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The Bermuda Triangle of economics

Steen JakobsenSteen Jakobsen , Chief Economist & CIO, Saxo Bank

Bermuda Triangle

The mystique of the Bermuda Triangle has caught the imagination and interest of generations. In much the same way it has also caught my attention and I feel that now there is a Bermuda Triangle of economics - a space where everything tends to disappear without radar contact, a black hole in which rationality and science is replaced by hope, superstition and nonsense pundits like myself pretending to understand the real drivers of the economy.

The Bermuda Triangle in real life runs from Bermuda to Puerto Rico to Miami. The economic one runs from high stock market valuations to high unemployment to low growth/productivity. Just like the real Bermuda Triangle, in the Bermuda Triangle of economics there is plenty of scientific evidence that can explain most, if not everything, of what is going on. But that does not suit Hollywood, sorry, the US Federal Reserve.

Neither does it suit mainstream banking analysis or the media in dealing with reality and facts: the mystique simply sells better! After all, there is a reason why people leave science education for PhDs in apps and virtual reality.

There is a myth that the sunken Atlantis could be in the middle of this triangle. It has been renamed Modern Monetary Theory (MMT) to make it suit the black hole's main premise of ensuring there is a fancy name for what is essentially the same economic recipe: print and spend money, then wait and pray for better weather.

The economic Bermuda Triangle, or EBT, is getting harder and harder to justify - if for nothing else because the constant reminders of crisis keep us all defensive and non-committed to investing beyond the next quarter. We all naively think we can exit the "risk-on" trade before anyone else. A less cynical person than me could think that some things in life need to be experienced - not talked about.

Where to from here?
A long time ago, policymakers entered a one-way street where reversing is, if not illegal, then impossible. Enough though about the polices. What is more important is what is next?

If a political scientist should create a simple model for how this Bermuda Triangle works, the first action point would be to test the premise of the policy. No theory is better than its premise - clearly.

The Federal Reserve version of the premise is to create a positive wealth effect that ultimately leads to better sentiment and investment. The barometer of success is the stock market, but does the stock market really correlate to wealth? Clearly the stock market has been on a tear, but is everyone, including the average Joe, benefitting? Clearly not. Ownership of stocks is almost exclusively for the top 10 percent of the population. Social divide is much higher today than it was before the crisis. 

In Japan, they are more open - they simply want to create a bubble. I repeat, a bubble. That is interesting when policymakers for years have said it is impossible to figure out when there is a bubble! I guess - proactively wanting a bubble makes it more transparent? Confused? Certainly I am, but then again Abenomics is "double Dutch" to me anyway.

So the premise does not hold, but how will the policymakers deal with failure? Change course? Never! It would be worse than blasphemy! A one-way street means cars can only go one way - not in reverse. Optionality is for democracies and capitalistic systems, not for a time of crisis. In times of crisis, we need the foresight of our great supreme leaders, sorry, politicians and central bankers, to guide us. Their divine insight will lead us safely ashore to the beaches of Lalaland, where the sun always shines.

No, the response is to do more. Take the Bank of Japan's quantitative easing (QE) infinite released on April 4. One month into the experiment and Japanese Government Bond (JGB) yields are higher, not lower.

JGB Yield - Saxo Bank

The yield curve is steeper, inflation expectations are flat but the Nikkei and USDJPY are higher. A success? Yes, except in the one area you wanted to impact: the yield and the yield curve!

The other part is that for this to work, the stock market needs to keep outpacing the fall in JGBs. The Government Pension Fund manages more than USD 1 trillion. Its allocation? Sixty-five percent in JGBs and less than 11 percent in stocks. Hence, the present scoreboard would read: 

USD 650 billion x (146.50 - 143.50) = 2% =  - USD 13bn.  USD 110bn  x 40% =  USD 48bn. A net gain of USD 35bn but...

What if the Nikkei comes off 10 percent - then USD 48bn becomes USD 37bn and the new equilibrium price of 138.50 is only five figures away.

JGB continues

A price point that will make Japan less well off, not better, plus it would have increased the funding price of the 240 percent debt-to-GDP ratio. Some strong macro fund managers think that a collapse in Japan is less than 12 to 18 months away, among them Mr. Kyle Bass stands out. Maybe Japan should be careful about what it wants. My conclusion on Japan is:

1. The Japan scenario is neither black nor white, but a continuous gradual process. Japan is notoriously slow in changing its political process and ultimately nothing will have changed materially one year from now. Yes, the Nikkei could be the start of a secular bull market as Stanley Druckenmiller recently said in New York, but it is already up 60 percent from the low. And with China and Europe slowing, it is likely to see a major correction and probably soon.

2. The unintended consequence of QE Infinite in Japan is so far (as shown above) a higher yield - even higher than the recent rise in US rates - USDJPY becomes vulnerable for a major correction down to 95/96.

3. Japan will not go bankrupt inside 12 months or even 12 years, but the hope of a recovery will wane and soon. Watch how the Upper House election in the Diet in July becomes the final destination for Abenomics. Prime Minister Shinzo Abe needs to secure 63 and 100 new seats; 63 seats to maintain momentum behind his economic policy and 100 to secure the majority to change the constitution.

Diet Election in July

Delivering "cheap money" is the easy part of his three pillar strategy, which got him elected. Using stimulus correctly and working on the supply side of the economy will be impossible due to structure, lack of immigration, health care and ageing costs. I wish Japan well, but nothing will be saved by using the economic Bermuda Triangle. Of all countries, Japan should know - it invented the economic version of it!

Another key event will be the German election.

In Germany,  Chancellor Angela Merkel will win the battle (the election), but will probably lose the war: she needs to step up. Europe expects it. The market wants it. The problem is, she can't afford it.

Bailing-in will mean a loss of rating for Germany, while staying austere will cost exports and long-term growth. Which scenario to choose? I personally think she will fail - fail to reconcile. She is already short of a Chancellor's majority and after the election, the Greens and SPD will hold her hostage. Staying in power will mean giving in. Simply. 

That, however, will be the end of the honeymoon for Europe. Germany cannot save Europe. Each country in Europe needs to realise that its recovery comes from its own political willingness to reform and eat reality pills. Europe is destined to repeat the history of Japan, unless an even more severe crisis makes us wake-up. 

This means we see the July to October period as a very important time frame for this experiment. We firmly believe the German election will be the game changer, but we could get a surprise in July unless Mr Abe gets JGB yields under control.

Policy conclusion

The Federal Reserve is testing the waters with its "tapering", but Fed chief Ben Bernanke is financing the budget deficits via his QE. Hence, he will continue less aggressively, but QE is not ending.

The Bank of England gets a new boss in July. This will kick-start American-style policies, which sits right in the middle of the economic Bermuda Triangle, with GBP being the main casualty.

The Bank of Japan will soon correct its maturity in buying - buying longer and deeper - as the July election looms.

The European Central Bank is close, very close to doing something that smells and feels like QE. Selling the sick man of Europe - France - makes a lot of sense here.

We are entering the realisation part of this global slowdown. Unlike three months ago, policymakers now realise that growth is not coming back in six months' time as they all love to estimate at their press conferences. So over the summer, the Federal Reserve, Bank of England, Bank of Japan, International Monetary Fund and European Central Bank will all go back to their drawing boards and... do more of the same.

Citigroup G-10 Economic Surprise Index

The policy is not wrong; clearly, it is only the amplitude of it. I agree with Jeff Gundlach, who believes QE is here to stay for a long, long time, but also that the only thing that will get us out of this funk is innovation and reality. How do I reconcile this?

By allowing the 70 percent likelihood for Extend-and-Pretend Season 4 through to the July to October period (German and Japanese elections), which will lead us to Japanisation (dis-inflation, no growth and productivity plus an ageing population).

Mad Men

There is a 30 percent chance of failing before July - failing as in the market collapsing or social tensions rising, governments falling and the financial system under pressure.

We are due for a new crisis. We have governments and central banks proactively pursuing bubbles. Hence, the probability of bursting one of those bubbles will need to have risen by the same magnitude as the desperate moves of policymakers.

We have a very balanced approach to investment, despite our strong views: 

Seventy percent of our assets are placed in the Saxo Balanced Portfolio, which is based on the approach in Fail-Safe Investing: Lifelong Financial Security in 30 Minutes, a personal finance book written by American investment analyst and politician Harry Browne

  • 25 percent in US stocks to provide a strong return during times of prosperity. For this portion of the portfolio, Browne recommends a basic S&P 500 Index fund such as VFINX or FSKMX;
  • 25 percent in long-term US Treasury bonds, which do well during prosperity and during deflation (but perform  poorly during other economic cycles);
  • 25 percent in cash to hedge against periods of “tight money” or recession. In this case, “cash” means a money-market fund (note that our current recession is abnormal because money actually is not tight - interest rates are very low);
  • 25 percent in precious metals (gold) to provide protection during periods of inflation. Browne recommends gold bullion coins.
We have done our own approximation and an introduction to the Saxo Balanced Portfolio (with historic returns) is available tomorrow here on

Then we have 15 percent in a Turtle Model, which is essentially an option model of bets in high-volatility trades with high leverage, but also strict discipline.

Finally, we allow a 15 percent allocation to Alpha trading or directional bets. Here are some ideas we think have traction beyond next week:

In the Alpha model, we are presently focusing on these trades:

  1. Short AUD. We firmly believe that the end or pause of the super-cycle in commodities will not only hurt Australia, but also come as a negative surprise despite plenty of warnings and a fuse that was lit many months ago with the peak of gold more than 12 months ago. We short the AUD.
  2. Short OAT - French Government Bond. This is new position initiated after Japanese investors replaced domestic funds as the biggest buyers of French Government Bonds in April - a well-known seasonal play  in which Japanese lifers and funds go overseas in the first months to fill out their new "mandates" at year end (March 31). Short OAT is a play on European QE. The Club Med pressure for easier rules on collateral and richer funding is happening. We short the "Sick Man of Europe".
  3. US dollar bull cycle has started. We do not see any alternative to long USD in this cycle of currency manipulation. The US started early and now we go full circle with the EUR being the final pawn. Of course, this will be preceded in July by the arrival of Mark Carney as the new governor of the Bank of England. Short GBPUSD and EURUSD now in place.
  4. Long EMG bonds. The weakness in BRIC and EMG is generally overlooked. Sure, they have performed poorly, but even success stories like Poland, Chile and South Africa call for further monetary easing. It will be too little too late as inflation is underlying most macro data, but FX and rates will take the correction. Be long mainly strong EMG bonds: Poland, Chile, Russia vs. OAT/BTP
  5. Overweight bonds. We have been overweight for a while and continue to like bonds. It is no longer only a valuation play, but also due to the implicit "equity put option" the fact that bonds - not that we predict it - will correct.

In Alpha terms, we are neutral on stocks; the Beta (Saxo Balanced Portfolio makes us long). In a world where money printing and monetary illusion is present, stocks can be plus/minus 25 percent.

We simply want to wait for negative chart patterns and policy mistakes to enable a short position.

The Fed's minute changes to its language will dictate the short term, but I must say the JGB rise in yield could indicate what my friend Mr. E calls, "The end of Bernanke's put". If this is so, then we will see the usual pattern of sell in May emerging, with elections for Japan's Upper House in July and Germany in September as the political risk. The tail risk remains Cyprus, growth in general, social tensions and a major financial institution failing.

Cyprus just announced that its temporary capital controls would remain in place at least for another two months. Iceland is in its fifth year of temporary capital controls. Want to bet how long restrictions in Cyprus will remain in place?

Japan is not a binary event, but QE Tokyo-style saved investors' bacon in the first and second quarters of this year. Japan's progress from here will be slow and gradual. Ultimately, deflation and a stronger JPY will be back.

MMT is sunken but not Atlantis -  the wealth effect is a pipe dream.

The individual: the inventor, the toolmaker, the consumer and the investor will be needed because the world is short on  innovation, appetite for life and risk and a belief in ourselves.

The Bermuda Triangle of economics has made us all entitlement receivers, creating a version of life in which we choose to believe that no change is good.

Thursday, 16 May, 2013 / 1:30

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