Wednesday, October 6, 2010

Japan Started The Second Rounds Of Quantitative easing

USD/YEN Technical Analysis Chart:

Japan is going to do more Quantitative Easing (QE). They plan for a 5 trillion yen fund to purchase bonds, commercial paper, ETFs & REITs.

Quantitative Easing(QE) is monetary policy used by central banks to increase the supply of money to buy financial assets, including government bonds, corporate bonds and mortgage-backed securities, from financial institutions in a process referred to as open market operations and hoping to increase lending and economic activity in the process. QE is a very risky strategy and on the long run could trigger higher inflation than desired or even hyperinflation. Money printing, by central banks could result in currency eventually becomes worthless.

Since May 2010, and prior to the currency intervention, Japan's currency strengthened by about 11% against the dollar--not to mention against the Chinese yuan--while strengthening 13 percent on a trade-weighted basis over the same period. A combination of a slowing global economy and a stronger currency has created a nearly impossible situation for Japan's exporters. Japan's second-quarter growth slowed sharply and unexpectedly as exports languished and domestic demand remained weak. The contrast between Japan's paltry second-quarter growth, flattered by deflation in real terms, and Germany's export-enhanced strong second-quarter growth--the result of the euro weakening in the face of southern Europe's rising debt crisis--underscored the benefits for exporting nations of a weaker currency.

Japan's chronically strong yen is symptomatic of the problems facing its economy in an environment of weakening global growth. It is important to remember that the stronger yen is not aberrant, as Japan's government has sometimes claimed, but rather is indicative of Japan's underlying deflation problem. Slower global growth exacerbates Japan's excess capacity, especially in the traded-goods sector. As a result, deflation persists or intensifies. Additional deflation strengthens the yen in two ways. First, it raises the real return on assets in Japan and therefore attracts funds either from foreign investment or through repatriation by domestic investors. The repatriation by domestic investors is intensified by the fact that the stronger yen means losses on their foreign investments denominated in foreign currencies. So, in response to the stronger yen, more foreign investment is repatriated, thereby adding further to yen strength and Japan's deflationary pressure.

In simple word, Japan is in somewhat of a currency-based liquidity trap, the underlying determinants of which suggest that without some exogenous shock designed to weaken or at least stabilize the yen, the deflationary appreciation of Japan's currency will continue. In this troublesome environment, Japan's new Democratic Party of Japan government and the Ministry of Finance have been at odds with the Bank of Japan. The government has been advocating aggressive measures to stabilize and weaken the yen, whereas the Bank of Japan apparently has wished to be more cautious. The Bank of Japan is reluctant to undertake quantitative easing that could be interpreted as an endorsement of the heavy borrowing required by Japan's government to finance its large deficits.

What they hope to achieve:
Japan with new round of quantitative easing, hopes to boost exports and steer its economy away from deflation. But Japan's problems are not unique; in the wake of the financial crisis, economies worldwide are facing a global shortage of demand and competing for their share of exports.

Side effects:
A side effect will be that this new money is expected to raise consumer prices giving people another incentive to buy now rather than later.
Of course there are risks. First, a central bank can lose money on its purchases, money that will ultimately have to be underwritten by taxpayers either with higher future taxation or by the central bank creating more money and risking higher future inflation. Second, go too far with creating and spending money and you will destroy the value of the currency. Inflation or even hyperinflation is the result. Third, if a descent into QE destroys confidence in an economy rather than gives reassurance that the authorities are on the case it can be counter-productive.

The other reason for the Bank of Japan's resistance to pursue aggressive quantitative easing is the fear of runaway inflation that might result from rapid money creation. Setting the price-level target is important because it preordains a tightening or reversal of easing policies from the Bank of Japan as soon as the price level rises above a path consistent with the modest 1 percent inflation target. By undertaking this round of quantitative easing, the Bank of Japan is not guaranteeing unlimited purchases of foreign currency or Japanese government bonds, but only an amount sufficient to weaken the yen and thereby cap Japan's damaging, self-reinforcing path to further deflation. Despite the Japanese efforts to devalue Yen against other currency investors rush to buy Japanese Yen and caused a sharp drop in USD/JPY . As you see in chart above it Japanese Yen acting very strong against US dollar, from technical aspect it has at least 3.5% more to go. Pay attention to 80.00 level. It should act as strong support level in coming weeks.

This strategy is not isolated to Japan. The USA, UK, and European union has joined the club. Market anticipates second run of QE in the US would start by November 2010.
When Federal bank of reserve starts to buy the US treasury it caused the flattening yield curve. My short term target for 10 Year US Treasury yield is 2.039%. In my opinion QE2 is just a different way to inject money into insolvent financial institutions. It would be a political suicide to tell to American taxpayers that they want to bailout insolvent banks once again therefore they are going to use QE2 as a cover up. Bernake(Chairman of the United States Federal Reserve) wants to help Zombie banks by buying Treasury bonds. In last couple months banks has bought huge sums of treasury bonds, and they will be the sellers to Fed. So when Fed buys bond financial institutions are going to pocket the money. Bernanke argues that QE2 could cause the wealth effect, it means when the stocks value increase people should feel wealthy therefore there is a chance they are going to spend more, and spending more would jump start the economy. I don't buy his argument because stock market rallied about 80% since March 2009 but there is no wealth effect so far! What is the guaranty we get it this time? If he is right why Japan central bank could not get any wealth effect after a decade of quantitative easing?

10 Year US Treasury: