Somehow they need to create economic demand, and this means that the Japanese will need to find a way to put that money to work.
This is a more complicated strategy, and so far, the Japanese have not done enough in this regard.
At the same time, we will likely see a globally coordinated effort by the major central banks to prop up their ailing economies with hyper-loose monetary policy coupled with blatant monetization. This means that the central banks will print money and then buy assets with this money.
Clearly, when someone supplies too much of any good, that good will lose value over time. The situation with currencies is no different. The Yen and other major currencies are likely going to weaken significantly over the coming weeks and months.
Underlying this strategy, however, is a subtle but insidious goal: The world's central banks mean to weaken their currencies to gain a competitive export advantage. It's just like the old "beggar thy neighbor" strategy, undertaken in the 1930s by the major countries resorting to competitive devaluations.
The US won't be happy, but the US economy is best able to withstand the onslaught of cheap goods flooding into our markets.
Another anomaly in this new paradigm is that gold has rallied alongside stocks. I think this tells us there are major problems bubbling just beneath the surface.
Stocks are trading at or near all-time highs, but a series of poor earnings reports may start to erode their support. Gold's strength is sending us a warning about this disconnect.