By Lior Alkalay
Senior Analyst, eToro
Last week, I covered the overall improved outlook for the Euro as liquidity injections become more frequent. However, I believe that this is only the tip of the iceberg. In my last article, Euro Bound to Rebound, I emphasized how the aggressive quantitative easing or monetization of debt had lifted U.S. growth and put an end to the vicious credit crunch. Now, as central bankers around the world begin to experience stagnant growth and the threat of tightening credit, it looks like the Bernanke cure – a result of his long study on the Great Depression – is becoming the ultimate tool. Central bankers, it seems, have finally realized that the only way is the printing way. After years of hawkishness, the ECB has finally ignited a Trillion-Euro liquidity program, and now the next big change is happening right now in Japan.
For years, the Bank of Japan had been rather conservative, avoiding aggressive stimulus while allowing the Yen to appreciate, but they are now making a Titanic-sized shift. The BoJ not only announced more asset purchases (which is, for all intents and purposes, quantitative easing) but also presented a target of 1% inflation for Japan. When considering that Japan is currently suffering from effective deflation this means ultimately more QE, in fact, quite a lot more QE. But the pure effect of QE is only a marginal effect; the real effect is on the Japanese bond market. The Japanese sovereign bond market is second only to the U.S., and demand for JGBs (Japanese government bonds) is what keeps the Yen higher. JGBs yield around 1% for a 10-year bond, and so when Japan has deflation (inflation that is less than 0%) then the Japanese bonds were actually yielding positive, and encouraged strong inflows to the Yen. However, now that the BoJ is targeting 1% inflation, the JGBs will actually yield zero thereby eliminating the multi-year demand and, consequently, melt down the last bastion of all of the safe haven currencies, the Japanese Yen.
The Yen is the Final Straw
The Yen could be considered the last in a series of safe haven assets that have gradually lost traction as central banks moved ever more aggressively with money printing and liquidity injections which have long been absent from the market. First, it was the U.S. Dollar which lost traction, and then it was Gold, which came off its highs, and now it is the Yen, which has ended its long term bullish rise. In fact, all those assets are characterized by high liquidity and so once liquidity becomes abundant, those assets lose traction, and when safe havens lose traction it is risk appetite that comes on. Another characteristic of low liquidity (other than the rise of safe havens, which has now ended) is Volatility. Since volatility spawns uncertainty, this is one of the key factors to withhold investment inflows into equities, and consequently, to growth. And what better indicator to illustrate where we are since the crisis began then the VIX, the ultimate volatility barometer.
As illustrated above, the VIX has been gradually moving toward its pre-crisis levels, thereby signaling that investors’ confidence levels are at their highest since the crisis first erupted. As safe havens lose traction, Volatility is low and so what is left but to invest in the economy. Put another way, so long as central banks feel confident in their ability to control their monetization process we can expect growth, and with it a growing willingness of investors to invest in the economy. Given that, global indices, Euro, Sterling and all other risk assets are poised for a strong recovery, as the global economy is healthier than one might presume, and liquidity is certainly going to be the norm for an extended period of time.
The bottom line is that while cautious investors might continue to fret, those investors who understand the ramifications and end results of QE-Nomics also understand that there is only one direction for stock markets and that is up. And while worried investors sell, the smart money is buying on the dips and banking the gains as equities continue to push higher. And when will it end, you ask? When Gold prices spike to new records that could be seen as a signal that inflation might be starting to spiral out of control; central bankers, or more appropriately central printers, might be spooked by it and take a big step backwards, but until then, it’s buy and hold time for investors.