Currency conundrum

Here's what I think about the current global macroeconomic backdrop.

China & Japan are keeping US yields low by lending us as much money as we care to borrow. China and Japan's purpose is to keep their currencies low against the dollar to promote their export business. OPEC also has amassed huge petrodollar reserves. However, their aim is different. They are seeking a higher return. Because of this, we see low yields financed by Asia, and a hedge fund/emerging market (EM)/stock market/buyout boom financed by OPEC. If the $ drops, OPEC will shift more investment away from the US, but Asia won't be deterred. They don't care if they lose money; their goal is to keep the money coming in.

The questions arises as to whether Asia can keep yields down if OPEC diversifies further. In fact, the Fed funds rate has been unchanged for almost a year. If we look back on the past five years we could hypothesize that while oil was going up in price, OPEC was pressuring yields upward. Since oil prices have been relatively steady in the past year, the trade deficit with China has ballooned and the upward pressure has been held in check.

Which forces will prevail remains to be seen, but even though this hypothesis does not predict which way rates will move next, it helps to give a framework with which to view future market developments. It will become crucial to monitor the trade deficit with China and Japan as opposed to OPEC.

The first set of opposing forces is that of OPEC and China. OPEC gets dollars and buys return-oriented products, and non-dollar products. Asia gets dollars and lends them back to us.

There is another struggle which I have observed: that between China and Japan. As devalued as China's currency is, Japan has lately succeeded in devaluing the Yen against the $, and therefore, the Yuan. China can't be happy about this, but because of US threats of tariffs and duties, inflation, an overheating economy, and a stock bubble in Shanghai, they have already lost. The question is, how much will Japan try to devalue their currency against the Yuan to make their exports competitive with China? Right now, Japan seems to have none of the problems listed above that China has. Japan has no inflation because they have no controls on investment capital leaving the country. Extra cash just flows into overseas investment. In contrast, in China, government controls on overseas investment keep all that extra money inside the border with few places to go except bubbles and price inflation.

At the same time, Japan has ultra-low interest rates, which is more effective than China's currency peg. Japan is still in a stubborn deflationary benign circle. If anything in global economics today tends towards equilibrium today, this is it. As the Yen slides, more investment capital goes overseas, which is deflationary for prices in Japan. If the BoJ raises rates, the currency strengthens, and a strong currency keeps prices down. As long as there are no shocks to this system, Japan can slowly and safely devalue their currency against the Yuan.