Claudia_Calich_100

Playing Russian roulette

The Russia and Ukraine geopolitical tensions have driven their asset prices since February. As the below research courtesy of BofA Merrill Lynch shows, investors’ base case scenario is that a major escalation of the conflict, in the form of a direct Russian invasion of parts of Eastern Ukraine, is unlikely. The possibility of an invasion seems analogous to Russian roulette, a low probability but high impact game.

Slide1

I just returned from a trip to Moscow. You would not know there is the possibility of a war going on next door by walking around the city, if you didn’t turn to the news. Its picture perfect spring blue skies were in stark contrast to the dark clouds looming over the economy.

The transmission mechanism of the political impact into the economy is fairly predictable:

  1. Political-related risk premia and volatility remaining elevated, translating into weakening pressure on the ruble;
  2. Pressure for higher rates as the ruble weakens (the CBR has already hiked rates by 200 bps, including the unexpected 50bps hike last week, but more will be needed if demand for hard currency remains at the Q1 2014 level and pressure on the currency increases further);
  3. Downside pressure on growth as investment declines and through the impact of sanctions or expectation of additional sanctions (through higher cost of capital);
  4. Downward pressures on international reserves as the capital account deteriorates and CBR smoothens the currency move;
  5. Decline of the oil reserve fund should it be used for counter-cyclical fiscal purposes or refinancing of maturing debt (the $90 billion fund could theoretically cover one year of amortizations, but in that case, capital flight and dollarization would escalate further as the risk perception deteriorates).

All these elements are credit negative and it is not a surprise that S&P downgraded Russia’s rating to BBB-, while keeping it on a negative outlook. What is less predictable, however, is the magnitude of the deterioration of each of these elements, which will be determined by political events and the extent of economic sanctions.

My impression was that the locals’ perception of the geopolitical risks was not materially different from the foreigners’ perception shown above – i.e. that a major escalation in the confrontation remains a tail risk. The truth is, there is a high degree of subjectivity in these numbers and an over-reaction from either side (Russia, Ukraine, the West) can escalate this fluid situation fairly quickly. The locals are taking precautionary measures, including channelling savings into hard currency (either onshore or offshore), some pre-emptive stocking of non-perishable consumer goods, considering alternative solutions should financial sanctions escalate – including creating an alternative payment system and evaluating redirecting trade into other currencies, to the extent it can. Locals believe that capital flight peaked in Q1, assuming that the geopolitical situation stabilizes. Additional escalations could occur around 1st and 9th of May (Victory Day), as well as around the Ukrainian elections on 25th of May.

Slide2 Slide3

The table below assigns various CDS spread levels for each of the scenarios, with the probabilities given per the earlier survey. The weighted probability average is still wider than current levels, though we have corrected by a fair amount last week. I used CDS only as it is the best proxy hedge for the quasi-sovereign and corporate risk. Also, the ruble would be heavily controlled by the CBR should risk premia increase further, and may not work as an optimal hedge for a while, while liquidity on local bonds and swaps would suffer should the sanctions directly target key Russian banks.

Slide4

The risk-reward trade-off appears skewed to the downside in the near term.

matt_russell_100

The power of duration: a contemporary example

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

US UK and German 10 year yields

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

The importance of duration

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come.  As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

jim_leaviss_100

Japan hikes consumption tax in April – will retail sales spike in March, only to collapse afterwards?

Next month, Japan will raise its consumption tax from 5% to 8% as a step towards reducing the nation’s 200%+ debt to GDP ratio by moving towards a budget surplus in 2020.  This may be the first of two hikes in the sales tax, with a further rise to 10% planned for October 2015.  Prime Minister Abe has said that the second hike will be dependent on an economic recovery, rightly realising that only a significant increase in Japan’s growth rate will make any impact on the national debt.  He’s said that the data from July to September 2014 will determine whether or not the second VAT hike goes ahead.

We’ve looked at the impact of pre-announced sales tax hikes before when I wondered whether the UK’s rises from 15% to 17.5% (at the start of 2010), and then again from 17.5% to 20% (at the start of 2011) would impact retail sales.  History had shown us that when Japan raised consumption tax in 1997, and when Australia did the same in 2000, retailers saw a huge boost to sales in the month before the hike (12% year on year rises in both cases) but when the higher prices came in retail sales collapsed to near, or below zero.  Rational consumers front loaded consumption ahead of the known price rises.

I thought that we would see something similar in the UK, but there is little sign of it in the data – after the 2010 VAT hike, sales did turn negative, but in neither case did we see any of the “rational frontloading” that Japan and Australia saw.  Perhaps the very weak period of GDP growth (averaging below 1.5%, and at times as low as 0.5% year on year over 2010 and 2011), and the UK’s famous squeeze on real incomes through higher inflation than wage growth meant that there was no ability to frontload consumption.  Or perhaps we are not as rational as the Japanese and Australians.

What happens when you pre-announce a consumption tax hike?

So the implications for Japan in 2014 are not clear cut.  But I was surprised to see that Japanese retail sales growth is already running much higher than in any of the historical examples at the same stage of the VAT hiking cycle, with a 4.4% year on year increase.  Cars and machinery equipment led the way – the big ticket items that you might expect to make most sense for consumers to buy in advance of higher prices.  Economists have attributed this to front loading, but it is also worth exploring alternative explanations.  Today’s release of Japanese wage data showed the first rise in base pay for nearly two years, so perhaps the recent improvement in some economic data, and the psychological impact of Abenomics are producing a real increase in consumer sentiment.  But pay is still only growing at 0.1% on an annual basis, and including bonuses and overtime it is negative.  Also the recent exit from deflation is squeezing real incomes.  The Japanese economy, and consumer, remains fragile – Abe will be hoping that this doesn’t end up being a replay of 1997.

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mike_riddell_100

China’s investment/GDP ratio soars to a totally unsustainable 54.4%. Be afraid.

Once upon a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets of unlimited civil liberties. They asserted with increasing self-confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economies, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again” – a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The passage is the opening to the highly readable and hugely influential 1994 paper The Myth of Asia’s Miracle. The period referenced is the early 1960s, the dynamic president was John F. Kennedy (read Bill Clinton), and the rapidly growing Eastern economies were the Soviet Union and its satellite nations (read East Asia). Author Paul Krugman took on the prevalent East Asian euphoria by drawing disturbing parallels between the unsustainable way that the Asian Tigers were managing to generate supersonic growth, and how the recently obsolete Soviet Union had also once achieved seemingly miraculous growth rates. Krugman’s paper gained widespread attention at the time (even more so post the 1997 Asian crisis), and succeeded in refocusing attention on the concept of productivity. It mattered not what the growth rate was, but how it was achieved.

To explain this and briefly summarise, consider what actually drives economic growth. Growth accounting shows that GDP per capita growth comes from two main sources; inputs and efficiency. The ‘inputs’ can be split into labour (e.g. growth in employment) and capital (e.g. the accumulation of physical capital stock such as machines and buildings). But long term, sustained per capita economic growth tends to come not from increases in the ‘inputs’, but from increases in efficiency, of which the main driver is technological progress. Nobel Laureate Robert Solow showed in his seminal 1956 paper that technological progress had accounted for 80% of US per capita growth between 1909 and 1949, although more recent studies have suggested a still substantial figure of more like 45-55% thereafter.

Krugman pointed to previous research showing that the Soviet Union’s rapid growth had not been due to efficiency gains. Indeed, the USSR was considerably less efficient than the US, and showed no signs of closing the gap. Soviet growth had been solely due to the ‘inputs’, and input-driven growth has diminishing returns (e.g. there is a finite number of workers you can educate). The USSR’s growth was largely ‘built on perspiration rather than inspiration’.

In a similar way, the Asian Tigers’ rapid growth was due to an ability to mobilise resources. There was no great improvement in efficiency, and no ‘miracle’ – it could be fully explained by the employed share of the population rocketing, education improving dramatically, and an enormous investment in physical capital (in Singapore, investment as a share of output jumped from 11% to more than 40% at its peak). But these were one time changes; they weren’t repeatable.

Fast forward to 21st century China.

There is a perception that China’s rocketing growth rate has always been reliant on heavy investment, but that’s not the case. Investment, or capital formation, has of course been an important driver, but the ‘pre 2008’ China did achieve rapid productivity gains thanks to the rise of the private sector and technological catch-up as the economy slowly began to open its borders.

In the chart below, I’ve looked at how much the world’s biggest economies have invested as a percentage of their GDP, and compared this to the countries’ GDP per capita growth rates. Countries with higher investment rates tend to have higher GDP growth rates and vice versa, which is intuitive and supports the discussion above. Since the 1990s, most (but not all) emerging/developing countries have been positioned towards the top right hand side with higher investment and higher growth rates, and the more advanced economies have typically been towards the bottom left with lower investment and lower growth rates. In one extreme you have China, where investment has averaged over 40% of GDP, and the GDP per capita growth has averaged a phenomenal 9.5%. The fact that China’s growth rate is well above the trend line in the chart is indicative of the productivity gains that China has achieved over the period as a whole on average. The country with the weakest investment rate is the UK.

Slide1

‘Post 2008’ China looks a different animal. Productivity and efficiency seem to be plummeting, where GDP growth is becoming dangerously reliant on the ‘inputs’, namely soaring investment. We’ve all heard about how China’s leaders desire a more sustainable growth model, featuring a rebalancing of China’s economy away from investment and export dependence and towards one that is more reliant on domestic demand and consumer spending (e.g. see the 12th 5 year plan covering 2011-2015 or the Third Plennum). In practice, what we’ve instead consistently seen is an inability or unwillingness to meaningfully reform, where any dip in economic growth has been met with yet another wave of state-sponsored overinvestment. (Jim recently blogged about economist Michael Pettis’ expectation that China long term growth could fall to 3-4%, a view with which I have a lot of sympathy. Please see also If China’s economy rebalances and growth slows, as it really must, then who’s screwed? for an additional analysis of the implications of China’s economic slowdown).

It was widely reported earlier this week that China’s 2013 GDP growth rate fell to a 13 year low of 7.7%, a slowdown that seems to have continued into 2014 with the release of weak PMI manufacturing reading yesterday. But much more alarming is how the makeup of China’s growth has changed: last year investment leapt from 48% of China’s GDP to over 54%, the biggest surge in the ratio since 1993.

The chart below puts China’s problems into perspective. As already demonstrated, there is a strong correlation between different countries’ investment rates and GDP growth rate. There also tends to be a reasonable correlation over time between an individual country’s investment rate and its GDP growth rate (Japan’s experience from 1971-2011 is a good example, as shown previously on this blog). Over time, therefore, a country should be broadly travelling between the bottom left and top right of the chart, with the precise location determined by the country’s economic model, its stage of development and location in the business cycle.

It should be a concern if a country experiences a surge in its investment rate over a number of years, but has little or no accompanying improvement in its GDP growth rate, i.e. the historical time series would appear as a horizontal line in the chart below. This suggests that the investment surge is not productive, and if accompanied by a credit bubble (as is often the case), then the banking sector is at risk (e.g. Ireland and Croatia followed this pattern pre 2008, Indonesia pre 1997).

But it’s more concerning still if there is an investment surge accompanied by a GDP growth rate that is falling. This is where China finds itself, as shown by the red arrow.

Part of China’s growth rate decline is likely to be explained by declining labour productivity – the Conference Board, a think tank, has estimated that labour productivity growth slowed from 8.8% in 2011 to 7.4% in 2012 and 7.1% in 2013. Maybe this is due to rural-urban migration slowing to a trickle, meaning fewer workers are shifting from low productivity agriculture to higher productivity manufacturing, i.e. China is approaching or has arrived at the Lewis Turning Point (see more on this under China – much weaker long term growth prospects from page 4 of our July 2012 Panoramic).

However the most likely explanation for China’s surging investment being coupled with a weaker growth rate is that China is experiencing a major decline in capital efficiency. Countries that have made the rare move from the top left of the chart towards the bottom right include the Soviet Union (1973-1989), Spain (1997-2007), South Korea (1986-1996), Thailand (1988-1996) and Iceland (2004-2006). Needless to say, these investment bubbles didn’t end well. In the face of a labour productivity slowdown, China is trying to hit unsustainably high GDP growth rates by generating bigger and bigger credit and investment bubbles. And as the IMF succinctly put it in its Global Financial Stability Report from October 2013, ‘containing the risks to China’s financial system is as important as it is challenging’. China’s economy is becoming progressively unhinged, and it’s hard to see how it won’t end badly.

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mike_riddell_100

EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?

On Friday last week, EM debt funds saw a daily outflow of $1.27bn, which equalled the record set during the dark days of September 2011, a time when the Eurozone periphery and the ECB were particularly active bungee jumping down a precipice.   Outflows were even bigger on Monday this week, as EM debt funds were hit by $1.44bn in outflows.  The fact that Monday saw a daily record wasn’t much of a surprise; markets were violent, even by recent standards, with some Turkish bank bonds down 10% intraday at one point.   Outflows were a slightly less bad $1.07bn on Tuesday this week (the most recent data available), but that’s still $3.78bn of EM debt fund outflows in just three days.

The chart below plots the year to date daily flows in US high yield and EM debt, courtesy of EPFR.  Note that this data is for mutual funds only and doesn’t include flows from insurance companies, central banks etc, so while it gives you an idea of how grim the picture looks, it’s perhaps only 10% of the whole picture.  Note also that the EM debt asset class is significantly bigger than it was just two years ago thanks to a huge amount of debt issuance, meaning that although Monday saw a record outflow in absolute terms, it actually ranked number four relative to the size of the market.

EM debt funds hit by record daily outflow on Monday this week

Do the outflows matter?  EM debt bulls might argue no -  fund flows tend to lag market performance and flows have historically had little if any predictive power in forecasting future returns. The collective human instinct is always to buy at the top and sell at the bottom, and the losses in EM assets in the last seven weeks told you the outflows were coming.  Bulls might also argue it is comforting that EM debt outflows haven’t actually been bigger.  EM debt has seen the biggest drawdown since Q4 2008 – in the last 7 weeks the JP Morgan GBI-EM Index, a commonly used EM local currency sovereign debt index, has plummeted  13%, and the JP Morgan EMBI Global diversified index, a widely used EM sovereign external debt benchmark, has fallen over 10%.  Real money investors aren’t yet capitulating, which suggests that the huge inflows of the last few years are relatively sticky.

EM debt bears might look at it another way – in the context of the enormous inflows into EM debt in the last four years in particular, outflows haven’t actually been that huge, and yet returns have been abysmal.  One of the unintended consequences of much tighter bank regulation and balance sheet deleveraging is that market markers have reduced ability to warehouse risk, so relatively small changes in EM debt fund flow dynamics are causing far greater swings in market prices.   If outflows continue at this pace or worsen, then the effect on EM debt will likely be cataclysmic.

Are these outflows just a tremor, or are we witnessing ‘The Big One’?  To begin to attempt to answer that, it’s necessary to figure out what has caused such a violent sell off.  About a year ago I tried to explain that the reasons most people seem to buy EM debt – strong growth, good demographics, low government debt levels, an ‘under-owned asset class’ – are broadly irrelevant.   Thailand and Malaysia had great demographics in the mid 1990s, but that didn’t prevent the Asian financial crisis.  Ireland and Spain had very little government indebtedness prior to 2008, but that didn’t help much either. EM debt returns are instead largely a function of US Treasury yields, the US dollar, and global risk appetite, where the mix varies depending upon whether you’re looking at EM local currency debt, or EM external sovereign or corporate debt (see Emerging market debt is cool but you may be surprised what you find if you strip away the marketing myths for more).

The recent EM debt sell off appears to justify this view of the primary drivers of EM debt returns.  Market commentators’ explanation for the recent leg down in EM debt is Bernanke’s tapering talk, and this is clearly a factor.  Treasury yields have jumped, the US dollar has soared, and EM currencies have mostly slumped.  This is something that we had anticipated and were positioned for as explained in January, see Why we love the US Dollar and worry about EM currencies.

If you assume this EM debt sell off has all been about Fed speak, then I’d actually be much more comfortable about EM debt valuations now. EM bond yields have risen significantly faster than US Treasury yields, while EM currencies have generally fallen sharply, so EM debt valuations are obviously relatively more attractive now versus two months ago.   At the time of writing back in January, 10 year US Treasury yields were 1.8% and we believed they looked ripe for a correction.  Now, however, yields are above 2.5%, and yet the solid but unspectacular trajectory of the US economy hasn’t really changed that much.  Meanwhile US inflation expectations have in fact fallen considerably – for example the US 5 year 5 year forward breakeven inflation rate has slumped from 3% to 2.4%.  Jim discussed the US economy following a research trip in a blog earlier this month, see While the market gets excited about unemployment falling to 6.5%, the Fed’s attention is turning to falling inflation.

However, the recent EM debt move is unlikely to be all about Fed speak.  EM debt has been a stand out underperformer in the great carry sell off of the last two months, and dynamics in Japan and China are surely also important.  I believe that the behaviour of domestic Japanese investors is playing a greatly under-appreciated role.  In the early days and months of the much hyped but so far little-achieving ‘Abenomics’, every man, his dog, and his dog’s unborn puppies seemed to have gone long USD, short JPY, long risky assets and particularly long EM debt.  Some did it in a very leveraged way, and these trades have been a disaster since the beginning of May.  As mentioned in a blog a month ago, Japanese investors have in fact done the precise opposite of what every market participant seemed to think they would do. Below is an updated chart from a blog last month (see Japanese investors are not buying foreign bonds, they’re selling).  Japanese selling of foreign bonds has accelerated further recently, with the announcement overnight that there were ¥1.2 trillion of sales alone during the week to June 21st. Taking a rolling three month average, Japanese investors are selling foreign bonds at a near record pace.

Japanese investors have been selling foreign bonds not buying

It is the China dynamic that I find particularly worrying.  Commentators have focused on the drying up of Chinese inter-bank liquidity as demonstrated by spiking SHIBOR rates, although I think fears are overblown.  There is much speculation as to why SHIBOR has soared, the only additional observation I have is that spikes in SHIBOR are nothing new – I wrote a brief comment about a previous episode in January 2011, see funny goings on in Chinese banking sector.  There was a near replica of the current SHIBOR spike exactly two years ago, and while the SHIBOR moves this time around are particularly big, it’s hard to see why this time it’s different and the PBOC won’t supply liquidity.

A much bigger longer term China worry is that market participants still believe that China can grow at 7%+ ad infinitum, but I can’t see any scenario under which this is actually possible.  China’s wages have doubled since 2007 and its currency has appreciated 25% against the euro and 35% against the US dollar (based on spot return) since China dropped its peg in 2005.  Competitiveness has therefore significantly weakened.  Intentionally or unintentionally, the Chinese authorities have tried to hit an unsustainable growth target by generating one of the biggest credit bubbles that the world has ever seen.   If you add that an enormous demographic time bomb is starting to go off in China (eg see article from The Economist here), China’s long term sustainable growth must be considerably lower than consensus expectations.  Some believe the Renminbi’s destiny is to become a currency to rival the US dollar.  I think it’s more likely that opening up the capital account will encourage big capital outflows as domestic investors seek superior investment returns abroad (as an aside,  Diaz-Alejandro’s paper Goodbye Financial Repression, Hello Financial Crash offers some background on Latin America’s experience with financial liberalisation in the 1970s and 1980s).

My central thesis remains, therefore, that China will experience a significant slowdown in the coming months and years and this will have profound effects for global financial markets and EM debt in particular.  If you like clichés, China is in effect ‘turning Japanese’, but unlike Japan, it has grown old before it has grown rich. Rather than regurgitate the arguments, see blog from March (If china’s economy rebalances and growth slows, as it surely must, then who’s screwed?).  I continue to believe that EM and developed countries with a heavy reliance on exporting commodities to China are vulnerable, countries that are increasingly reliant on portfolio inflows from developed countries to fund their current account deficits are vulnerable, and those countries that tick both boxes (eg Australia, South Africa, Indonesia, Chile, Brazil) are acutely vulnerable.

In sum, EM debt now offers relatively better value than a few months ago, and it therefore makes sense to be less bearish on an asset class that we have long argued has been in a bubble.  That doesn’t mean I’m bullish.   The arguments put forward in September 2011 (see The new big short -  EM debt, not so safe) are more valid now than ever.  Foreign ownership of many EM countries’ bond markets has climbed higher (see chart below), and the EM debt outflows of the past few weeks are a pimple on an elephant’s derriere in relation to the decade-long inflows.  These inflows were initially driven by US investors fleeing the steadily depreciating US dollar, and more recently driven by European investors looking to park money outside the Eurozone.   Following the recent sell off, the vast majority of investors who have piled into EM debt in the last three years are underwater, and it will be interesting to see how they react.

Foreign ownership has increased enormously

The recent EM debt sell off probably isn’t yet ‘The Big One’, it is more a tremor.  ‘The Big One’ will probably need either US growth and inflation surprising considerably to the upside or China surprising to the downside.  If that happens then EM debt could really rumble, and these eventualities still don’t seem to be remotely priced in. It will take a much bigger sell off in EM debt, and specifically much higher real bond yields, before I’d turn outright bullish on EM debt and EM currencies.  Developed markets and specifically US dollar assets appear more likely to appreciate, and it’s ominous that previous periods of US dollar strength (1978-1985, 1995-2002) have been coupled with EM crises.

mike_riddell_100

Japanese investors are not buying foreign bonds, they’re selling

One of the stories that has driven global financial markets higher for the past few months has been about how Japanese investors are piling, or will pile, into foreign assets. Surely a rational Japanese investor would dump Japanese assets in an attempt to escape the exploding yen and the ravages of domestic inflation, or at the very least seek out a bigger yield than the puny returns available on the artificially suppressed domestic government bonds?

Well, they haven’t been buying foreign bonds; actually they’ve done the opposite. There were lots of headlines earlier this month after Japanese investors were (just about) net purchasers of foreign bonds in the three weeks to May 10th. But data out overnight showed that there were ¥804.4bn worth of net sales of foreign bonds in the week to May 17th, which more than reversed the previous three weeks’ purchases.

The chart below shows the weekly net purchases of foreign bonds, where the data is based on reports from designated major investors including banks, insurance companies, asset management companies etc. The blue line in the chart below is the 3 month moving average, and it shows that Japanese redemptions of foreign bonds are running at close to the highest rate since data began in 2001.

It’s difficult to deduce too much from all the data, but it appears likely that the rally in the Nikkei, the drop in the yen and the rally in semi-core Eurozone government bonds has been down to foreign investors front running something that so far has not actually happened. Japanese investors may still flee their domestic market, but it will require (mostly foreign) investors’ already high inflation expectations to be realised (the bond market is pricing in Japanese inflation averaging +1.8%pa for the next 5 years, despite there being little evidence that QE in Japan or other countries has succeeded in either generating inflation or in weakening currencies). It probably also requires changes to the higher capital charges that major Japanese investors face when investing in overseas assets, although even with this, funding costs and hedging requirements will ensure that home bias continues.

Bondvigilantes Japanese purchases of foreign bonds MR May 13

Nicolo_Carpaneda-100

Lessons from Zimbabwe

Stefan took some time off over Easter for a quick holiday in Zimbabwe and, as always, he remained on the lookout for economic insights.

As the only country to experience hyperinflation this millennium, Zimbabwe can certainly provide valuable lessons. From late 2008 its inflation was estimated to be running at a staggering 489,000,000,000% on an annual basis. The economy collapsed, and the population suffered food and fuel shortages, amid a mad dash for foreign currency.

Zimbabwe’s experience is particularly pertinent at a time when central banks are experimenting with unprecedented levels of monetary easing. At times, politicians may view inflation as a convenient way to reduce exorbitant debt burdens but inflation is a dynamic force and Zimbabwe’s cautionary tale teaches us to be careful what you wish for…