"Playing Golf with Ben Bernanke"

Now that the dust has settled somewhat, bond markets, currency markets, commodities markets and even stock markets have found new levels one after the other. It's right to reflect on the process we have been through in the past five months. New Monetarism, the idea that the spread of cheap money shows up not in the high street, but instead in financial asset inflation, is clear. Sequentially, a series of bubbles have been burst by the withdrawal of capital from the global system. At the root of it lies the breathtaking speed at which the Japanese have removed money from their system. For several years now the Bank of Japan (BOJ) have been supplying about 35 trillion yen to the bank account of Japan PLC (see first chart). In a series of rapid moves, they have reduced this down to just 13 trillion and are currently withdrawing about one trillion every couple of days. If you take money out of people's bank accounts, then they may start raiding their savings and investments to maintain expenditure.

Most of these savings have been in the form of foreign bonds and other vehicles that have been sold in gigantic amounts sending bond yields higher. The repatriation of this money has created demand for the yen sending it soaring against, in particular, the US dollar. With a stated target of about six to seven trillion yen, you might conclude that this process is close to an end and with it they have prepared the ground for a rate rise as and when economics and the politics of the situation allow. As a best guess, the first opportunity for changing rates may come in July after the Tankan Survey has been contemplated. But this remains an opportunity for the BOJ rather than a certainty.

The money markets may tell you that rates could rise by 0.5% or more by year end, but a simple correlation with the last time this amount of money was sloshing around the system should tell you that interest rates of 0.25% could likely be their first move. This is one of the major events that we may have to cope with and get right in the coming months. It could easily trigger competitive bond yield rises that will likely end the cosy equilibrium we currently enjoy.

Interestingly, this event could coincide with the end of the current US interest rate cycle. There has been a shot across the bow of US policy makers as they have witnessed a significant and rapid weakening of the all-important US housing market which should be taken as a message that somehow interest rate policy is biting and this is a process that cannot go on forever. The one thing that anyone who has studied the US Federal Reserve for any length of time will understand is that historically they have always gotten it wrong.

Adjusting borrowing alone to fine tune an economy is like walking around a golf course using only a putter; it's just not good enough for all situations. Time after time we have witnessed the fact that the Fed has had to react to the data long after the point of no return has been passed. Looking at some of the stats currently emerging they look as bad as the kinds of things we saw in the early 1990's which wasn't pretty and took a long time to mend. Loan delinquency rates have been showing early signs of reversing from their low levels, for instance, but a couple of data points aren't really a trend and a convincing moderation of the economy is, most likely, a Q3 or Q4 event.

And then there are the currency markets. The US dollar has already fallen by about 9% this year against the majors. If you factor in the scenario that the US will be hit with a triple whammy of a current account deficit, budget deficit and stable/declining interest rates then there is only one way for the greenback to go and that is down. Of course, how economists look at currencies is very different to how accountants look at currencies and key to this is how the equity market behaves. If the balancing items of US assets (the things that fill the hole in the balance sheet created by the deficits, like equities and real estate) also start to decline then the US dollar has a serious problem on its hands and it should decline. The process of global realignment, the displacement of wealth from the west to the east, can really take hold at that point. Unfortunately, there is no precedent for modelling such an event because the euro has only been in existence for seven years, so the uncertainty and confusion of "the right level"for the US dollar will be high but the direction will likely be certain - down.

If we had to play out the rhythm of what has been said here about bond yields then it would probably look like this. The first two phases relate to a withdrawal of support for the bond market by important users (pension funds and the Japanese) while the latter two are concerned with the Bank of Japan rate rise and finally the decline in US economic fortunes. Maybe for fun at some point we'll overlay what really happened one day (primarily so that clients and colleagues can have a jolly good laugh at our pretensions of being able to see around corners) but clearly these events coupled with the adjustments in currency markets could create significant opportunities for global bond investors in the coming months.

We are going to have to be patient as these events are some way off and so we are currently using options to implement part of our strategy primarily because of timing issues. So, in the meantime, maybe I should give Mr. Bernanke a call and offer him the opportunity to ruin a perfectly good walk in the country; "Hi Ben, Stewart here. Got your golf club ready? Great. A piece of advice though - I'd bring a couple extra if I was you. You're gonna need them."