Sunday, 26 September 2010

Don't fight the Fed or the BOJ?

David Tepper, founder of the multi-billion dollar hedge fund Appaloosa Management, who normally adopts a rather low profile may have discovered a new career as a broadcaster when he was interviewed on CNBC last Friday morning (24th). His manner was attention grabbing in the same way that could be said of a loose cannon, and his enthusiastically bullish outlook, which may have helped to light the fire under US markets that sustained for the rest of the day, is likely to have appealed to CNBC viewers and equity bulls alike. Moreover his reasoning was profoundly simple and seemed to have only one real underpinning - amounting to the simple notion "Don't Fight the Fed".

While it would be rash to question the judgment of someone who has a laudable track record of returns to participants in his hedge fund, there was one rather awkward issue that the CNBC anchors failed to raise with Mr. Tepper. It has to do with whether, in the longer term, US Treasuries are likely to be a buy or sell for portfolio managers.

Essentially the argument presented by Mr Tepper was that either the US economy will recover on its own accord without further QE from the Fed, or if it doesn't then the Fed has stated that they will oblige with further asset purchases (i.e. buying more Treasuries and agency securities) financed from the public balance sheet. For Mr. Tepper this can only present a benign outlook for most assets classes in the longer term.

But, surely there is a difference in the outlook for the US Treasury market depending on which of the either/or scenarios comes to pass. If the economy starts to show more signs of a robust growth, and the Fed is not required to do more QE, then one would have thought that this would not be good for Treasuries. There would be no advantage to getting ahead of the Fed now by buying more government bonds as they would no longer be net buyers of these securities. Furthermore if a more favorable dynamic begins to propel job growth and increasing GDP one would expect 2.5% yields on 10 year bonds to seem very skimpy. Needless to say, there is considerable capacity for capital losses on existing longer maturity bonds if the US economy surprises most market participants, especially the Fed, with renewed vigor.

Returning to the core notion that it is never wise to fight the Fed there seems to be an asymmetry within the capital markets with respect to whether or not it is wise to fight the BOJ.

The following comes from a BBC news item on the question of intervention by the BOJ last week to weaken their currency.


The governor of Japan's central bank has not ruled out further interventions in the currency markets in its fight to control the rising value of the yen.

Speaking at a conference in Kobe, Masaaki Shirakawa said the Bank of Japan (BOJ) was "ready to implement appropriate action" if required.

The BOJ intervened in the currency markets for the first time in six years earlier this month.

Its decision to sell large amounts of yen helped drive down the currency.

Previously the yen had reached a 15-year high against the dollar - a concern for Japan's exporters who are seeing their profits squeezed by the poor exchange rate.

Mr Shirakawa said the BOJ would closely watch the impact the strong yen is having on the economy.

"We have to pay more attention than before to the downside risk to the economy," he said.

"We are ready to implement appropriate action in a timely manner if judged necessary."

The comments came two days after the central bank was suspected of intervening in the markets for a second time, leading to a sharp fall of more than 1% in the value of the yen against the dollar.

Later the Japanese prime minister Naoto Kan said he was unaware of a second intervention by the BOJ.


Although the Japanese PM would not acknowledge it, there is a firm belief that the BOJ intervened a second time during Asian trading on Friday (24th) and yet the market sharply reversed following the selling of yen and purchase of US dollars by the BOJ, and by the end of the trading day in North America the yen was stronger against the dollar than at the time of intervention.

Perhaps the fact that the BOJ is now on record as saying that it wants a cheaper yen and yet the markets seem not to take their intention seriously, is a reflection, that unlike their deference to the Fed, traders seem quite comfortable in fighting the BOJ.
One other possibility is that the more that Japanese policy makers seem keen to reduce the rate of exchange for their currency against others, the keener is the appetite of the PBOC - the central bank of China - to buy yen for strategic reasons. The most benign of these reasons might be their desire to further diversify their holdings of foreign currency in general and as an alternative to stock piling more US Treasuries, the more problematic strategic reason would be their policy of preserving the competitiveness of the yuan vis a vis the yen and other major currencies.

To the extent that the latter policy of currency management is their predominant motivation, the BOJ and the US Treasury will find themselves increasingly well aligned in their criticism that the yuan is substantially in need of re-valuation.

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