We have made no secret of the fact that the entirety of the Japanese Prime Minister Abe economic recovery program is predicated on the foundation of a weak currency. The effectiveness of that program has now become suspect mainly due to an 8% increase in the value of the Yen against the US Dollar since the beginning of this New Year.

Both Prime Minister Abe and his counterparts over at the Bank of Japan are attempting to push Japan out of its deflationary spiral by generating an annual rate of inflation of 2%. That cannot happen if the Yen keeps moving relentlessly higher.

Keep in mind that this upward movement in the Yen is also taking place at the same time that China has been working to devalue their currency, namely the Yuan. That works to undercut the competitiveness of Japanese products here in the US in comparison to those goods produced in China destined for sale here as well.

This is not being lost on either the Bank of Japan and the Abe government both of which have been increasingly been making verbal noise about the yen rally.

As explained in my post from yesterday, the problem that the Bank of Japan has is the sheer size of the Yen carry trade. All of that massive amount of money created by the various world Central Banks with their Quantitative Easing programs has had to go somewhere. That “somewhere” has been into various asset classes [mainly stocks]. That was exactly what the CB’s intended.

The idea was that the combination of ultra low interest rates would force investors into equities as the only game in town for obtaining yield in a near Zero Interest Rate Environment which would have the INTENDED EFFECT of pushing stock prices inexorably HIGHER and creating as a desired goal, ” A WEALTH EFFECT”.

The theory behind this being that consumers are much more likely to take on new debt [with lower interest rates spurring them on] if their stock portfolios in their 401K’s and IRA’s were constantly moving ever onward and upward.

In other words, people look at their net worth increasing on paper as stock prices move higher, they “feel” richer as a result and based on that, they open up their wallets and buy more stuff with much of that new stuff being bought on credit.

Fine and dandy as long as it works. When it stops working, it just stops. The reason is that which we have mentioned here before.. once you PULL FORWARD FROM THE FUTURE demand for goods and services, you will have a difficult time matching those levels of demand anytime soon again because it has been satiated. At that point no matter how low interest rates go, or how high stock prices go, consumers simply are not able or willing to take on any more financial obligations.

I happen to believe we are at this point now as evidenced by all this talk and discussion about negative interest rates. One only does that when they are desperate to gin up more borrowing. But what good does that do if while you try to coerce banks to make more loans, consumers and for that matter, business, is not interested in borrowing or taking on more debt? Result – you get a big fat goose egg!

Now throw on top of that cascading equity markets and that so-called “WEALTH EFFECT”? Well guess what? It has evaporated along with stock prices and along with all those PAPER PROFITS (unrealized gains) that are now history for so many. If one could not entice consumers to go further into debt even with interest rates moving lower and lower while stock prices were moving higher, how could anyone believe that these same people are going to be in the mood to take on new debt now that stock prices are falling apart? CHECKMATE!

As more and more investors realize this, they are getting increasingly nervous [ although we are not yet seeing a panic in US stock markets ]. As that nervousness grows, they are dumping assets that they perceive to be overvalued or risky. Since there has been so much of this move higher in stocks built around easy monetary policies which would spur borrowing and thus overall growth, that is now reversing. As it does, and as those assets are sold, the method whereby many large funds financed their speculative buying of those assets is coming unwound.

That is what is fueling the move higher in the Yen and why the Bank of Japan now has a serious problem to contend with. They must intervene at some point and take the Yen lower or risk their entire economic recovery model imploding as the Yen keeps rising. However, they are now up against the monster they helped to create because those trillions of Dollars, Yen and Euro created fueled its uncontrollable growth. Let’s call it the GODZILLA of STOCKS!

(Click on image to enlarge)

While Japan has massive reserves, the size of the carry trade is also massive. That creates a quandary for the BOJ. If they intervene as they need to do at some point, and if all that happens is that they force the Yen lower only briefly, speculators will take note of that and will come in and buy it with a vengeance. This will test the resolve of the Bank of Japan to continue attempting to force it lower in the face of a massive short covering tied to the unwinding carry trade.

I think you can see where this is going. It ain’t gonna be pretty. About the only way I can see this carry trade unwind reversing and going back on again, is for some sort of very large and very robust brand new monetary stimulus. That would spur risk taking once more and take the pressure off the rising Yen but the big question is for how long?

I tell you what makes me very, very nervous – the possibility of a scenario in which we get some sort of monetary response from the Central Banks which works for perhaps a day or two, or maybe even a week and then is promptly reversed by the markets with yet another rush out of risk trades and back into safe havens. At that point, one would have to start seriously preparing for the worst.

I am not saying this is going to happen as i have no idea how all this plays out. I can only posit what would be in my own mind, the worst of all possible reactions to another round of CB action. If that occurs, heaven help us all because at that point, the Central Banks will have run out of options.