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Thursday, 23 May 2013

Summary

For the time being, the consensus expects major central banks to keep their feet firmly on the stimuluspedal.

In our view, the Fed will start to wind down QE in the fall. Over the coming period, we foresee moremarket speculation to this effect.

Japan is stumbling into a difficult situation; it badly needs to prevent rising interest rates and an overlyweak yen. Its only option is to impose restrictions on the outflow of capital, in one way or another.

Eurozone tensions could flare in the course of the year on large budget deficits in the debt-ladencountries and less capital flowing into the markets outside Europe. The ECB will likely continue to ease its

policy. It could focus especially on "bespoke measures" to boost the supply of credit in the weak member

states.

To hedge against Eurozone risk, we advise to go short on French bond futures and long on Germanfutures (gradually). In addition, we recommend steadily decreasing equity positions.

The 10-year US Treasury yield (now around 2.0%) could climb to 2.5%-3% towards year's end and thento 3.25% early in 2014. The 10-year German Bund yield (now near 1.4%) will probably not exceed 1.8%(by much) over the coming period.

EUR/USD could drop to 1.20 in the next few months or quarters and then to 1.10. Rallies in-between willprobably stop near 1.34.

In the near future, USD/JPY can fluctuate between 95 and 105. EUR/JPY could peak, then fall back to115.

Calm before the storm

At first glance, it would appear that the

situation of the global economy and financial

markets is clear-cut. In the US, the economy

had been picking up at a fair pace until the

fiscal consolidation (from January 1st) started

to bite. Early in Q2, growth slowed to around

1.5%. The fiscal drag is expected to wear off in the

course of the year. Nevertheless, many analysts do

not think the economy will accelerate much beyond a

2% growth rate.

US inflation is expected to ease rather than rise as

unemployment decreases very slowly. If so, this

would imply that incomes are unlikely to rise rapidly

and consumers cannot up spending to any great

extent. At least: not without extra borrowing. As to

the latter, there are few signs that this is on the

cards. The post-war baby boomers, in particular, will

be more inclined to save than to take out new loans,

as their old-age provision is shrouded in uncertainty.

Based on this, many economists conclude that


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the Fed is poised to keep its foot firmly on the

stimulus pedal and that it will wait until early

2014 before winding down QE. If they are

correct, cheap money will flood the markets for

the foreseeable future.

Europe

And what about Europe? On the whole, the

Eurozone is still in recession. At best, it will

gradually emerge from this as the year

progresses.

The main reasons for this forecast are that the

effects of the fiscal tightening will likely wear

off while there is downward pressure on

inflation. Both factors can be expected to boost

consumer purchasing power. However, this effect

will not be strong; the banks have to shrink their

balance sheets so will not be able to supply a lot of

credit. Especially the banks in the weak Eurozone

countries.

The ECB is pursuing a loose monetary policy in order

to fight the recession. Before long, it could take new

measures to help the banks. The latter is also being

debated at European level. Particularly the possibility

of a banking union and increased support by the

European emergency fund for the distressed banks.

Yet all of this will continue to be an uphill struggle,

as the banks have no choice but to reduce their

balance sheets. On top of this, Germany is far from

sanguine about a much looser ECB policy, which

could cause the German economy to overheat. In

addition, the country fears it will be saddled with

losses run up by banks outside Germany.

In short, the German government is very wary of

such policy measures. However, the situation has

changed now that German exports are in

competition with export products from Japan,where businesses have obtained an advantage

after prices dropped 30%. As a result, Germany

may become more enthusiastic about an ECB

policy that drives down the euro.

Clearly, good things and bad things can be said

about the European economy, but it seems that the

highest achievable growth rate in 2014 will be

approximately 0.5%-1%. So in any case, the ECB

is unlikely to lift its foot off the monetary gas

pedal in the near future.

The ECB's current stance may be less

accommodative than the policy of the Fed but it

helps to create a positive outlook for the


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interest rate and equity markets. At the same

time, it could contribute to a weakening of the

euro.

Abenomics

In Japan, "Abenomics" (the nickname for the

administration's new policy) consists of three

components:

Flooding the system with liquidity in

order to boost the economy. One

objective is to drive down the yen. Inaddition, the authorities want to

transform deflation into a 2% rate of

inflation. This is crucial, as Japan has

huge debts, at various levels. In a

deflationary climate, the debt burden

weighs increasingly heavily (for as

interest payments and capital

repayments stay the same, nominal

incomes decline).

To kick start the economy, and

regardless of the fact that the

budget deficit already amounts to

9% of GDP, initially a substantial

fiscal stimulus is needed. As the

Japanese public debt is around 240% of

GDP, there is not much scope in this

respect. Expanding the budget deficit is

only possible in the short term, in order

to provide the economy with a temporary

impulse. As soon as growth takes off, the

fiscal policy should become more neutral.

(The administration plans to do this

through a VAT hike. To some degree, this

will put a drag on the economy. To offset

this, a persistently loose monetary policy

is required, as well as the measures

described below).

The third arrow on the government's

bow comprises structural growth-

boosting measures. Especially the

abolishment of existing regulations.

Many of those restrict competition

between domestic businesses in

Japan as well as import competition,

which is hampering innovation. In

addition, the job market should

become far more flexible.

Success of Abenomics is an open question

It remains to be seen whether the Abe

government will achieve all of this. Some

months from now, new elections will be held,


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which will act as a litmus test. The markets

assume that, in the meantime, the money taps

will stay open and that, on balance, Japanese

stock prices will therefore continue to rise as

the yen depreciates further. Japan has a current

account surplus. Consequently, this is only possible if

a lot of capital leaves Japan. In the circumstances

low growth rates in Europe and the US most of this

money will flow to other Asian countries, where

growth is still quite robust. However, these states

are not at all keen on an inflow of foreign capital that

will make their currencies more expensive andimpede competitiveness, which forces them to

intervene in the foreign exchange market. (And sell

the domestic currency against, for example, the US

dollar and the yen). This will increase money supply

in the countries in question and heighten the risk of

bubbles. However, there seem to be no alternatives.

The above is evidence of enormous money

creation around the world. So far, this has

driven up stock prices and other asset prices

to ever greater heights. Meanwhile, the real

problems are being glossed over and obscured

by a smothering layer of money as investors

threatened to fall prey to euphoria. The trillion

dollar question is how much longer will this

continue? More about this below.

Change on the horizon firstof all in Japan

In previous reports, we have extensively

described that central banks are trying to turn

the usual state of affairs on its head. Whereas

"normally", stock and other asset prices tend to

rise in response to improved economic

prospects, this time round, massive liquidity

creation is used as an instrument to drive up

asset prices and improve the economic

prospects. The idea is that as the value of assets

appreciates, debts remain the same. Central banks

hope to promote borrowing and discourage saving,as this seems the only way to stave off deflation and

boost economic growth, against a background of

high indebtedness. Yet, the problem is that

gigantic money creation is required to achieve

this:

Without a better economic outlook, it is

very difficult to boost asset prices.

In the past decades, asset prices have

soared a number of times, only to tumble

again soon afterwards. It is barely

possible to convince people andcompanies that they should take out

more credit once the value of their assets

goes up. Most of all baby boomers who

are approaching pensionable age.

The problem is that once credit picks up,

inflation fears will flare up. Owing to the massive

money creation, if credit were to be supplied on the

same scale as it was in recent decades, the specter

of hyperinflation will haunt the markets.

The only remedy is to remove money from the

system on a large scale, as credit supply

increases. This is easier said than done for

before long, it will send asset prices lower,

which have been artificially boosted. If they fall

too sharply, tightening credit will nip the

economic recovery in the bud.

Unless enough money is removed, inflation fears will

send long-term interest rates higher and if the debt

burden is colossal, soaring borrowing costs could be

"fatal". In short, the central bank will need to

perform a delicate balancing act. In the past, it

has often been unable to do so.

Although the US is the first country where

credit shows signs of picking up, we think the

problems will start in Japan. For a number of

reasons.

Limited benefits from weaker yen

Many investors assume that the Bank of Japan will

continue to pursue a loose monetary policy for a long


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time as the yen continues to depreciate. We fear

they are mistaken. Japan's imports exceed its

exports. And, although the yen has become

significantly cheaper, exports have not

suddenly exploded. It frequently takes years to

open up new markets. In addition, few businesses

will decide to move production to Japan based on

currency fluctuations alone. Not least because

experience shows that sooner or later exchange

rates tend to move in the opposite direction.

If the yen depreciates, established exporters canearn substantially more without expanding exports

or committing to higher investment in Japan itself.

At the same time, as soon as the yen weakens,

import prices start to rise. Originally, when

USD/JPY was below 80, the Japanese currency

may have been significantly overvalued. From

this angle, the rally so far has done Japan good.

However, various studies show that the

balance will tip the other way if USD/JPY

climbs above the range of 100-110.

A recent survey of the Japanese business sector also

indicated that most companies do not want the pair

to exceed 105. Understandably, voices within the

government say they hope the currency market will

not weaken the yen too much. This suggests that the

verbal interventions is effectively halting or

delaying the depreciation of the JPY near its

current level of 103.

Also relevant in this respect is that other

countries really do not want a stronger

domestic currency. Japan needs to tread

carefully, or it could have a currency war on its

hands. Keep in mind that the Asia crisis in 1997

followed a period of yen weakness. At the time,

this generated excessive money supply in other

Asian countries and various bubbles emerged, which

popped eventually.

In conclusion, we can say that although Japan

needs a very loose monetary policy, the yen

should not fall much further, as this would

damage rather than help the Japanese

economy.

Japan has to prevent rising interest rates

Another problem is that lately, Japanese (long-

term) interest rates have risen considerably.

This is no surprise.How many investors are prepared

to accept a Japanese government bond yield below

1% if the administration and the central bank say

they will do everything to raise the rate of inflation

to 2%? The risk of an additional depreciation of the

yen will remove the incentive for foreign investors topurchase and/or own Japanese government bonds.

Self-evidently, the Japanese central bank can extend

its bond-buying program in an attempt to keep

interest rates down. The snag is that this will place

downward pressure on the yen and increase the

chance that the authorities will overshoot the 2%

inflation target. At the same time, they need to

counter the upward pressure on borrowing

costs for if interest rates continue to rise, the

government will soon go bust (the reason why

the previous Policy Board of the Bank of Japan

refused to go down this road). The root cause of

these problems is the fact that Japan has a

humongous national debt.

On top of this, Japan has to beware of a "crisis

of confidence". The latest data suggests that

Japanese economic growth is close to three

percent, due to the fiscal and monetary

stimulus and the cheaper yen. This could

continue over the coming quarters but what

will happen next? To start with, next year the

fiscal policy will switch from accommodative to

restrictive. Not much can be done to change this as

the budget deficit and public debt are huge.

Plus, the wrong kind of inflation could occur in

Japan. That is to say, a "cost push" instead of a

"demand pull". If so, inflation will rise on the back of

higher import prices and not because of higher

demand as a result of wage increases or easier

credit. The question is will this benefit Japan? In our

view, wages will not rise substantially in the coming


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period. Under such conditions, higher inflation

will only undermine consumer spending power.

Structural reforms are key

Finally, it is uncertain if the current

administration will manage to implement the

necessary structural reforms. Typically, the latter

initially act as a drag on the economy before

boosting growth at a later stage.

Clearly, it is unwise to simply assume that the

yen will continue to depreciate for theforeseeable future and that stock prices will

soar unabatedly. The easy part of Abenomics is

behind us; the hard work is about to begin.

At the very least, the Japanese government

should prevent interest rates from rising and

counteract the depreciation of the yen. This

implies it needs to reduce the outflow of

capital. Probably the first weapon of choice will be

verbal intervention. This has already started. There

have been statements that the JPY should not

weaken much further and there is a lot of pressure

on major Japanese investors to continue to purchase

Japanese bonds on a large scale. If this is not

effective, the Japan can also sell part of its foreign

bond holdings. In the most extreme case, the Bank

of Japan could wind down QE.

Whatever the tactic, eventually the rest of the

world will have to learn how to live with less

cheap money. Many investors continue to count

on a Japanese "river of liquidity" but this could

dry up sooner than expected.

The Fed is beginning to havedoubts

As we explained, the consensus seems to be

that the Fed will continue to flood the economy

with money for the time being. Presently, USgrowth rates are near 1.5%. As a result, inflation

continues to ease. If this process continues, deflation

will loom. Unemployment is only going down very

slowly. In other words, the central bank's objectives

(inflation close to 2% and jobless rates below 6.5%)

have not been achieved or have moved further out of

reach. Many investors think this automatically

points to ongoing stock market rallies, low

interest rates, shrinking credit spreads, and

dollar weakness.

However, this is just part of the story. The

fiscal drag on the US economy may besubstantial put it will lessen from Q3 onwards.

This is important. Recently, the IMF calculated

that underlying growth in the US i.e. in the

private sector is around 4%. Quite possibly,

towards year's end, overall growth could be near

2.5%-3% and near 3%-3.5% in early 2014.

Meanwhile, that growth rates in the private sector

are close to 4% can only be down to higher

borrowing and/or a lower savings rate. In essence,

wages are not increasing sufficiently to boost growth

to this degree.

In other words, without the fiscal drag, the Fed

would already have started to lift its foot off

the stimulus pedal. So now we have a bizarre

situation of soaring asset prices whereas the

Fed is expected to unwind QE later this year

which will drive down those same asset prices.

For the moment, the central bank cannot change

tack; it is terrified of throttling down too soon and

failing to boost the economy at all. However, it would

be preferable if asset prices could stop rising so they

would fall less sharply later on. (This applies to stock

prices and credit spreads more than housing prices,

which are still far below their peaks and therefore

less vulnerable).

US economy strong enough to cope with tighter

Fed policy?

In view of the above it is understandable that

debates rage inside the Fed about the timing of

unwinding QE.


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The main issue here is the estimation of the strength

of the underlying economy. We think the US

economic data will point to so much inherent

vigor that the markets will start to discount

that the Fed will unwind QE in the fall. Of course

we realize that the fiscal drag will only disappeargradually. However, this is offset by lower

commodity prices (especially oil prices) which will

help consumers. As will higher property prices. In

addition, the US banks seem more minded to supply

credit. On balance, we expect these stats to improve

from the summer onwards.

If so, the financial markets will increasingly

realize that the era of "unlimited" money

creation is drawing to a close. In our view this

will impact more and more on stock prices, bonds,

and credit spreads whereas it will underpin the

dollar. The process will probably unfold gradually.

Meanwhile, the rest of the world will come to

understand that, as in the case of Japan, the US

capital flows will decline. Which brings us to the

situation in Europe.

Europe profits from search foryield

Regardless of Europe's many unsolved problems, the

EMU has been remarkably quiet off late. This is still

connected to Mario Draghi's promise that the ECB

would "do whatever it takes to preserve the euro.

An additional reason is the worldwide search for

yield. As loose monetary policy around the globe

drives down interest rates on deposits and

government bonds to historically low levels, the

superfluous liquidity is "searching" for higher-yielding

assets on a massive scale.

These developments have had an upward effect onthe capital markets in Spain, Italy etcetera. This is

not necessarily beneficial for the countries

themselves. Nursing their economies back to health

requires lower wages and asset prices, which is very

painful. They also need to implement a raft of

unpopular structural reforms (see also our recent

reports). Until approximately six months ago, high

bond yields meant they had no choice in this matter.

Now that bond yields have dropped, there is less

pressure on the politicians to take decisive steps in

the right direction.

We fear they may come to regret this in the second

half of the year.


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Even if borrowing costs remain low, the growth

prospects for most weak Eurozone countries are far

from buoyant. In all likelihood, budget deficits will be

large for the foreseeable future. This would not be so

bad if cheap money would continue to flood the

global markets. However, as indicated above, we

expect this to change, slowly but surely.

In addition, we foresee growing Eurozone tensions in

the later part of 2013. Increasingly, this will put

pressure on the ECB to apply more QE and depress

the euro. Germany in particular is opposed to large-scale monetary easing. However, there is a high

chance that the other member states will overrule

Germany and that Berlin will resign itself to

restricting the scope of the expansionary measures.

To achieve the latter, Germany will probably insist

that the ECB focuses mainly on facilitating the supply

of credit to small and medium-sized businesses in

the peripheral Eurozone countries.

Plus, it cannot be denied that a weaker euro would

be convenient to the Germans at this point in time.

Back to summary ^

Implications for the financialmarkets

Summarizing, current and future market conditions

are as follows:

That US economic growth is slow is

not exactly surprising. In Q2, the fiscal

drag amounts to 1.75%-2%. In other

words, if overall Q2 growth runs to

1.5%-2% we assume this is the case underlying growth is around 3.25%-4%.

As the effects of the fiscal tightening will

wear off gradually, in itself the prospects

for the US are good, unless the private

sector falls short of expectations. The

data indicates the latter is unlikely. The

chance is high that growth rates will

rise to 2.75%-3% later this year and

then to 3%-3.5% in early 2014. In

other words, to stave off inflation

risks, the Fed will need to unwind QE

at some point during the fall. More

and more Fed members seem to be

hinting at this albeit with the

qualification that depending on the

data in the coming months this

could happen earlier or be put off for

longer. The implication for the

financial markets is that although QE

will not wind down immediately, this

process will certainly be on the cards

in the not-too distant future.

Japan is increasingly vocal about the

risks should USD/JPY rise much

further. Even more importantly, it

needs to keep interest rates down.

The only way to achieve this is

though restrictions on the capital

outflow. Success in this respect will

benefit the Japanese bond and stock

markets. The reverse of the medal is that

the rest of the world will have to live with

a decreasing capital inflow from Japan.


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The Eurozone has been pretty quiet in

the past period. This is thanks to the

earlier statements by ECB president

Draghi, but also because of the large

worldwide liquidity surplus. However, in

the near future we could see the adverse

effects of persistently large budget

deficits and minimal economic growth in

the peripheral countries, as less capital is

flowing into the markets from Japan and

the US. As a result, the euro could

weaken on higher Eurozone tensions especially after the German

elections in late September and

mounting pressure on the ECB to

ease its policy. Theoretically, a

depreciated euro would be an effective

way to help the debt-laden countries and

boost Germany's competitiveness,

especially in relation to Japan.

Nevertheless, it is important to

remember that the ECB has limited

room to ease its policy because of

German opposition. In all likelihood,

this will force the central bank to

concentrate on getting the banks in

the problem countries to lend again.

End of an era

Our main conclusion is that the period of abundant

money creation all over the world is coming to an

end. Perhaps not in Japan (at least not straight

away). However, in any case Tokyo will have to

restrict the amount of capital that flows to foreign

markets. In all likelihood, the United States will

be the first country to slowly lift its foot off

the monetary gas pedal. The opposite applies

to Europe, where the central bank may well

ease its policy further, albeit to a limited extent

while for the moment, the ECB is applying far

less monetary easing than the Fed.

We think the rally in the stock markets does

not have much further to go. True, in the final

phase a rally can gather steam but time wise, it

largely seems to have run its course. First and

foremost, the rallies in the US equity markets

as the Fed could wind down QE before long. If

Eurozone tensions flare simultaneously, and

regardless of a more accommodative ECB policy, the

European stocks could drop concurrently. We think

the latter is a real risk. In this context we refer to

the warning issued by the Chief of South

Korea's central bank, earlier this week. He

indicated that bond yields in many countries could

soar once the Fed begins to scale down the pace of

bond purchases. Many banks own large bond

portfolios so could run up substantial losses. It verymuch remains to be seen if they can survive this.

This is also relevant when we consider Italy

and Spain. Less cheap money from Japan and

the US and unrest in the euro area could send

bond yields higher later this year. In our view,

a reasonably cost-effective hedging method

in regard to a euro break-up as well is to go

long on German government bond futures and

short on government bond futures. Increasing

turmoil in the Eurozone places upward pressure on

French bond yields. In the meantime, the French

economy is diverging from the economies in the

strong EMU countries. It seems a good idea to profit

steadily as the France-Germany yield spread

continues to shrink; especially as the costs need not

be high.


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Implications for bond yields and currenciesBased on the absolute interest rate levels in the US

and Germany, we think the yield on 10-year US

Treasury Bonds (now near 2.0%) will have risen to

2.5%-3% by the end of the year and to around

3.25% in early 2014. However, we cannot rule

out that stock prices will tumble in the course

of 2013. This could hit the economy so hard

that it forces the Fed to increase QE. If so, bond

yields will fall again. For the moment, we do

not believe this to be the most likely scenario.

As we mentioned earlier, the stock marketscould peak before long, especially in the US. At

first, the subsequent pullback could unfold

slowly. Such a gradual drop will probably not

prevent long-term interest rates from rising.

Usually, higher US bond yields drive up interest rates

in Germany as well. On the other hand, it is clear

that the European economy is much weaker and

there will be pressure on the ECB to ease its policy

sooner once Eurozone tensions flare. Under such

conditions, German government bonds will be a safe

haven. This is why we do not think the yield on 10-

year German Bunds now around 1.4% will climb

far beyond 1.8% in the coming period.

Whereas the Fed is expected to unwind QE, the

ECB is more inclined to ease its policy. This will

have a downward effect on EUR/USD. In

addition, we foresee mounting Eurozone

tensions. Therefore EUR/USD could slide to 1.20

over the coming months or quarters and later to

around 1.10. Rallies in-between will probably end

near 1.34, if that (it would surprise us if the pair

exceeds 1.30). As indicated, we doubt whether

USD/JPY will rise much further in the near future; it

will probably stay around 95-105 over the coming

months or quarters. As a result, EUR/JPY could peak

shortly and then drop to 115.


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Back to summary ^

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