Fri, 17 May 2013
Aggressive easing policies, particularly in the U.S. and Japan, are creating a global currency war and establishing the foundation for a possible worldwide recession, says Komal Sri-Kumar.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm pleased to be here today with Sri-Kumar. He is the president of Sri-Kumar Global Strategies, and he is also the chairman of the TCW comprehensive asset allocation committee. We're going to talk about central bank actions and its impact on the fixed income and equity markets. Sri, thanks for joining me today.
Komal Sri-Kumar: Good to be with you, Jeremy.
Glaser: So let's start in the United States and talk about the Fed. They've recently indicated that they might have some more flexibility in terms of their mortgage-backed security buying. They might increase it or decrease it based on economic indicators. Do you think this is a sign that we're going to see even more Fed action or there's going to be a pullback soon, or is this just more of trying to get the markets thinking that's going to happen, but that the Fed is really going to stick with their current plan?
Sri-Kumar: Good timely question, Jeremy. I think we have a very dovish Fed chaired by Ben Bernanke. And while they've been giving messages including over the weekend that they could increase or decrease the amount of bond purchases, I think the move is likely to be one-way at least for the foreseeable future, namely, they either keep up their current $85 billion per month, or even increase it if they don't get economic recovery of a sufficient magnitude out of it. I don't see them going down. The reason for that, it is as if you've had a drug addict for the last four years and you've been increasing the amount of drug and suddenly you say, do you want to reduce it, do you want to go through the risk of how the patient might react? And it's the same thing with the economy. The economy seems to be growing at a very miniscule rate. Provided the QE is on, why would you want to tamper it? That's not my view, but that I think is where the Fed is coming from.
Glaser: The Fed, obviously, isn't the only central bank that's in expansionary mode right now. The Bank of Japan has announced some new plans for the last couple of months for a very aggressive expansion of the monetary base. What do you think Japan is trying to do there, and what do you think about that program?
Sri-Kumar: I think that are two separate issues. I think the Japanese have been trying now for over 20 years to get an economic recovery since the stock market collapsed in early 1990, and they don't have it. So this is their latest effort, but Jeremy, the Japanese issue is much more troubling to me. Let's see why. Japan's GDP is about one third that of the United States, roughly, and Japan is buying about $80 billion worth of bonds, Bank of Japan, every month, roughly similar to the Fed's $85 billion worth every month.
And for a country which has a debt/GDP ratio of 230%, in Japan's case, and a much smaller economy, it is really troubling that they would go to the extent of increasing money supply. Why? The risk is that there might be a flight from the Japan government bonds; the 10-year yields were as low as 38 basis points in early April. They've surged to over 70 basis points a month and a half later. They've more than doubled. What happens if it goes to 1.5%, 2.0%? The Japanese government might think it indicates economic recovery, but equally it might be a flight from Japan. So it's a very fine line that the Japanese are really going across right now.
Glaser: What's happening with the yen there? Obviously, it's been falling in respect to the dollar. Would you see the Fed trying to weaken the dollar some more, getting to kind of a currency war to keep exports looking attractive?
Sri-Kumar: Yes, I think there is a currency war on, and I think the Japanese are playing it. Even though, over the weekend the European Union and the G-7 leaders indicated that there was no currency war and that Japan's quantitative easing is OK, in reality, Jeremy, in the last two or three days, even Australia and New Zealand have had to fight appreciating currencies by lowering interest rates. So I think overall, the Japanese are going to continue with what they're doing. There is going to be more of a retaliation, and globally we don't fully know where it's going to end.
Glaser: So what's the impact of that? What's the potential worst-case scenario of these currency wars?
Sri-Kumar: The worst-case scenario is what we had in the 1930s. That is when you had what were known as beggar-thy-neighbor policies. The countries were all depreciating with respect to each other. We have something similar going on today. The G-7 countries have told us that if you're doing it for domestic economic reasons, it is OK to depreciate. Am I going to tell you anything different? I'm also always going to tell you it's for domestic purposes. But, obviously, it has significant external implications. Japanese corporations are big exporters, and their earnings are doubling and tripling as a result of the latest policy. Clearly there is going to be a retaliation, and the worst case is that those kinds of efforts eventually cause a global recession, much more severe than if you did not have the currency war.
Glaser: Is that something that you think is likely, or is it just an outside chance that these policies could lead to that global recession?
Sri-Kumar: I think it is more than an outside chance. I'm not yet ready to say it is likely, but the probability is rising because you have Japan, which has no end in sight, and they are going to keep doing it. And I think Japan is not going to get an economic recovery out of it. That's why I'm worried. If you don't get a recovery and you keep repeating it, eventually it is going to have a negative impact globally. So I'm going to say, the probability is something like 40% that you have a real, serious global issue coming out of Japan.
Glaser: So how do we exit from these very expansionary policies then? If we have Japan in expansionary mode, and the Federal Reserve and other central banks [also implementing policies], what's the way out of it? How do they begin to wind this policy down?
Sri-Kumar: It is time now to think about an exit, but exits are always very difficult because it means going the other way and whatever kept the market going up, you have to think in terms of cutting back and hurting the market. So the exit is going to be very difficult. I think the exit will give rise to a recession, whether it is in the United States or in Japan. The reason for the recession is that bond yields are going to rise quite significantly when the exit takes place. We are all aware that when Lehman went bankrupt, in September 2008, the Fed's balance sheet was about $800 billion. Today, it's 4 times as much at $3.2 trillion. So when you're going to cut back from that and exit, let's say from a $4 trillion level at the end of 2013, the markets know that the Fed has an enormous store of bonds with it. Therefore, bond yields rise in anticipation of that, and there is a significant risk of any economic recovery being aborted by the expected increase in yields.
Glaser: So you've mentioned some of the risks of these programs. Do you see any potential benefits? Do you think that any of these programs will be effective?
Sri-Kumar: I have maintained for the last four years that you will not get an economic recovery off of monetary easing because monetary theory tells us that at extremely low interest rates, further increases in money supply or decreases in interest rates do no good in terms of helping with the real economy. So I don't think it's going to be beneficial. What the governments have to do are structural changes in Japan's case, since we have talked about it, Jeremy. The new prime minister decided recently that firing of workers is not going to be made any easier because it's politically difficult to implement a firing policy. That's a structural change. You need to be able to fire workers more easily so that younger Japanese workers can get the job, rather than people thinking of their positions as a lifetime occupation. Second, the population in Japan is aging. They need a change in the immigration laws to allow for younger immigrants to come in and settle down in Japan. Those are the types of things which are going to give Japan economic growth. It's not going to be money supply.
In the U.S., we are talking about decreasing entitlements, increasing the retirement age, and reducing Social Security benefits. Those are all necessary if we are to make the structural changes and labor market adjustments to create jobs in the U.S. Again, a QE4 or QE-infinity is not going to achieve it.
Glaser: You mentioned earlier that the exit could increase the bond yields fairly rapidly. What does that mean for bond investors? How should they be thinking about that from a portfolio standpoint?
Sri-Kumar: I think bond investors should be thinking both in the short term and in the medium term. Short term I define as one year or less. I think U.S. bond yields are headed lower. I think the speculative bubble is going to get bigger. The 10-year Treasury yield I see going toward the 1.50% mark, which would still be a significant return coming from Treasuries.
Longer term, inflation picks up in my thinking. There is going to be a pickup in the economic growth. Then at that time, the stock markets start also to experience it. But yields rise, and the presence of so many bonds in the Fed hands makes the bond yields go up much higher. So in the short term, the bond investors benefit. Medium term, they take a significant hit.
Glaser: Sri, thanks so much for your thoughts today.
Sri-Kumar: Thank you for having me, Jeremy. Good to be here.
Glaser: For Morningstar, I'm Jeremy Glaser.