In the Name of Allah, the Beneficent the Merciful
Report Completed: 07 August 2013
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The Federal Reserve Chairman, Ben Bernanke, made some statements on 19 June 2013 that sent shockwaves throughout the financial markets in the United States and Asia. There is no change in policy. This, Chairman Bernanke, emphatically stated several times at the 19 June 2013 press conference. So why did the markets react the way they did? This analysis will assist in understanding why the markets responded in the manner that they did to Chairman Bernanke's suggestion that the asset-purchasing program will “taper off” in late 2013 or in mid- to late-2014 although this possibility is clearly stated in the Federal Reserve's Open Market Committee's (FOMC's) 22 May 2013 statement.
Topic: Understanding the Fed's Latest Moves
FOMC Statement 19 June 2013
The first thing that must be done is to actually look at the Feds' actual policy statement on 19 June 2013. According to the 19 June statement, the monetary policy has not changed. Mortgage-backed securities (MBS) will continue to be purchased at the rate of US$40 billion per month and long-term Treasury bonds will continue to be purchased at the rate of US$45 billion per month with the Fed Fund rate remaining at the range of 0%--1/4%. Why did the markets react the way they did? What is the problem with “tapering off” the asset-purchasing program at an early date that caused so much panic and volatility in the markets? To clearly comprehend the market's response it would be best to examine the actual FOMC's April 30—May 01, 2013 meeting minutes and what will be affected by the possible earlier-than-expected “tapering” of the asset-purchasing program.
FOMC's April 30-May 01 2013 Meeting Minutes
The minutes state on page 7, paragraph 3:
Most participants emphasized that it was important for the Committee to be prepared to adjust the pace of its purchases up or down as needed to align the degree of policy accommodation with changes in the outlook for the labor market and inflation as well as the extent of progress toward the Committee’s economic objectives. Regarding the composition of purchases, one participant
expressed the view that, in light of the substantial improvement in the housing market and to avoid further credit allocation across sectors of the economy, the Committee should start to shift any asset purchases away from MBS and toward Treasury securities.
With this being clearly expressed in the April 30-May 1 meeting minutes, the markets should not have been surprised if the FOMC decided to pull back on their rate of MBS purchasing early or later. There were two main conditional factors that must be satisfied in order for the FOMC to begin to change their rate of MBS purchasing.
According to page 9, paragraph 3:
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.
The FOMC's maximum unemployment rate target is 6 .5%.
The current unemployment rate (March 2013) is 7.6%.
The FOMC's longer-run goal of inflation is at or above 2%.
Inflation currently runs under the 2% target rate according to the minutes.
Neither of these conditions were satisfied. So what caused the markets' panic of earlier-than-expected “tapering” of the FOMC's asset-purchasing program?
The FOMC's Asset-purchasing Program
The Federal Reserve decided to purchase mortgage-backed securities (bonds) at a rate of $40 billion per month and Treasury bonds at a rate of $45 billion per month. This is the current composition of the assets being purchased through this program. This program was designed to create inflationary pressure in order to “stimulate” the economy. The bank holding companies that own these mortgaged-backed bonds will be the direct recipients of this asset-purchasing program. According to this 21 February 2008 Bloomberg report, these bank holding companies positioned themselves to directly benefit from the asset-purchasing program.
Asset Composition
Treasury Bond Purchases
$45 billion per month is allocated towards the purchase of long-term Treasury bonds with maturities up to 30 years. Traditionally, the purchasing of Treasury bonds (T-Bonds) by the FOMC is utilized to create inflationary pressure. However, at a rate of $45 billion per month is unprecedented! What makes T-bond purchases effective, is that currency can be in circulation for up to 30 years. This has long-term inflationary effects on the economy. This is vastly different from simply “printing dollars”.
Mortgage-backed Bond Purchases
$40 billion per month is allocated towards the purchase of mortgage-backed bonds from bank holding companies in order to increase economic growth. The liquidity (cash flow) received is then allocated towards mainly commercial and industrial interests such as commercial and industrial (C&I) loans and commercial real estate (CRE) loans. Consumer-market loans have been prioritized in narrow allocation mainly towards asset-backed loans such as subprime auto loans, home loans, and student loans.
Compositional Effects of Asset Purchases
Treasury Bond Purchases
The $45 billion per month allocated towards the purchase of “long-term Treasury
securities” (T-Bonds) is strategically implemented to induce inflationary pressure. This strategically-induced inflationary pressure is the direct cause of upward price movements in the world's markets. The current rate of T-Bond purchases positions the US dollar to risk currency devaluations. The current Fed Fund rate—the rate in which subordinate banks can borrow from the US central bank—is between 0.00% and 0.25%. The currency devaluation risk, as previously mentioned, positions the subordinate banks to receive inflationary dollars at near-zero interest. This discourages consumer lending practices due to the lack of volume required to sustain credit issuance under such monetary conditions. Issuance of loans with inflationary dollars at near-zero interest put subordinate banks at risk of accumulating negative balances over the long-term. Commercial and industrial (C&I) credit markets are not as vulnerable to the effects of this “accommodative” monetary policy due to the amount of volume C&I markets produce. The volume in reference is cash flow or revenue. Under these monetary conditions, consumer credit markets are riskier than C&I credit markets due to the limited revenue-generation components that make up the consumer market which significantly affects the frequency and sustainability of repayment on loans. Most consumers are dependent on wages or salaries that do not necessarily increase when the cost of living increases. Most consumers face employment-loss risks due to economic and market factors beyond their control. Therefore, the risk of loan defaults and infrequent repayment on loans are much higher in the consumer credit markets than in C&I credit markets under current monetary conditions. This is what discourages consumer lending. The C&I credit markets are not as vulnerable to these monetary conditions, but they are vulnerable nonetheless. C&I markets are not limited by their revenue-generation components and are capable of generating massive volumes of revenue at a much higher frequency than consumer markets. The volume of revenue-generation and revenue-generation frequency significantly reduces the credit risk of C&I markets under current monetary conditions. However, the ultimate risk of sustained inflationary pressure is that eventually costs catches up with revenue. When this occurs, profit margins are reduced. Production costs increase at a rate that current price levels become unsustainable. Maintenance of profit margins imposes price incrementation (increases). Price incrementation eventually slows down demand. Demand reduction results in decreased production and downward pressure on prices. This ultimately results in lower revenue-generation. This is commonly known as the law of diminishing returns. This will continue until either production levels decrease to the point where satisfactory profit margins are restored and/or demand increases at the lower price level. With lower revenue-generation, debts are more difficult to repay. As common general business practice, debts are always paid first before distribution of profits. Debts are not only in the form of direct loans, but are commonly issued through corporate bonds. Therefore, the lower revenue-generation directly affects a company's bond rating—determining its ability to pay back its creditors. Sustained lower revenue-generation can also affect a company's ability to retain its equity value which can result in significant capital-loss. Under sustained inflationary pressure, lending institutions would normally be reluctant to issue credit to C&I entities without raising interest rates to reflect the compensation required for receiving devalued currency. Even more so, yields on corporate bonds would rise—reflecting a company's ability to pay back its creditors--under sustained inflationary conditions. Current monetary conditions do not reflect sustained inflationary pressure, but ever-increasing or incremental inflationary pressure. The near-zero interest rate would make it very difficult for a lending institution to engage in credit issuance at any level under such monetary conditions ...unless certain accommodations were implemented to offset the natural effects precipitating from these monetary conditions.
Mortgage-backed Bond Purchases
The $40 billion/month allocated towards the purchase of mortgaged-backed securities (MBS) is strategically implemented to induce economic growth under the current monetary conditions. Due to the current financial regulations and the accelerated merger and acquisitions of banking institutions , qualified bank holding companies are in position to benefit from the central bank's asset purchasing program. The $40 billion will go towards purchasing MBS directly from qualified bank holding companies on a monthly schedule. This enables credit issuance to C&I interests. The proceeds from the direct MBS purchases enable subordinate banks to issue loans and other forms of credit and capital to C&I borrowers. C&I borrowers are then able to sustain their corporate bond ratings and credit ratings with the acquired capital. The acquired capital enables C&I market expansion. Hence, economic growth can continue under current monetary conditions, albeit with short-term sustainability. The additional $40 billion/month does not contribute to additional inflationary pressure. The additional $40 billion/month is strategically implemented to provide capital to qualified bank holding companies for the purpose of credit issuance to C&I interests under incremental inflationary conditions at near-zero interest rates. The current monetary policy
requires this kind of accommodation. Otherwise, credit issuance would be null. Without the necessary credit issuance, C&I interests would become unsustainable.
Market Response to Perceived Asset-Purchasing Reduction
Chairman Bernanke's 19 June 2013 statements caused ripple effects within the world's financial markets—more for what was deducted from his statements and less for what was actually said. His June 19th statements, the June 19th FOMC statement, and the April 31-May 01 2013 FOMC minutes are congruent and reflect no policy change unless the targets of 2% longer-run inflation and 6.5% unemployment levels have been reached. The FOMC clearly stated in page 7, paragraph 3 of their May30-April 01 2013 minutes that they reserve the right to adjust the pace of its
purchases up or down as needed to align the degree of policy accommodation with changes in the outlook for the labor market and inflation as well as the extent of progress toward the Committee’s economic objectives.
The market response to Chairman Bernanke's statements reflected shock, surprise, and disappointment. The level of volatility and downward trajectory of equity and bond values was unprecedented. In light of FOMC consistency in policy implementation and statements, the volatile market response to Bernanke's remarks begs the question: why? Why did the markets respond in this manner to Bernanke's remarks which reflect the FOMC's consistent policy position? The widely-promoted answer is that the volatility in the markets is due to the hinting by Bernanke that the asset-purchasing program may be “tapered-off” earlier than expected. Most economists expect the asset-purchasing policy to be incrementally-reduced by mid-to-late 2015. It was deducted from Bernanke's remarks that asset-purchasing reduction may begin as early as Q4 2013. What precipitated this deduction? Does current market activity reflect economic improvement? If so, why would asset-purchasing reduction signal uncertainty as reflected by downward equity and bond values (the equivalent of upward bond yields)? What is the fear? If asset-purchasing reduction occurs, which assets the markets fear will be purchased at a reduced rate? Treasury bonds? Or mortgage-backed bonds? As previously stated, the purchasing of mortgage-backed bonds provides direct liquidity to qualified bank holding companies for the purpose of credit issuance to C&I interests. Without MBS purchasing, credit issuance would be null under current monetary conditions. Conclusively, without this necessary credit issuance, C&I interests would become unsustainable. It can be logically deducted that it is the reduction of MBS purchasing that the markets fear.
Why fear MBS purchasing reduction when the FOMC economic objectives have not been met? Do the markets perceive improvement in the US labor market and the FOMC's longer-run inflation goals? To better elucidate the root cause of this perception, an analysis of the FOMC's April 30-May 01 2013 minutes must be conducted. It may be this perception that triggered the volatility in the markets after Bernanke made his June 19th remarks.
Analysis of FOMC April 31-May 01 2013 Minutes
Commercial and Industrial (C&I)Credit Issuance
The increase in C&I credit issuance may have attributed to the perception of improved economic conditions in the US. According to page 4, paragraph 4:
Yields on corporate bonds fell roughly in line with those on Treasury securities of comparable maturity, generally leaving their spreads little changed. The rate of corporate bond issuance by nonfinancial firms remained robust in March and April. Consistent with recent trends, some companies reportedly retired a notable portion of their outstanding commercial paper and issued longer-term bonds in comparable amounts. Syndicated leveraged loans were issued at a record pace in the first quarter, supported by strong demand for this type of asset, particularly from nonbank institutions. Gross public issuance of equity by nonfinancial firms was solid over the same period.
According to page 4, paragraph 5:
Conditions in some segments of the commercial real estate (CRE) sector continued to improve in recent months. Outstanding CRE loans held by commercial banks edged up in the past two quarters following a prolonged period of decline, and commercial mortgage-backed security issuance was strong in the first quarter. According to the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) conducted in April, the fraction of banks that eased standards on CRE loans over the past three months increased to a relatively high level, while demand for these loans strengthened further. CRE prices continued to move up slowly, and price indexes for various market segments
reached levels last seen in late 2008.
Note that lending standards have been eased for C&I interests. This significantly increased loan distribution within commercial and industrial credit markets.
According to page 4, paragraph 8:
Total bank credit expanded moderately during the first quarter of 2013. Gains continued to be concentrated in commercial and industrial (C&I) loans, which increased especially strongly at domestic banks. In the April SLOOS, relatively large net fractions of these banks reported having eased standards and reduced spreads on C&I loans to firms of all sizes.
The increased loan distribution within C&I credit markets and the subsequent gains may have contributed to the perception of economic improvement and the nearer attainment of FOMC's longer-run inflation and unemployment level goals.
Consumer Credit Issuance
Consumer credit markets are riskier than C&I credit markets due to the limited revenue-generation components which significantly affects the frequency and sustainability of repayment on loans. Loan distribution within the consumer credit markets have been narrowly-focused on collateralized, or asset-backed loans such as auto loans and home loans. According to page 4, paragraph 7:
Consumer credit continued to expand in January and February, mostly driven by sizable increases in non revolving credit. Growth was particularly strong in auto loans as well as in student loans extended through the Department of Education’s Direct Loan Program. In contrast, total revolving credit was about flat amid continued tight underwriting standards and terms on credit
card loans. Issuance of consumer asset-backed securities— in particular, those backed by subprime auto loans—remained robust in recent months.
Consumer credit markets experienced a tightening of underwriting standards and terms due to the above-mentioned risks under current monetary conditions.
According to page 6, paragraph 6:
Financial conditions appeared to have eased further over the intermeeting period: Longer-term interest rates declined significantly, banks loosened their C& I lending terms and standards on balance, and competition to make commercial and auto loans was strong. Businesses were reportedly still borrowing to refinance, but they had begun to take out more new loans as well.
Auto loans were strong due to their asset-backed nature. This also fueled demand for gasoline consumption.
According to page 6, paragraph 1:
Participants saw the housing market as having strengthened further during the intermeeting period
and pointed variously to rising house prices, growth in home sales, a lower inventory of houses for sale, a reduction in the average time houses stayed on the market, and encouraging reports from homebuilders. More all-cash or investor purchases were being reported, and the pace of home purchases overall appeared to be constrained less by a lack of demand than by a lack of homes for sale, in part reflecting fewer newly foreclosed houses coming onto the market. The rate of
new delinquencies on mortgages declined nearly to pre crisis levels, and the pipeline of properties in the foreclosure process was being slowly worked down, in part through modifications and short sales. Over time, the supply of homes for sale was expected to increase as new construction picked up and sellers saw more attractive opportunities to put their houses on the market. The improvement in the housing sector was also seen as contributing to a pickup in activity in related industries.
Due to inflationary pressure precipitated by Treasury bond purchases, home values began to rise and due to the asset-backed nature of home loans, the consumer credit market experienced an expansion of credit issuance in the residential real estate market.The upward trajectory of home values increased demand for residential investment properties. The increase in home sales and home values may have contributed to the perception that the US economy had made significant improvements and the FOMC may be getting closer to attaining their unemployment and longer-run inflation targets.
The question is: Is there actual significant economic improvement? Are the FOMC unemployment and longer-run inflation targets being met?
If not, why not?
Unemployment Levels
During the so-called World Financial Crisis/Credit Crunch of 2008, most companies were unable to sustain their revenue-generation levels and profit margins due to falling prices and rising debt levels. This forced companies to cut costs at a frequent and significant rate. The major portion of those cost-reductions were labor costs. Most laborers had only the options of accepting lower pay, accepting reduced benefits, or losing their jobs altogether. This created a very large unemployment pool. The supply of skilled and unskilled laborers is significantly higher than the demand. This positions companies to be very selective in their decision-making when it comes to making the right investments in the labor pool. This may explain why according to page 2, paragraph 4:
After faster gains in January and February, private nonfarm employment increased at a subdued rate in March, and government employment declined slightly. The unemployment rate was 7.6 percent in March, a little below its average in the fourth quarter of last year. The labor force participation rate also edged down to below its fourth-quarter average. The rate of long-duration unemployment and the share of workers employed part time for economic reasons declined somewhat in March, but these measures remained well above their pre-recession levels. Indicators of near-term labor
market conditions were consistent with projections of moderate increases in employment in the coming months: Measures of job openings generally moved up, but the rate of gross private-sector hiring and indicators of firms’ hiring plans were subdued, on balance, and initial claims for unemployment insurance trended up a little over the intermeeting period.
Due to the supply-demand factors affecting employment levels, the high supply of laborers significantly affect the wages and salaries of those who are currently employed. This is why according to page 6, paragraph 5:
Most of the recent reports from business contacts revealed little upward pressure on prices or wages.
This clearly demonstrates that the high supply of labor significantly dampens the demand for that labor which is reflected not only in hiring levels but also in labor costs (wages and salaries).
There are other factors affecting employment levels as well. During the height of the so-called World Financial Crisis/Credit Crunch of 2008, many of the skilled laborers, professional-class employees, and unskilled laborers had to look for employment outside of their traditional fields. Many went into business for themselves, and others had to seek relief through employment insurance. This may explain why according to page 6, paragraph 4:
Participants generally saw signs of improvement in labor market conditions despite the weaker-than-expected March payroll employment figure. Employment growth in earlier months had been solid, and more-recent improvements included the further decline in the unemployment rate in March and the gradual progress being made in some other labor market indicators. However, several participants cautioned that the drop in the unemployment rate in the latest month was also accompanied by another reduction in the labor force participation rate; the decline in labor force participation over recent quarters could indicate that the reduction in overall labor market slack had been substantially smaller than suggested by the change in the unemployment rate over that period. One participant commented that assessing the shortfall of employment from its maximum level required taking account of not only the gap between the unemployment rate and its corresponding natural rate, but also the gap between the labor force participation rate and its longer-term trend—a trend which was admittedly subject to considerable uncertainty. A few participants mentioned that job growth may have been restrained to an extent by businesses postponing hiring because of uncertainties over the implementation of health-care legislation or because they were unable to find certain types of skilled workers.
Why would the implementation of health-care legislation be a factor in making hiring decisions? Considering that health-care insurance companies must spend 80% of their premium, this may force health-care insurance companies to raise their premiums in order to maintain profit margins. Considering that most businesses buy group health-care insurance for their employees and recoup the costs through wage-garnishing methods, this would significantly raise labor costs for those businesses.
All of these factors may explain why according to page 7, paragraph 4 under “Committee Policy Action”:
Labor market conditions had shown some improvement in recent months, on balance, but the unemployment rate remained elevated.
Inflationary Effects of Treasury Bond Purchases
The purchasing of Treasury bonds have the very real precipitous effect of keeping dollars in circulation up to 30 years. This particular effect can induce what is known as inflationary pressure. Inflationary pressure pushes prices in the upward direction. Since the US dollar enjoys the world's largest area currency usage (ACU) and all currencies are still directly pegged to the US dollar, US-induced inflationary pressures directly affect world markets. Purchasing Treasury bonds at the rate of $40 billion per month increases inflationary pressure incrementally. Even incremental inflationary pressure is subject to the law of diminishing returns where prices eventually fall due to reduced demand caused by costs eventually catching up with revenue levels—diminishing profit margins and productivity levels. The US dollar's unique position enables the Treasury bond purchases to directly affect the direction of price in all global markets including commodities, equities, and debt.
The Effects of Asset-Purchases on Global Markets
Food Inflation
Food inflation in both developed and developing economies has been around since September 2005. It initiated from the raising of interest rates during the deflationary period of September 2005-March 24, 2009. During this period, it was the justified increase in ethanol-production that initiated food inflation due to the increased demand for corn which is the staple ingredient in most food products. Food inflation increased further since Treasury asset-purchasing began on March 25, 2009 when the FOMC purchased $100 billion worth of Treasury bonds. Food inflation directly affects the cost of living and therefore affects labor costs. If food inflation is allowed to outpace wage and salary earnings, then productivity levels will suffer. This was seen in Haiti, India, and other developing economies.
According to page 3, paragraph 7:
Economic growth in foreign economies overall in the first quarter of 2013 showed only a small improvement from that registered in the second half of 2012. Real GDP growth picked up in the United Kingdom, and recent indicators suggested that the pace of contraction moderated in the euro area. In contrast, economic growth in China slowed abruptly after surging late last year. Foreign inflation appeared to increase a little in the first quarter, partly as a result of higher food prices
in several emerging market economies, but remained quite moderate.
Precious Metals
The purchasing of Treasury bonds has pushed commodity values in an upward trajectory, in particular gold and silver. However we have recently witnessed price drops in precious metals. Why? The price of gold and other precious metals has dropped for a couple of reasons:
1. As previously stated, prolonged inflationary pressure will result in costs catching up with revenue. This results in the reduction of profit margins. When this occurs, the demand for such commodities dampen. The productive output decreases due to increasing expenses to maintain the same level of productive output. Equipment prices increase, refining costs increase, shipping costs increase, and of course labor costs increase. The increase in price/value of these precious metals lowers the demand because the increasing costs lower the profit margin generated from production of these precious metals.
2. Labor costs is the second reason. Labor costs (skilled and unskilled) increases because the cost of living increases. This is the source of the many mining disputes going on around the world like in Azania (S. Africa) and Papua New Guinea. Labor costs become a major factor in the production of mined commodities. If left unattended, the increased cost of living with no upward movement on wages and salaries will significantly reduce production. The decline in production and increasing production costs significantly reduces the profit margin which also lowers the demand for those mined commodities. This is appropriately referred to as a “correction” as demonstrated in the falling prices of these precious metals. As everything in nature, market prices must eventually reach equilibrium or balance. Prices will continue to fall until demand increases. The lower price and lower production levels will eventually increase demand for the mined commodities. As demand increases, production will follow as long as the spread (difference) between revenue and costs increases.
Energy and Other Commodities
According to page 3, paragraph 5:
Overall consumer prices, as measured by the price index for PCE, edged down in March and rose just 1 percent from a year earlier. Consumer energy prices declined in March, and retail gasoline prices fell further in the first few weeks of April. Consumer food prices only edged up in March. Consumer prices excluding food and energy were flat in March, and their increase from 12 months earlier was similar to that for total consumer prices. Near-term inflation expectations from the Thomson Reuters/University of Michigan Surveys of Consumers were slightly lower in April, and longer-term inflation expectations in the survey were little changed and remained within the narrow range that they have occupied for several years.
According to page 5, paragraph 5:
Spending by consumers continued to expand, supported by better credit conditions,
rising equity and housing prices, and lower energy prices;
It appears that energy prices also are subjected to the law of diminishing returns as demonstrated by the sustained lower prices and the recent price jump experienced in the energy sector. This is the natural behavior of price movements during a period of prolonged inflationary pressure. The fall in commodity prices may be the key to why the FOMC claims they have not reached their longer-run target of 2% inflation.
US Stock and Bond Markets
When Chairman Bernanke made his June 19th remarks, the US stock markets fell and bond yields rose. Why? Is it that they perceived that there was significant economic improvement and feared the reduction of mortgage-backed asset purchases? As explained before, without subordinate banks receiving the liquidity available from the FOMC's purchases of MBS, credit issuance to C&I entities would be null under the current monetary conditions. C&I interests would then become unsustainable. It is natural for US markets and companies to fear the reduction of MBS purchases at any time under the current monetary conditions. Why did bond yields rise? This naturally means that the value of the bonds decreased which may signify an increase in credit risk. A reduction in MBS purchases means less liquidity available in C&I credit markets. The US bond markets may respond the same way to a reduction in MBS purchases at any time under the current monetary conditions.
Chinese Stock Market
The CSI300 slid 3.3% on Chairman Bernanke's June 19th remarks. Why did the Chinese stock market fall? It can be for several reasons:
>Incremental inflationary pressure has significantly increased labor costs in China. This has made manufacturing (one of China's staple sectors) more expensive. This has a dampening effect on Chinese exports. Even worse, labor costs are beginning to equal that of the US labor market. Many US companies are now considering manufacturing their products in the US where quality control can be better maintained. China risks losing significant business from US companies.
>The double threat is that if MBS purchases are reduced, then China would lose business from the US market anyway because US companies would not be able to sustain their operations and continue purchasing Chinese products or continue having US products manufactured in China. The US market is one of China's largest export markets.
>Incremental inflationary pressure also erodes the purchasing power of a currency. China currently holds approximately $16 trillion of US debt. Under current monetary conditions, if MBS purchases are reduced and US companies are unable to sustain operations, the US could possibly face credit default. China would then be left “holding the bag” and face a $16 trillion loss. Of course this is an extreme possibility, but a plausible possibility nevertheless.
Japanese Government Bond (JGB) Yields
Japanese Government Bond (JGB) yields rose on Bernanke's June 19th remarks also. Japan's central bank has recently initiated its own asset-purchasing program during this period when the markets perceived that Chairman Bernanke hinted at a reduction in asset-purchasing. The Japanese yen is reported to currently be under deflationary pressure, and a government bond-purchasing initiative is appropriate for that kind of monetary condition. Why did JGB yields rise on Chairman Bernanke's statements? China is one of Japan's largest export markets, and Japan export the raw material that is used by China to manufacture US products. If China loses business with US companies due to MBS purchasing reductions, then Japan also loses business with Chinese companies due to export reductions. The current conflict between China and Japan over the rights to the Senkaku (Jpn)/ Diaoyu (Ch) islands has significantly damaged trade relations and has adversely-affected Japanese exports to China. The US currently is Japan's largest export market and face possible loss of business from US companies if MBS purchases are reduced. This poses a credit risk for Japanese companies as reflected in the JGB's rising yields.
Conclusion
The Treasury bond purchases at the rate of $45 billion per month was strategically implemented to induce incremental inflationary pressure which drives prices up and puts the US dollar at currency devaluation risk. The near-zero interest rate makes credit issuance nearly impossible due to the risk of a lender precipitating negative balances. The MBS purchases at the rate of $40 billion per month provides direct liquidity to subordinate bank holding companies for credit issuance purposes to C&I interests. Without this credit issuance, C&I interests would become unsustainable under the current monetary conditions. For this reason, the world markets are concerned about the reduction of MBS purchases at any time under the current monetary conditions. It was the perception of economic improvement in the US that caused the world markets to respond the way they did to Chairman Bernanke's June 19th statements. Due to the current monetary structure of the US economy, any reduction of MBS purchases will be the equivalent of pulling the rug from under the world economy. US businesses would not have a leg to stand on. The MBS purchases are the required accommodation necessary to sustain the US economy under the current monetary conditions.
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