Japan Has Run Out of Bullets - The Implications of Joint Intervention

In an earlier post, I had opined on whether it was time to buy Japanese securities after the immediate effects of the tsunami, earthquake, and nuclear meltdowns. At the time, I believed government intervention was possible - indeed even likely. However, I had not reckoned on the extent of intervention.

For years, analysts believed that the Japanese authorities had been rendered powerless from perpetual deflation as expressed in near zero percent interest rates. With rates already at record lows, there was no further room to cut and bond bears eagerly gathered around the short JGB (Japanese government bonds) trade. But instead of rates rising, the central bank was able to maintain rates at record lows for years and frustrate the shorts. The reasons behind this anamoly are two fold - one, most of the demand is domestic and two, regulatory barriers discourage foreign speculation. Indeed, Japanese corporations and elderly pensioners are sitting on an estimated cash hoard of at least ¥1,500 trillion ($18 trillion) of savings. But that was before the natural disasters of mid-March.


The worst two-day rout in 40 years caused a 6.2% drop in Nikkei share index, wiping £90 billion (roughly $145.45 billion) off stocks. The yen rally to a postwar high of
against the dollar of Y76.25 on March 16. In a desperate attempt to stabilize the markets, Japanese authorities printed an astounding amount of money. The numbers are mind boggling - 15 trillion yen ($183 billion) in liquidity during the first week and then an additional 13-15 trillion yen in the following week for a total of 28-30 trillion yen. The BOJ also intervened in the currency markets by selling over
Y2,000bn ($25bn) against the dollar on March 18. Other central banks followed in an extremely rare joint operation. Japan has essentially run out of bullets and is now borrowing cartridges from other nations.

While the exact amount of currency sold to weaken the yen is unclear what is clear are the implications behind the currency operations. In the past year, myself and other pundits had mused that the G20 was the new organization that had superceded the G7/8 in influence (Canada was the last member to be invited to join) after the financial crisis of 2008-2009. The interventions of mid-March proved that the G8 economies (USA, Great Britain, Canada, Italy, France, Germany, and Japan) continue to retain considerable power in world financial markets. While emerging markets such as China, Brazil, India, and (arguably) Russia are leading world growth, the centers of financial and political stability continue to emanate from the developed world.

The takeaway message here is that more - not less - government intervention is here to stay for the foreseeable future. Even though individual governments may have exhausted their own financial resources they can rely on tools such inter-bank swaps, forwards, and no interest loans (to name a few) from other nations. World governments have learned from their lessons in 2008 and 2009 that coordination is essential to bringing stability to financial markets. This has important implications for volatility and the Bernanke put in the coming months. But that is a topic for another time.

The Chinese Position on Libya

It should come as no surprise to China watchers that the country has followed its historical pattern of abstaining from voting on critical UN resolutions. I speak of course of the current Libyan crisis and the UN vote on a "no fly zone." For the most part, this was a reasoned policy balanced on its lack of influence in certain volatile parts of the globe. What is the point after all, leaders reasoned, of interjecting themselves into a volatile part of the world that has historically captivated the West and three monotheistic faiths? For example, China has famously abstained on UN votes in nearly all Middle East centered resolutions such as both Gulf Wars against Iraq. However, in the present situation, that same line cannot be used.

The Chinese presence in Libya was substantial - comprising tens of thousands of workers in petroleum extraction, refining, transportation, logistics, and engineering. Additional workers were active in construction and mining. Indeed, China was Libya's primary customer for oil and natural gas exports, superseding even the EU as a customer base. In the immediate days and weeks of the initial protests, Beijing reacted swiftly and decisively by withdrawing nearly all of its staff in a massive evacuation operation to protect them against political violence. No expense was spared in round the clock airlifts, boats, rail lines, and buses to evacuate nearly 36,000 Chinese citizens. The official China news agency, Xinhua called it "a decisive success in China's largest-scale overseas evacuation since the birth of new China in 1949." The reaction was a shrewd one given the rebels' treatment of loyalists and government allies - namely the violent street justice executed against "African mercenaries" hired by the regime. In any event, the operation was a combined military and civilian effort that was swift, orderly, and above all effective in comparison to the chaotic and often ad hoc efforts of other nations.

Now that its citizens have been largely evacuated, China is now in the difficult position of balancing its strategic energy policies against its role as an emerging global power in international relations. The cozy relationship between the Politburo and Muamar Qadafi would surely come under intense scrutiny and perhaps even be jeopardized by any new regime. Several rebel spokesmen have already threatened to cut off ties w/Qadafi's business partners, a thinly veiled allusion to China. Although the exact amount of capital invested in Libya is not readily available to the public, Beijing has surely spent an enormous amount of money, time, and resources in cultivating a decades long working relationship with the country's leadership. This relationship in turn was founded in the shadow of numerous Western sanctions against Libya in the 1980s and 1990s for Libya's erratic actions such as sponsoring terrorist groups. Qadafi himself has seemed to turn on his erstwhile (unnamed) business partners and condemned them as cowards for abandoning him so quickly. In that light, the Chinese actions can be viewed as a poor attempt to ingratiate itself with both the West while preserving its investments in Libyan soil.

Or perhaps I am being too critical of Beijing. After China's initial opposition to the 2003 invasion of Iraq due in no small part to its substantial investments w/the Saddam Hussein regime in infrastructure, personnel, and logistics, Chinese firms were able to move back into the energy market by working w/the new US/British run government. Perhaps a similar event would occur again.

The successful model for a no fly zone can be found in the 1999 NATO campaign against Serbia. But even this is an inaccurate description. While the political talking heads intended to start by owning the airspace over Serbia, it quickly became apparent that they needed to escalate their selection of targets beyond mere air fields and radar sites. Strategic targets - including those of no military value - were quickly added. Bridges, roads, power stations, broadcasting towers, and government party buildings were all added to the list. Air strikes were eventually coordinated w/ground assaults by the separatist KLA (Kosovo Liberation Army). In a similar vein, any air campaign against Libya would become a de facto air arm of the rebel army. Add to that mix that even the rebels are unsure who is in charge and we have a recipe for political disaster akin to the situation in Iraq following the deposing of Saddam Hussein. So, perhaps the Chinese are right after all to be cautious. Still, the threat of prolonged air raids may be enough to move Qadafi to the bargaining table. Indeed, the no fly zone's political value may supersede that of any military one. It is even possible that a partitioning of the country may emerge - the rebel held east (full of oil) and the more urban west (not so full of oil).

Is US Farmland a Bubble?

A few days ago I posted about rising agricultural land values in South America. Well, here is a look at the US market. While the US continues to suffer from prolonged deflationary effects in residential and office space, agricultural land values have soared. Is this a bubble too? Only time will tell. But the year long surge in corn, wheat, and soybeans - some by over 100% - means a correction has been in order for some time now.

Farmland Fund Expects Prices To Keep Soaring
Cheap farmland is hard to find.

Values in Iowa and other key agricultural states jumped 12% in 2010, the second-biggest increase in the past 30 years, according to the Federal Reserve Bank of Chicago.

Nationwide, prices have doubled during the past decade and climbed about 58% when adjusted for inflation, U.S. Department of Agriculture statistics show.

Still, Greyson Colvin is hunting for deals as managing partner of two farmland funds for his agriculture-focused investment firm Colvin & Co., which aims to acquire undervalued properties.

"The farmland market is certainly tighter than it's been over the last 12 months," Colvin acknowledged.

Colvin manages about 1,500 acres of farmland in South Dakota and Wisconsin, worth $7 million, in the Sather Agriculture LP fund, along with about 350 acres held in individual accounts. The fund, which was launched in 2009, had a return of 29.6% in 2010, up from 7.8% in 2009, according to the company, compared with 15.1% and 26.5%, respectively, for the S&P 500.

There are signs investors will continue to reap gains from the sector, Colvin said. He touted farmland as "the one element that you can't replace across the agricultural equation" and said rising global demand for meat will keep pressure on growers to increase production of grain, which is used to feed livestock.

The company targets land that produces corn and soybeans, the dominant crops in the fertile Midwest. Colvin and his brother-in-law, an associate in the company, inspect properties personally before making purchases to check their quality.

He scoffed at observers who warn soaring land values may form a bubble. Agricultural fundamentals are the best in decades, he argued, saying rising farm income and cash rental rates justify the appreciation in farmland.

"We really believe that farmland is actually underpricing commodities at this point in time," Colvin said.

Indeed, farmers have the potential to cash in big on coming harvests, as corn, soybean and wheat futures recently surged above 2 1/2-year highs on concerns about tight supplies. Domestic corn inventories are expected to plunge to a 15-year low by the end of the crop's marketing year on Aug. 31 due to strong demand and a disappointing harvest last fall.

If cash prices for corn, which is trading around $6.20 a bushel, remain above $5 at the end of the year, Colvin said farmland values should be up an additional 10% to 15%. The outlook for corn prices is uncertain because farmers are projected to harvest a record crop this fall to replenish supplies.

Source CME News for Tomorrow

Is is Time To Finally Short JGBs and Buy Equities?

JGBs or Japanese government bonds, have been in a bull market for years. Near zero percent interest rates leave bonds with no more room to advance and is in large part, blamed for much of the financial malaise that has gripped Japan for the past generation.

In response to the devastating earthquake, tsunami, and multiple nuclear fallouts, the Japanese government has unleashed a massive spending program on an order that would make Ben Bernanke proud. Trillions of yen are being printed to address the short term liquidity crunch, pay for much needed repairs, and to support equity markets. (Note - While I do not intend to downplay the human toll of recent events, this is a blog dedicated to financial speculation and its ripple effects. It is possible to be both humane while still sticking to the original mission statement).

But even before the recent catastrophe Japanese public finances were in a dismal state. With public debt to gdp approaching 230% the JGB bond market had attracted the attention of bond vigilantes eager to short. In comparison, the US debt level is closer to 95%-100% (depending on which source you rely on).

While these bond bears had initially arrived in the early to mid 1990s following the dramatic Japanese market corrections and property bubble, most had moved on to greener pastures, unwilling and/or unable to fight the firepower of the Japanese central bank. Other bears switched to the increasingly lucrative forex trade where they sold the low yielding yen to buy higher interest bearing currencies like the Aussie, Real, and Kiwi.

In the intervening years, Japan continued to wallow through deflation. Its ranks of elderly grew while the number of young people shrank. These members of the "lost generation" became disaffected by societal changes beyond their control. Many became "otakus" or socially ignorant shut-ins whose only refuge was the Internet. The complete lack of job security for young workers who can only find temporary employment has made life difficult for new families and caused the birth rate to be cut in half (job openings are restricted to care for the ranks of middle aged and elderly that were promised a cradle to grave existence by prior managements). Society became more insular and engrossed in domestic affairs.

Nowhere was this demonstrated more dramatically than last year when China overtook Japan as the world's 2nd biggest economy. But even this event was noted with weary resignation by a population already accustomed to a diminished role on the global stage.

So, will the recent turn of events cause them to return? The short answer is possibly. But not right away.

Rising bond yields are correlated with rising equity markets. Or are they? In the months following the Kobe earthquake of 1995 the Nikkei continued to slide. The Topix bottomed out in June 1995 (Japan's largest index after the Nikkei, similar to the rivalry between the DJIA and the S&P 500). Even the Nikkei failed to regain its pre-2008 highs. Japan's government has traditionally been able to rely on domestic consumption to finance most of its needs. This is a generalization but foreigners find it difficult to engage the non-Japanese investor. Companies and families are now faced w/the prospect of liquidating their assets (including JGBs) to pay for much needed supplies like food, water, and housing - not to mention the enormous debris clearance and reconstruction efforts. Some bears are beginning to awaken from their hibernation, entranced by the prospects of JGBs achieving junk status in the near future.

But the BOJ has never intervened on a scale like this before. Additionally, the worst effects of persistent deflation seem to have been priced out. Indeed, the effects of deflation are so strong that JGB yields are STILL implying zero inflation despite oil >$120/barrel and staple food prices advancing over 150-200% in a year!

Risky Business in Asset(less) Lending

Retail investors have been on a hunt for debt based yield ever since Bernanke announced QE 2.0 last year. However, most bargains had already been snapped up earlier in 2009 by savvy fund managers. Most of the best issues have already been priced out of the market as reflected in lower interest rates. This was a win win situation for both debtors and lenders as the former were able to refinance at a critical time while the latter was able to achieve impressive gains.

But as the year progressed, less financially sound companies began to seek similar sources of funding among investors. Those who missed the initial rally in high yield issues have piled onto riskier and riskier issues. The principal cases in point are the recent surge in covenant line loans, pik toggles (payment in kind), and other mezzanine based debt structurings.

These types of deals were blamed by some critics for being a harbinger of the financial crisis in 2006-2008. The higher returns being offered to investors are a reflection of the greater risk involved to junior creditors. The most worrying parts are loan provisions that allow a borrower company to default in the event of deteriorating finances or even natural disasters such as acts of god. Unlike senior note holders, junior creditors are usually left holding the proverbial bag in case of a default. They are usually unsecured, or lack collateral, in their underlying loans.

So, what are some warning signs of a potential default? Here is a short list - large borrowings to pay special dividends, large bonuses paid to management, poor cash flow, goodwill comprising an unexpectedly large part of the balance sheet, and potential legal suits.

http://www.ft.com/cms/s/0/9f7c528c-4da3-11e0-85e4-00144feab49a.html

The German Success Story

Great article from Time Magazine about how Germany is becoming the success story of the EU. Exports have driven much of the country's growth since the doldrums of post-reunification.

http://www.time.com/time/magazine/article/0,9171,2053595,00.html

Chinese Farmland Continues to Experience Dry Conditions

Some interesting news coming out of China. Of particular concern is the wheat crop. 2011's wheat harvest is dependent to a great degree on Chinese output. The problem is compounded by some local governments' insistence on re-routing water tables for industrial use. Winter wheat in particular is very water intensive.

Most Of China's Cultivated Farmland Lacks Irrigation -Official
More than half of China's cultivated farmlands are dependent solely on weather conditions for water, with only 49% served by effective irrigation, a senior Ministry of Agriculture official said in an essay on an academic website.

The government targets spending of CNY4 trillion ($608 billion) over the next decade on water conservation infrastructure projects. It is redirecting $12 billion this year from property tax revenues to irrigation projects and making water conservation the centerpiece of its 2011 agriculture policy.

Zhang Hongyu, the ministry's supervisor of agricultural policy, said on the Chinese Academy of Social Sciences Rural Development Institute website Tuesday that "irrigation is the weakest link in China's agricultural production infrastructure."

Two-thirds of China's farmlands are affected by drought, steep slopes, poor soil, salinity and other factors, he said.

In China, efficient water use through irrigation is just 60% that of developed economies, Zhang said in the essay, without elaborating.

In his essay, which was first published in the Communist Party's People's Daily newspaper, Zhang also called for the government to redirect industrial investments to the agriculture sector to "release the potential of rural consumption."

"The need to expand domestic demand is a basic necessity of improving agricultural infrastructure," he wrote.

Even as rural incomes have risen on the tide of surging agriculture commodity prices, China last year recorded its widest rural-urban income gap since 1978.

Source - CME News for Tomorrow