Sky Blue Monthly (Jan. 2000)
All Rights Reserved, 2000
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Jan. 5, 2000
In the Dec. 1999 issue of Sky Blue Monthly, we said, "Therefore, the Fed has only 2 opposite choices: 1. Let yen take off and then the US T-Bond market will get smashed and US stock market bubble will burst right here. 2. Intervene the forex market with BoJ and ECB to suppress yen and increase money supply to jack up the stock market. (i.e. pump up the bubble to an even bigger size) From the Fed's past behavior, we expect the Fed to take the second option. " Some of these predictions came true. Bank of Japan (BoJ), indeed, intervened the forex market to suppress yen by selling yen for USD during the last days of last millennium. However, the Fed and European Central Bank (ECB) were not involved. BoJ was rumored to have bought about $2 billion USD during those thin volume days. That was quite a small amount for a forex intervention. In fact, during the whole 1999, BoJ had bought $42 billion USD in 12 interventions. Most of them were bought from mid-June to mid-July. (About $30 billion USD) During the first days of new millennium, BoJ still has not done with their interventions. (We are not good at tracking numbers. If any reader can provide more accurate numbers with the source of the data, we will appreciate it.) Given the strength of yen, we suspect that sooner or later, BoJ has to intervene the forex market every trading day.
Another very important factor was the growth of M3 (in the USA). M3 is a good measure of board money supply. M3 growth has surged to an annualized rate of 21.8% in the 8 weeks ended December 20, 1999 in the USA. This means that the total of M3 (not adjusted for seasonal variation) is up $244.9 billion. Some readers may ask, "If M3 surges upward, where is the inflation? " Remember Friedman's theory -- "Inflation is purely a monetary phenomenon." This sentence is a widely accepted foundation of Milton Friedman's monetary theory. Then, why is inflation rate not rocketing up in America?
By using our macroeconomic theory (FFEE), we will attempt to explain the details. Increase in money supply will cause: (1) CPI inflation (Friedman and Chicago School love this.); (2) Asset inflation (The best example can be found in 1988-1989 Japanese Nikkei and real estate bubble.); or (3) Capital outflow in form of Carry Trade. Friedman is 33% correct, according to FFEE. (We respect Milton Friedman. He is a great economist who is always provocative and energetic.) Case (1) is a common knowledge, so we won't explain it in details here. Too much money is chasing limited amount of goods and services in Case (1), hence, consumer price index (CPI) goes up. Case (2) is much more complicated. We found out others had done a great work in this aspect. If you study Japanese bubble economy during the late 80's, you will understand what an asset inflation powered by soaring money supply really means. Let me write down the links; you must go to these 4 links and read them all before you resume reading our Sky Blue Monthly.
This study is simply a masterpiece. We cannot put it better. The conclusion (Part IV) is the most important section. After reading all 4 sections, you should notice the eerie similarity between 1989 Japanese economy and 1999 American economy. Even you have read it, we still cannot resist to quote (and to emphasize) the following: "Even the standard inflation measures, the consumer and wholesale price indexes, failed to pick up the bubbles. This appears to be an artifact of national accounting. Neither the wholesale nor the consumer price index takes account of the prices of equity securities; and land values are factored into the consumer price index only with a lagging measure of residential rents. The huge jump in capital values, especially in commercial real estate, was simply not measured in the indices, and accordingly it was technically off the radar screen for the Bank. " We believe that, besides the equity bubble and real estate bubble are off the radar screen for the central bank, there is another reason for inflation to remain low. Every time newly created money and newly created credit appear, we simply have to observe where they are going to go. If they flow into the retail market, we will get a CPI inflation; if they flow into equity market or real estate market, we will get an asset inflation. There is nothing mysterious about this. If the newly created money and newly created credit mainly flow into NASDAQ, well, then it is not really a puzzle that CPI inflation rate is still relatively calm despite the rapid growth in M3.
In comparison, asset inflation sounds much better than CPI inflation. If CPI inflation rate is high, then it means that your money is losing value fast because it will soon be able to purchase less and less goods and services. That doesn't sound appealing. If asset inflation rate is high, your stocks (XYZ.com) are soaring upward into the stratosphere and your house value is rising fast. This is very appealing! You feel rich because of all the gains from the stock market and real estate market. You go out and spend. This spending by those who are just like you stimulates the economy. As a result, this "wealth effect" guarantees a strong economy. It sounds like the best thing in the world. As we have seen in the case of Japan, the opposite is true. (Sadly)
Let me quote Northern Trust Chief Domestic Economist Paul L. Kasriel (my idol): "So, what's wrong with the Fed creating credit and money out of thin air? It's good for the stock market and the economy, isn't it? Well, if the creation of credit and money out of thin air were good for the economy, then I would submit to you that all the world's economic problems would be over. The Fed and other central banks can create credit and money at practically a zero cost. Although the creation of money and credit by the Fed causes the demand curves for goods and services to shift out, it does not cause the supply curves also to shift out. Unless the supplies of goods and services are available in unlimited quantities at constant or falling prices, this increase in demand for them emanating from the Fed-created credit will lead to increases in their prices. " (Quoted from Dec. 2, 1999 issue of Positive Economic Commentary.) That is right. Creating credit and money out of thin air by central bankers cannot increase the supply of goods and services large enough to match the increase in demand. True, the resulting rise in general price by increase in demand due to "wealth effect" will be in the future, maybe several months or even years down the road; but the bond traders usually spot the problem first. Look at US T-Bond futures. It has been in a downtrend since early Oct. 1998. Rising interest rate can be very deadly to asset bubbles. March 2000 T-Bond futures contract has already sunk below a major support level at 90-00. Next few weeks will be critical. If T-Bond continues to sink, there will be more troubles for the high-flying stock market. (In fact, we expect an old fashion stock market crash in extreme panics if March 2000 T-Bond reaches our objective 80-00.)
We have discussed Case (1) and Case (2). Now, we turn to Case (3). Case (3) has been discussed in detail in Dec. 1999 issue of Sky Blue Monthly. http://skybluemonthly.freeservers.com/sbm/sbm99z.htm So, we won't do it again here, because we don't want to sound like a broken audiotape. One very important thing to notice is that in Case (1) and Case (2), the harm is done inside the country. In Case (3), capital outflow to other nations may cause new bubbles there. The massive capital outflow from the USA to the Third World in the early 90's created bubbles in the developing countries, especially South East Asia. The massive capital outflow from Japan to America since 1995 has caused much euphoria in American stock market. As we know, a Carry Trade has to be unwinded sooner or later. When it is unwinded, the affected economy will suffer a massive blow due to catastrophic capital outflow. This is the major difference between 1990 Japanese Nikkei crash and the current US NASDAQ. Nikkei back then was driven mainly by domestic liquidity. NASDAQ now is driven by both domestic liquidity and foreign liquidity. This is particularly dangerous because when the foreign capital leaves, it will mean capital outflow. It also means that USD will likely be hit if this occurs.
The key is still the YEN/USD cross. If yen continues to appreciate against USD, T-Bond will be in danger. (See Dec. 1999 issue of Sky Blue Monthly for details. http://skybluemonthly.freeservers.com/sbm/sbm99z.htm ) If T-Bond sinks, it will bring down stock market with it. BoJ is still working very hard on all those interventions. Those interventions were sterilized. Why doesn't BoJ try unsterilized interventions? (See my old paper "An Outrageous Plan for Bank of Japan" under "Economic Thoughts" for more information. http://skybluemonthly.freeservers.com/thoughts/thboj.htm ) Our reasoning is: a very important factor was Japanese Government Bond (JGB). It was sitting precariously on the trend-line support during the summer of 1999, while BoJ was suppressing yen by buying USD ferociously. We believe this was the reason that BoJ did not increase money supply to smash yen. If BoJ increased money supply aggressively, what if JGB broke the trend-line and headed south (due to rising inflation expectation)? Then, the spread between JGB and US T-Bond would narrow! There would be no reason to do the "Yen Carry" trade if this happened. Then, all hell would break loose. We believe that this consideration is still dominant up to these days. In the long run, our opinion is that JGB will break the trend-line support sooner or later. Japanese economy is recovering and the demand for credit and money will increase. Hence, the yield of JGB will rise and JGB will break the trend-line.
For those who don't really understand the difference between sterilized interventions and unsterilized interventions, here we go: An unsterilized intervention is a monetary policy. A sterilized intervention is closer to a fiscal policy. e.g. Bank of Japan buys USD in the forex market by selling yen. If this is an unsterilized intervention, BoJ increases money supply. If this is a sterilized intervention, BoJ actually keeps money supply unchanged. In a sterilized intervention, BoJ sterilizes an intervention by selling Japanese Government Bonds equivalent to the intervention. Thus, what BoJ has done is "acquiring USD and then selling JGB", hence, a sterilized intervention is actually a loan from BoJ to the USA, therefore, a sterilized intervention is closer to a fiscal policy than a monetary policy. (If BoJ uses the acquired USD to buy Treasury issues, then it is a loan to the USA. )
Let us do a short conclusion: If yen appreciates against USD, US T-Bond will sink. Besides, it is possible for US T-Bond to tumble even without soaring yen; if US T-Bond (March 2000 contract) breaks 90-00 decisively and then heads south sharply, US stock market, particularly NASDAQ, will be in deep trouble. Rising interest rate (particularly rising real interest rate) is deadly to asset bubbles, including stock bubbles and real estate bubbles. Also, T-Bond won't bottom until stock market bottoms. In the next few weeks, we will glue to the monitor and watch T-Bond very closely.
Feb. 2000 issue of Sky Blue Monthly will be available by Feb. 14, 2000.
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