Central banks have been printing money in enormous volume since the 2008 crisis, but markets are suddenly behaving as if they are in disinflationary environment. Henry Maxey, CEO of the London-based investment firm Ruffer, explained in a recent review how the uncoordinated financial policies of the U.S., Japan, and China have created a strong disinflation against a background of reflation, creating the potential for a meltdown.
Initial signs of disinflation
Money is being added to the global market at an astounding rate—the Federal Reserve and the Bank of Japan alone are printing the equivalent of $1.7 trillion each year. Historically the safest option for investors to protect themselves is to buy gold and wait for things to calm down, but gold is at a 34-month low and it’s expected to have its worst quarter in nearly a century. Emerging markets and commodities are risker than gold, but they serve a similar role in protecting value from Western debt problems and out-of-control central banks—yet their value has also fallen in recent months.
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Maxey explains that the deflation starts with the Japanese government’s decision to devalue the yen. Instead of targeting exchange rates directly, the Bank of Japan announced that it would double its monetary base as a form of domestic stimulus, knowing full well that forex traders would price this into their evaluation of the yen, causing it to depreciate.
“The removal of the yen as the world’s default ‘hard currency’ rotated the dollar into the position of the world’s ‘least soft’ currency,” says Maxey. “A stronger dollar has the effect of sucking liquidity out of emerging markets most of which have explicit or implicit dollar ties. Declining liquidity in emerging markets has revealed their individual structural weaknesses while also reducing their demand for, and hence the price of, commodities.”
The net effect is that Japanese domestic reflationary policies exported deflation to the rest of the world.
Bernanke tries out tapering
Meanwhile the Fed is trying to extricate itself from qualitative easing without damaging a fragile recovery. Looking back at past Fed missteps, Maxey highlights the conflicting conclusions that Fed chairmen Ben Bernanke could draw. In 1994 the Fed raised interest rates rapidly and unexpectedly, creating havoc in the bond market. Between 2004 and 2006 the interest rate went up steadily every quarter, creating moral hazard among traders who felt they knew exactly what was around the corner.
Maxey argues that Bernanke started the tapering debate to stay between these two extremes and introduce volatility without raising rates. Investors know that change is coming, but they don’t know when or how quickly. They can prepare for the end of QE, but only with so much certitude.
But the attempt backfired, raising long-term real rates by 1 percent. “Like the dodgy rock band which doesn’t understand the sensitivity and feedback loops of its sound system, Bernanke tapped the microphone and the amplifiers blew up,” said Maxey.
Maxey identifies three problems with Bernanke’s plan. First, investors didn’t expect tapering to start so soon and hadn’t priced the change into existing rates. Second, global fixed income markets have gone from $40 billion ten years ago to nearly $100 billion today while banks are currently unable to take on large inventory positions, make the whole system more susceptible to shocks. Third, the tactic of selling bonds to hedge against interest rate risk, which in turn encourages more selling.
China reigns in domestic credit
The last piece of the disinflation puzzle is the Chinese policy of rectification, allowing interest rates to spike in an attempt to reign in the domestic credit market. Although the decision was made without considering its effect on the global economy, Maxey expects it to be another source of disinflation at the least, and the potential cause of a Chinese financial crisis.
Maxey warns that the end result of these three disinflation pressures could be severe.
“The disruption caused by this impulse has been brutal and could result in something significant breaking e.g. the collapse of a financial institution, an emerging market blow-up, or a sovereign crisis.”