MacroScope

Where is the Japanese money? Mostly it has been heading back to home shores as we wrote here yesterday.

The assumption was that the Bank of Japan's huge money-printing campaign would push Japanese retail and institutional investors out in search of yield.  Emerging markets were expected to capture at least part of a potentially huge outflow from Japan and also benefit from rising allocations from other international funds as a result.  But almost a month after the BOJ announced its plans, the cash has not yet arrived.

EM investors, who seem to have been banking the most on the arrival of Japanese cash, may be forgiven for feeling a tad nervous. Data from EPFR Global shows no notable pick-up in flows to EM bond funds while cash continues to flee EM equities ($2 billion left last week).

But first, some good news. Retail investors are demonstrating some interest in emerging assets. Barclays says launches of toshin or investment trusts last week garnered $2 billion in subscriptions, with a Pacific Rim equities fund, partly geared to Asia, receiving $1.2 billion.  The previous week saw a $500 million ASEAN fund while an emerging equities toshin started in March took in $1.6 billion. There has also been net new uridashi bond issuance in the Mexican, Brazilian, Turkish and Russian currencies over the past few weeks, Barclays data shows.

The bad news is that Japanese  funds and insurers -- and that's where the big money is -- have steered clear of emerging markets, and indeed foreign assets so far.   Barclays writes that could be bad news for markets such as Hungary and South Africa, which have poor fundamentals and have benefited from talk of Japanese cash:

There’s been a lot of noise surrounding the rhetorical shift away from austerity in the euro zone in recent days, the notable exception being Germany. It is now widely acknowledged that monetary policy alone cannot turn economies around. But of course it has a vital part to play.

That puts the focus on the European Central Bank and growing expectations that it will cut interest rates to a new record low next month. Yesterday’s poor German PMI could have been the tipping point. On three of the four times the survey reading has fallen below 50 since the collapse of Lehman Brothers a rate cut followed the month after. Germany’s PMI duly slipped into contractionary territory yesterday.

In all this, we shouldn’t lose sight of the fact that a quarter-point rate cut may move markets but will have only a small impact on the euro zone economy. It’s also true that the ECB has shown no signs of wanting debt-cutting drives to be mothballed. Its reaction to any shift in that direction remains to be seen.

Are European bond investors looking for love in all the wrong places?

The premium bankers demand to hold various types of euro zone debt over that of Germany has recently come down. In normal circumstances, this might suggest markets are no longer discriminating between the risks associated with different member countries’ bonds. But analysts say the recent convergence is based on a precarious belief of ECB action rather than any real improvement in economic fundamentals.

Spain and Italy still offer a comfortable premium over Germany. But a narrowing in yield spreads that is being driven by a fall in the funding costs of Spain and Italy, rather than by a rise in German yields, gives reason for pause.

According to Lyn Graham-Taylor, fixed income strategist at Rabobank:

The fact there is almost no movement from Germany and a huge movement in peripherals is indicative to us of this convergence for the wrong reason.

Two analyses published this week highlight how alarmed investors are about inflation in Brazil.

In the first, published on Wednesday following a poll on global stock markets, equity investors say an interest rate hike wouldn’t be a bad idea – a paradox, since stocks usually drop when borrowing costs rise. Are they keen to move to bonds? Not really; their argument is that an interest rate hike could assuage inflation fears after eight consecutive months of above-forecast price rises. A rate hike could also reduce concerns of economic mismanagement after several government attempts to intervene in key sectors such as banking and power generation.

The central bank signalled it could act later this year, but would rather wait because the recent inflation surge could be just temporary. Bond investors disagree, according to a separate analysis published today. In their view, inflation will remain above the 4.5 percent target mid-point through at least 2018, raising uncertainty about long-term investments needed to bridge the gap between Brazil’s booming demand and its clogged roads and ports.

The 1994 bond market massacre is remembered with horror by those who lived through it. Yields on 30-year Treasuries jumped some 200 basis points in the first nine months of the year, hammering investors and financial firms, not to mention thrusting Mexico into crisis and bankrupting Orange County.

The accepted story is that an over-eager Federal Reserve set off the carnage by raising interest rates too soon – the sort of premature move that current Fed Chairman Ben Bernanke has suggested, again and again, that he is not going to make.

But what if the conventional wisdom about 1994 is wrong? Steven Englander, Citigroup’s head of G10 currency strategy, says that when it comes to the Fed’s balancing act of a mandate – price stability and full employment – the Greenspan-led incarnation, in this instance at least, deserves top marks.

Brazil inflation jumped above expectations in February, despite a steep cut in electricity rates. It was not the first time, though; inflation has been running higher than consensus forecasts since July, considering the market view one month before the data release:

The total gap between market consensus and the actual inflation figures amounts to 1.19 percentage point – about one quarter of the inflation rate reported. Reuters polls conducted a few days before the official numbers come out have also proved wrong since July, with a total error of 0.37 point.

Why is that? Part of the difference was due to an unexpected jump in food inflation. But another part has to do with the mix of strong demand and weak supply that has dragged down the Brazilian economy over the past two years.

That’s not a typo in the headline. In a recent speech that took some mental gymnastics to absorb, Federal Reserve Chairman Bernanke countered critics of his low rates policy by arguing that a loose monetary policy is the best way to ensure rates can rise to more normal levels.

Why? Because interest rates will naturally move higher once stronger economic growth leads to higher rates of return on investment, Bernanke said. Here’s his argument:

One might argue that the right response to these risks is to tighten monetary policy, raising long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my discussion this evening has convinced you that, at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability. Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low. Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading–ironically enough–to an even longer period of low long-term rates. Only a strong economy can deliver persistently high real returns to savers and investors, and the economies of the major industrial countries are still in the recovery phase.

Earlier this month, Fed Governor Jeremy Stein made waves that are still rippling with a speech on the risks of credit bubbles. The policymaker said that the U.S. central bank could use interest rates, as opposed to the more conventional tool of regulation, to cool overheating in junk bonds and other markets.

With worries growing that the Fed’s easy-money policies are inflating dangerous bubbles in financial markets, the speech could portend an earlier-than-expected reversal of quantitative easing or raising of ultra low rates. But don’t take my word for it. Here’s what St. Louis Fed President James Bullard had to say about Stein’s speech, when he visited New York University last week:

“My main takeaway from the speech … was that he pushed back against the Bernanke doctrine. The Bernanke doctrine has been that we’re going to use monetary policy to deal with normal macroeconomic concerns, and then we’ll use regulatory policies to try to contain financial excess. And Jeremy Stein’s speech said, in effect, I’m not sure we’re always going to be able to take care of financial excess with the regulatory policy. And in a key line he said, raising interest rates is a way to get into all the corners of the financial markets that you might not be able to see, or you might not be able to attack with the regulatory approach. So I thought this was interesting. And I would certainly think that everybody should take heed of this. This is an argument that, maybe you should think about using interest rates to fight financial excess a little more than we have in the last few years.”

Jonathan Spicer contributed to this post

When the Fed adopted thresholds for its low interest-rate policy last December, Fed Chairman Ben Bernanke said they would make “monetary policy more transparent and predictable to the public.” But now that the policy is fully in place, it doesn’t seem that the public and the Fed are predicting the same thing at all. Not even close.

In their policy statement following a two-day meeting that wrapped up Wednesday, Fed policymakers removed any reference to date-based policy guidance, saying only that exceptionally low rates would remain in place as long as unemployment remains above 6.5 percent and inflation is not seen to top 2.5 percent. But as recently as December, the Fed’s statement suggested policymakers did not believe those thresholds would be met until at least mid-2015.

The market, as personified by traders ofU.S.short-term rate futures at the Chicago Board of Trade, believes differently. According to CME Group’s FedWatch, which uses fed fund futures prices to estimate market expectations, traders were pricing in a 55 percent chance of a first rate hike by October 2014 – eight months before the Fed’s forecast last month. Threshold-based policy does not seem to have brought the market and the Fed onto the same page – not even to the same year.

It’s that time again: Fed watchers are already parsing possible changes to the January policy statement, even before it is released. Goldman Sachs economists in particular have identified one passage ripe for some type of tweak — one that could signal the appetite for continued bond buys:

With Treasury purchases under the new regime already underway, the statement that Treasury purchases would ’initially’ occur at a pace of $45 billion per month will have to be adjusted. If ‘initially’ is replaced with another modifier such as ‘at the present time’ rather than deleted, it would suggest downside risks to the size of     the Treasury program later this year.