An Analysis of the U.S. Long Bond and its relation to the Japanese Yen

You are looking at a price chart of Japanese Yen going back to 1999 and extending to the present. This might perhaps seem to be a strange price chart to examine when the subject heading is the U. S. Long bond, but I submit one cannot understand the recent price action in U. S. Treasuries apart from understanding what is happening to the Japanese Yen.

Here is a chart which any individual remotely familiar with Technical Analysis can immediately see is pointing to a significantly higher price. The continuous Yen chart reveals an extremely powerful reverse Head and Shoulders formation which has as its minimum objective, a move to .9900. Just above that lies the “penny yen” above the December 1999 high at .9919. All things considered, things look quite rosy for the yen and by contrast, quite bleak for the U. S. dollar/yen exchange rate.

What is of interest in this chart requires a closer look so let’s zoom in a bit to see the year 2003 as it has thus far played out. Going back to December 2002, one can detect market action that can best be described as a ranging being bordered at the top by the .8650 area and on the bottom by .8250 area until late September of this year. The explanation for this is quite simple. The Japanese monetary authorities have been trying to cap the yen and prevent it from rising against the U. S. dollar in an attempt to keep their export advantage. Their feeling is that a weaker yen is in their economic interest. Domestic demand in Japan is still moribund and the thought is that the only salvation for Japan lies in continuing to sell its products abroad until domestic demand can rebound. A strong yen makes the costs of Japanese goods more expensive overseas, especially to its biggest customer, the United States. Any let up in export demand therefore cannot be tolerated.

By referring to the chart, one can see that each time the yen threatened to break out of the broad rectangular trading box to the upside, the monetary authorities stepped into the foreign exchange markets and vigorously bought dollars against the yen dropping the yen back down into its trading range where technical reasons then kicked it back closer to the bottom of the range. The signal that this gig was up however occurred in late September of this year when the yen catapulted out of the 9 month long trading range with a huge gap up move followed by another gap upward a few days later.

The reason behind this move occurred at the G7 summit which was held in Dubai. There noises began to emanate that the U. S. was opposed to “intervention” in the market place and wanted to see currencies trade to their “natural” levels. Speculators world wide wasted no time in clearly ascertaining that the U. S. was no longer in favor of a strong dollar and was beginning to lose patience with the BOJ’s frequent yen-weakening forays. Political pressures due to job losses in the U.S. necessitated some sort of response by the administration to boost the export of U. S. manufactured goods or supplies such as agricultural food products in an attempt to help the bottom lines of American business with products or services to sell abroad. Savvy currency traders who immediately perceived the repercussions of the situation were swift to react. They began unloading long dollar positions taken on since the yen was approaching the top of the trading band again. The long dollar or short yen positions were covered en masse resulting in the violent gap on the price charts. Even the BOJ with its massive firepower could not stand in front of a tidal wave of this size and was forced to regroup to determine its next move. What the new strategy that was apparently decided upon consists of can be determined from another close up view of the same chart.

We can now see that the Bank of Japan has indeed been forced to retreat but their retreat has been an orderly one that any disciplined and well–trained army would execute in a situation in which they had no possibility of winning. They fall back and regroup and make a new stand at a position that offers them some sort of advantage where they hope to buy time and avoid the inevitable and wait for deliverance. The new ground that the BOJ seems to have staked out is capped near the .9300 level. Repeated attempts by the Yen to break this level have been successfully repulsed in all but one brief instance in early December. Even that only lasted two days. The problem that BOJ is facing however can be clearly seen by the failure of the yen to move back down to the bottom of the new trading range even after the severe thrashing it received on December 10. It simply does not want to stay down. The problem for the monetary authorities is quite simple – the moment they step out of the way and cease their price capping operations, they yen will explode to the upside. They are trapped and have no choice but to continue capping if they hope to revive their economy by relying on the export front.

How is all this related to the U. S. Long Bond? The answer in my opinion is relatively easy to understand. When the BOJ steps into the currency markets to intervene on behalf of the yen, it is required to buy dollars in order to weaken its own currency. The latest estimates suggest that this year alone the BOJ has spent upwards of the equivalent of $168 billion in attempting to cap the yen’s rise. The question that needs to be asked is what exactly does the BOJ do with all these dollars that they have purchased? Are they sitting there somewhere in Japan in a big warehouse neatly wrapped and bundled in boxes? Of course not. The answer is simple – they use them to purchase U.S. Treasuries and U. S. government agency debt.

Look at the following data supplied from the U. S. Treasury’s web site at www.treas.gov and see for yourself.

                                                 MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

                                                           (in billions of dollars)

                                                         HOLDINGS 1/ AT END OF PERIOD

	2003	2003	2003	2003	2003	2003	2003	2003	2003	2003
COUNTRY	Oct	Sept	Aug	July	June	May	Apr	Mar	Feb	Jan
Japan	501.9	484.4	464.7	456.5	454.4	442.5	401.9	399.4	390.5	384.8
Mainland China	141.9	137.6	139.4	141.6	138.1	137.2	134.9	133.2	121.8	120.7
United Kingdom	113.6	108.6	120.6	112.3	92.7	83.3	82.6	83.2	78.2	80.9
Caribbean Banking Centers 2/	58.7	65.8	67.9	69.1	60.8	64.3	56.7	60.8	48.9	46.6

Please notice that these totals are in BILLIONS of Dollars! Also observe the steady increase throughout this entire year. Notice also the sheer size and scope of Japan’s holdings in comparison to the next largest foreign holder of U. S. Treasuries which is China. It is not even close! Japan holds nearly 3 ½ times the Treasuries that China does. The Japanese are holding $.5 trillion dollars worth of U. S. paper and this does not include U.S. mortgage debt or stocks. That is a staggering sum under any circumstances. Why are they holding such huge quantities? My contention is that they have no choice but to hold them if they hope to keep the yen from appreciating further.

Let’s take a look at this. It is a fact that Japan is running a huge trade surplus with the United States. They are selling us more goods that we are selling them. Every time a Japanese company sells its good to a U. S. customer, a transaction is required in which the dollar is sold and the yen is bought.

Let’s take the case of a TV. A company such as Sony manufactures the TV in Japan which is then shipped abroad and sold to a U.S. distributor. The U.S. distributor is required to pay in either dollars or yen for their purchase depending on the contract stipulations. If they pay in dollars, Sony receives those dollars and then must convert them into its own native currency, the yen, if it is to do anything with that money in its native land. This requires Sony to then get rid of its dollars in exchange for yen. If American company XYZ is required to pay for their purchase of Sony TV sets in yen, then it must sell dollars and buy yen so as to be able to make the payment directly to Sony in yen terms. Either way, the dollar must be sold and yen purchased. One can easily see that the more goods that Japanese companies sell to the U.S., the more dollars will need to be sold and yen to be bought on the market. If as is the present case, the amount of Japanese goods exported and sold to the U.S. exceeds the amount of American goods exported and sold to Japan, then pressure will hit the dollar and drive up the relative value of the yen all things considered.

On the other hand however, if Japanese investors desire to buy American stocks or paper assets rather than Japanese stocks or paper assets, that necessitates that yen be sold and dollars be purchased. If there is a greater demand among the Japanese for American stocks than there is a Japanese trade surplus, the dollar will tend to rise against the yen regardless of the pressures resulting from the deficit in the balance of trade that the U. S might have. This of course is a somewhat simplistic explanation of how the real world works but it is sufficient for our general purpose.

During the bull market of the 1990’s, Japanese demand for American stocks was greater than the U. S. trade deficit with Japan. The result was a rising dollar and a falling yen. That all began to change when the great bear market began in 2000. Japanese investors began exiting the U. S. stock market. Now all of a sudden things began to change on the monetary front. The trade deficit that the U.S. was running with Japan became more and more important as there was insufficient demand from Japanese investors to offset the pressure on the U. S. dollar being applied by currency transactions necessitated by import/export business. The result – the dollar began to fall against the yen. The trend has continued to this present day.

Now what Japanese exporters will do when they receive payment for their goods in U.S. dollar is to exchange those dollars for yen with the Bank of Japan. Add that to their outright purchase of dollars in the currency markets and the result is that the BOJ ends up with a huge stash of dollars and must put those dollars somewhere. The BOJ has several options they could choose from. They could very well use the dollars to buy more gold but that would run counter to the Fed’s wish to restrain the price of gold. They could use those dollars to buy Euro bonds but that would tend to force up the euro in relation to the yen crimping their exports to Europe so that is not a viable option in great quantities either if they wish to avoid shooting themselves in the foot. Voila! They can buy U.S. Treasury paper and by so doing drive up the price of U.S. bonds helping to keep interest rates from rising and slowing down the U.S. economy thereby hurting their number one customer in terms of exports. They have the best of all worlds.

The only problem is that the U. S. authorities have made it clear that they want a weaker dollar. Japan’s actions are complicating this process by keeping the dollar from dropping faster that it would under normal market driven conditions. That is opposed to U. S. wishes. On the other hand, the Fed does not want long term interest rates to rise since its only hope of keeping the U.S. economy from derailing is to continue to attempt to provide a benign interest rate environment. The problem that the Fed is facing however is a result of its own policies.

Long term interest rates are undergoing an increasing tendency to rise as a result of the huge expansion in the U.S. money supply. Demand from China for industrial products such as copper, nickel, steel, etc, are driving up the price of commodities as can be clearly seen at a cursory glance of the CRB index. Simply put, the Fed has set in motion a process that will lead to inflation- there is no way around that. Typically, the bond market would correctly put two and two together and anticipate this scenario and bond prices would begin to drop on the long end correctly reflecting the need for interest rates to rise in an attempt to compensate for the loss that bond holders will experience in that kind of environment. What therefore is the Fed to say to the BOJ?

I submit that there is a tacit or planned agreement between the BOJ and the Fed and Treasury that allows and actually welcomes Japanese intervention in the forex markets with the understanding that this will be permitted as long as the BOJ uses the accumulated dollars to buy U. S. paper. It is a quid pro quo arrangement. The BOJ benefits by slowing down or even halting the rise in the yen and the Fed benefits by seeing the BOJ do its bidding for it by keeping a massive floor of support under the bond market thus holding down long term interest rates and preventing them from rising with massive purchases of U. S. Treasuries. I believe that this is one of the items which was discussed and consequently agreed upon at the G7 Summit in Dubai in September. 

We can see this strategy displayed for us by glancing at a price chart of the U. S. long bond.

Notice carefully the precipitous drop in the long bond beginning in June of this year when the Fed contradicted its own previous deflation talk sending the bonds reeling as bond traders went directly from a deflation scenario to an inflation scenario and attempted to adjust their bond positions accordingly. The resultant exit shoved long term interest rates up rapidly sending a shock wave through Wall Street and unleashing fears of a severe contraction in the U.S. economy. Now compare this chart to the short term Yen again and you will notice that during this time frame, the BOJ was still merrily engaged in capping the yen and refusing to allow it rise.

While bonds were falling off the cliff during June and July, the dollar/yen ratio remained relatively tranquil trading in the band that had contained in since December 2002. I believe that it is at this point in time that the Fed became desperate and actually feared losing control of the situation. Enter the arrangement.

Bond prices began to stabilize in August as can be seen by the bond chart at precisely the same time that the yen began to rise prior to its break out at the G7 summit. Since that time, bonds have carved out a trading range capped around 111-112 and supported near 104, then 106, then 108. So too has the yen carved out a trading range as was detailed earlier but at a higher level. It appears to me that both the Fed and the current Administration, in spite of its former condemnation and diatribes against “currency manipulation” is now satisfied with BOJ forex intervention capping the yen near .9300 in exchange for the subsequent purchase of U. S. Treasury paper at various agreed upon support levels. In effect, the Fed seems to have found a willing ally to do its dirty work for it by attempting to artificially keep long term interest rates much lower than they should be with all the inflationary warning signs that abound. I believe that this is the only possible plausible explanation for the total and complete disregard that the bond market has been giving to these unmistakable signs.  No sane bond trader can look at the following CRB chart and reason within himself that there is no evidence of inflation as the mouthpieces at the Fed continually assert in spite of all the evidence to the contrary. The CRB index does not close into 7 year highs in a deflationary environment. Besides that, any one who actually believes that the government does not alter the basket of goods and services that go into making the CPI is a prime candidate for ocean front property in Arizona. The Feds have a vested interest in understating the true rate of inflation which is a subject for another time. One quick example will suffice – think cost of living adjustments to Social Security payments.

In summary, once again we have the scenario where central bankers are standing directly in front of a tidal wave of opposing forces. Those forces are calling for significantly higher long term U. S. interest rates. The profligate spending of Washington combined with the massive trade and current account deficits along with the seemingly unceasing production of paper dollars from the electronic printing press so dear to Fed Governor Bernanke all have combined to act as a lead anchor on the U. S. Dollar dragging it irresistibly downward further contributing to the erosion of its value and leading directly to future inflation.  Those of us who have been privileged to have the knowledge that GATA gave to us revealing the blatant manipulation of the gold price by the monetary authorities should be no more surprised at this latest gambit either. Just like the futile attempt to hold back the gold price, this too shall fail as market forces will eventually and inevitably overwhelm even the resources of the combined BOJ and the Fed.

In the interim, from a trader’s perspective, I therefore do not expect the bonds to “fall out of bed” sending interest rates soaring through the roof in a relatively short period of time. Instead I see bonds beginning to break down and establish a long term gradual downtrend which will be marked by subsequent counter trend rallies as the price fixers once again make their presence felt and attempt to stem the flow of money exiting the bonds rekindling hopes that the inflation beast has been slain and all is well and right with the monetary world once again. As gold has continued upward and will continue to do so in spite of the fierce resistance encountered from the gold cabal made up of bullion banks doing the bidding of the ESF and for their own selfish reasons as well, so too will bond prices head lower only to find fierce counter rallies from time to time as the masters of the fiat money system, a.k.a., the central banks, attempt to resuscitate their darling system as it gasps beneath the tidal wave of overwhelming forces gathering against it.

I do think that we will reach such a crisis point however at which the attempts by the central banks to arbitrarily contain long term interest rates will fail and we will see a dramatic rise in rates here in the U.S. The short end of it all is that once bonds break loose from the death grip of the BOJ and long term interest rates begin to rise in earnest, the gold price will begin to move up in parabolic fashion and we will witness a bull market that will make the late 70’s rally in gold look like amateur’s night at the forum.

Dan Norcini

December 16, 2003

Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at dnorcini@earthlink.net with comments.