The Hunt for Yields and the End of Currency Wars

​Context
Almost all countries of the world currently have trouble keeping their economies afloat and their government budgets under control. Many structural issues plague industrialized economies: demographics, offshoring, high-value-creation-without-job-creation growth of the technology era, high effective corporate tax rates and fiscal complexities, government and household debt.
 
Central banks around the world are stuck with an ongoing debate about what to do, with growing ranks of monetary policymakers saying that it is time for monetary intervention to back off and for structural aspects of growth to resurface: job creation, production, and productivity. In all this, there is a desperate quest for yield by pension funds and other major fund managers who face zero or even negative nominal returns. Let’s explore all this to get a clearer picture of what is going on.

​The hunt for yield
Since 2008, all central banks have been “printing money” to pump up asset prices and credit expansion to fight deflation. This is done to fight the negative wealth effects of falling asset prices: if stock prices, housing prices, and other asset prices fall, people have declining net worth, which causes them to try to rebuild their balance sheets by spending less, paying down debt, and saving more. This then causes demand for goods and services to drop, which kills corporate profits, production, and job creation… the result is stagnation.
 
This self-reinforcing cycle is called “debt-deflation” decribed by Irving Fisher in the 1930s: if prices fall, the real value of nominal debts acually rises (your 500k mortgage debt is “heavier” if your house loses half of its value or if your stock portfolio loses value!).
 
Although inflation is probably higher than it otherwise would have been if central banks had not conducted such stimulative policies, it is becoming more and more apparent that there are limits to what central banks can do.
 
The other thing that all these stimulative policies have done is to create money that has mostly floated around in financial markets, creating all sorts of macro phenomenon: asset bubbles, massive global carry trades, currency swings, etc.
 
One thing that is obvious is the very low yields on safe assets, which have become close to zero throughout the industrialized world. Since asset managers must seek returns for the funds of their clients, they seek higher yields.
 
Recently, the global economy has been giving us all a lesson in standard textbook macroeconomics: the economies with higher REAL returns have become more attractive for global capital and the higher real returns have supported the currencies of those economies. Real returns can be approximated by taking the 10-year government bond yield and subtracting core inflation from it. Here are the results:

​Not all bond markets are equal:

1. The USA and Japan have “safe haven” currencies, which means that in times of global market stress and “risk-off” mode, their currencies tend to appreciate, which is a great “bonus” for global capital seeking risk-adjusted returns;
2. The credit rating is not the same in all countries: those with AA status or better are generally preferred.

 
The country that has a good mix of a good credit rating, a solid labor market, AND a high real return is New Zealand, and indeed global capital has been flocking to this country, thus supporting the Kiwi a bit too much relative to what the RBNZ (the central bank) would like, if we judge on the various times the monetary authorities have tried to “talk down the dollar” (the NZD) without much success up to now.
 
The global hunt for yield has also pushed global capital flows into riskier markets to get the higher returns, but the risk in some emerging markets has recently caused some worries and thus caused global capital to park in safer markets that offer relatively “better” real returns: Japan and New Zealand, thus supporting JPY and NZD relative to other currencies.
 
Sources of demand and growth
Many industrialized countries are stuck with stagnation, even with all the monetary stimulation we have seen in recent years. This seems to be caused by many factors, some of which are impossible to change in any reasonable time horizon: demographics and public debt.
 
Here are a few regions and countries with the ratio of POP65+ to POP15-64. It shows us that some countries simply can’t count on lots of taxpayers and active workers due to the demographic structure:

As you can see, most industrialized countries are old (and aging). This is structural: we will simply not get more and more workers (and taxpayers) relative to what we once had.
 
Since GDP is the income generated by the production that meets expenditures by households, firms, governments, and other countries wanting what we produce, what are the options going forward to get reasonable growth outlooks?
 
Here are the debt loads of household and governments for selected countries:

Most of the household debt is mortgage debt, which is considered “good debt” because it is attached to a valuable asset, but a high ratio still signals that households have little breathing room for extra spending and are vulnerable to interest rate shocks… Scandinavian households sure are in love with debt!
 
The higher the debt loads in a country (governments + households), the more the economy is vulnerable to an increase in interest rates. As interest rates rise, debts become harder to manage due to debt service costs. The country that seems best positioned is Germany, with relatively low debt loads in governments and households and a low unemployment rate.
 
Barring government spending, to boost short run economic activity, you need consumer spending, investments by firms, housing activity, or exports.
 
The end of currency wars?
Japan seems out of options, with a spectacularly high government debt, very special demographics, low growth, and general stagnation. But Japan can’t “afford” anything else than zero percent interest rates, because anything higher will cause the debt service to rapidly grow at a rate higher than nominal GDP. Since interest rates eventually follow the same path as inflation, the 2% inflation target of Japan is not credible: they can’t “afford” it, because interest rates would eventually also increase.
 
Others seem to be stuck in a deadlock of refusal to spend more on government stimulus programs or cut taxes, which means it seems hard to kickstart growth due to “everyone waiting for something to happen.” Since many housing sectors are maxed out and stock valuations are high, there is a void of possibilities for growth and returns.
 
This situation has naturally caused all players to “default” to export growth strategies, even without really wanting it explicitly. When interest rates are high and have room to drop, you can “hope” for private sector spending expansion (via credit) if you cut rates, but when rates are zero and everything seems maxed out, there is little to hope for other than export growth… which means depreciation and “currency wars.” This seems to have been the case until recently… BUT…
 
The lack of extra monetary stimulus from Japan and the moderately “hawkish” talk by the Fed seems to signal that some monetary authorities want to end this spiral and gradually move away from eternal stimulus mode to let the structural aspects of growth resurface.
 
It started in 2014 when the Fed hinted at stopping QE and gradually returning to normal monetary conditions. Just this “talk” of ending QE created huge appreciation pressure on the USD and a global USD carry trade reversal, with global capital leaving emerging markets and flocking to US markets, leaving emerging currencies to crash and emerging markets to experience capital flight.
 
After all, the USA and Japan have low unemployment rates for their respective economies, which means there is no need for further stimulus. The excessive liquidity supplied by central banks may have created the beginning of asset bubbles, which authorities might want to avoid bloating any further (2005-2007 anyone?).
 
If such is the case, expect no extra stimulus from Japan and expect the tightening bias to continue at the Fed. Now does this mean the Fed will raise rates in September and that the market may not fully heed the warning signs? That is hard to say now, as the Fed faces contradicting signals from data as well as the coming US elections. The call is particularly hard to make and the likelihood of a rate hike seems low, but perhaps not as low as the market has priced in. If a rate hike comes, it will be a clear signal that the Fed has decided that all this monetary stimulus is enough and wants to avoid being stuck with asset bubbles in 2 years. If the BOJ also does little extra monetary stimulus, it will clearly mark the end of currency wars. An interesting Fall awaits…
 
Feel free to comment if you have any thoughts or insights! Cheers!
 
YourPersonalEconomist