As previewed last week in “Something Big Is Coming: Bernanke To “Secretly” Meet With Kuroda; “Helicopter Money” On The Agenda“, the week’s key event, albeit behind closed doors, was the surprising meeting between Ben Bernanke and the BOJ’s Kuroda as well as Japan’s prime minister Abe. The outcome of the meeting has been, as we expected, nothing short of a whirlwind reaction in markets where speculation that Japan is set to become the first nation to openly espouse “helicopter money”, or central bank funded fiscal policy stimulus, has seng the Yen plunging (at least check the USDJPY was above 104), the Nikkei soaring and unleashed a global “risk on” wave.

But what was actually said? Since the meetings were held in private, nobody will ever know, although one can infer based on the upcoming actions by the BOJ and the Japanese Ministry of Finance, both of which are expected to boost monetary and fiscal stimulus, respectively, in the coming weeks, with Japan expected to unleash a new fiscal stimulus of around JPY 10 trillion or more. As such, we have to rely on heavily filtered and watered down official interpretations of what the Citadel analyst and Brookings blogger told the BOJ.

According to the WSJ, the former Federal Reserve Chairman Ben Bernanke rejected the notion that the Bank of Japan is short of ammunition when he met with Prime Minister Shinzo Abe Tuesday. Bernanke noted during the face-to-face meeting that Japan’s central bank still has a range of monetary easing measures at its disposal, according to Chief Cabinet Secretary Yoshihide Suga.

This contradicts BOJ executive director, Kazuo Momma, who just yesterday said that the Bank of Japan will need to reduce the pace of its record purchases of government debt as it is approaching the limits of the bond market. “Of course they can’t keep stacking up 80 trillion yen ($784 billion) of bonds forever,” said Kazuo Momma, who worked at the BOJ until the end of May. “They are aware they are nearing the limit, whether that is now or later.”

“With that awareness, it’s not impossible that they will increase the pace from 80 trillion yen to 100 trillion yen or 120 trillion yen, but it’s incredibly difficult,” he said in an interview on Monday in Tokyo. “Based on common sense, you’d think they’d start considering reducing the pace a little bit in the near future.”

Alas, common sense was never Bernanke’s strong suit who according to rumors urged the BOJ to do precisely the opposite, namely monetize even more debt, however since the BOJ is indeed running out of bonds to buy, it would need to government’s assistance and issue even more debt, ostensibly to fund “infrastructure projects”, which would then be promptly monetized by the central bank.

Sure enough, Bernanke recommended the BOJ coordinate its policy with fiscal measures aimed at shoring up Japan’s economic output to end over a decade of deflation, according to Mr. Suga.

Bernanke refused to speak to reporters following the talks at Mr. Abe’s office. The meeting lasted for a half-hour.

Brushing aside a view among Japanese economists that BOJ policy has reached its limit, Mr. Bernanke’s assessment added to speculation that Tokyo will unleash new rounds of fiscal and monetary stimulus to reboot Abenomics, Mr. Abe’s growth plan.

Mr. Bernanke visited Tokyo at a time of intense speculation that Mr. Abe may resort to so-called “helicopter money,” a radical form of monetary easing advocated by the former Fed chief. The strategy involves a central bank directly financing government spending or tax cuts. Japan once implemented the measure in the 1930s-40s and ended up stoking sky-high inflation.

But despite Bernanke’s insistence to keep his mouth shut about what transpired during his historic meeting, the answer leaked out anyway: Koichi Hamada, a close adviser of the prime minister, said Mr. Bernanke may have discussed helicopter money with Japanese officials he met with during his visit, including BOJ Gov. Haruhiko Kuroda and Ministry of Finance policy makers. Hamada, a Yale University professor, attended Tuesday’s meeting with Bernanke and Abe.

As a reminder, Mr. Bernanke said in a blog in April that monetization by a central bank could be the “best available alternative” under extreme circumstances, for example when demand is very weak but a central bank is out of ammunition and parliament is unwilling to rely on borrowed spending.

And just like that, the final phase of monetary policy – incidentally a very familiar one to the Weimar Republic – is about to begin, with helicopter money first coming to Japan, to be tried out as a trial balloon, and then everywhere else.

For a few months in early 2016 it was cool to make fun of Kyle Bass’ career bet on Yuan devaluation; now that the Yuan is back to 6 year lows and sliding as China once again quietly loses control of its capital outflows, it is not so cool any more.

And with every passing day, it is only going to get worse because despite all the rhetoric, China’s economy is getting worse by the day.  As SocGen puts it, “there have been signs of reviving capital outflow pressure since early 2Q. If the deprecation continues apace, capital outflow pressure will build up further and potentially quite quickly. The fact that the PBoC keeps stepping up capital controls despite the innocuous official flow data seems to suggest that it is also expecting an uphill battle.“

And speaking of SocGen’s outlook for China’s currency , this is what the French bank – which just cut its Yuan forecast from 6.80 to 7.10 – thinks will happen next.

A New Normal for the RMB

We revise our peak forecast for USD-CNY to 7.10 from 6.80. Similar to immediately following the August devaluation, consensus is too complacent on the ability and willingness of policymakers to arrest the nearly three-year-old depreciation trend.

The new normal in recent months is gradual RMB depreciation that doesn’t create a negative feedback loop to other currencies or broader market sentiment. This could embolden policymakers to keep pushing the limits of depreciation, especially if speculative positioning stays subdued. Implied volatility, risk reversal, forward points, and the forward curve have all been unresponsive to the recent RMB weakness. This is partly due to the reluctance of speculative investors to add exposure after being burned by the RMB depreciation trade in January, but also because intervention remains ongoing despite not showing up in headline reserves or the forward book.

The best solution remains for policymakers to let the RMB find its market clearing price. This is not an exact science and we can only guesstimate what the level would be – 6.80 was our previous assumption but 7.10 now seems more realistic. The recent depreciation at a time when the dollar has not been strengthening suggests policymakers are increasingly giving in to capital flow pressures and are willing to the test the limits of depreciation. Further depreciation could reinforce capital outflows in the short term but should eventually help capital flows reach equilibrium.

7.10 peak – our base case, 80% probability

The next wave of RMB depreciation will see USD-CNY trade up to 7.10 by mid-2017.Since USD-CNY bottomed in early 2014, there have been five waves of depreciation and each has followed a predictable pattern: three to five months of USD-CNY increasing (+3.5% on average), followed by modest gains (+1%) spanning an equivalent time span, before another round of depreciation ensues. The predictability is  suboptimal from a policy perspective, but it appears to be the PBoC’s standard playbook. While there could be some consolidation or modest strength after the current depreciation phase ends (3.6% since April), the ensuing wave and medium-term path should see USD-CNY reach 7.10 over the next year.

Cumulative depreciation of 6% over the next year would be similar to what has been experienced since October. This would not be an atypical base case for a country in a structural slowdown, with perceptible credit and banking sector risks, an imbalance in the supply-demand of capital, a tenuous reserve adequacy position, and local residents harbouring a strong desire for FX diversification.
We continue to believe that consensus is underestimating the chances of CNY depreciation, both from the ability and willingness of policymakers to prevent further depreciation. Consensus is at 6.80 in one year, which was our prior out-of-consensus call immediately following the August devaluation (back in late August consensus was at 6.50).

A gradual and controlled depreciation with periods of stability and bouts of accelerated weakness is still the most likely scenario (80% probability). A move to 7.10 may continue to be absorbed by investors without disturbances to broader market sentiment occurring, and as such we see no need to revise our EM forecasts, which currently entail modest spot depreciation that broadly matches the forwards.

Importantly, the USD-CNH trading pattern since 2014, of only retracing a portion of its gains and never revisiting the lows after an up move, should remain in place. Coupled with little fundamental justification for a stronger CNH over a 12-month horizon and fairly neutral speculative positioning, it is unlikely that USD-CNH will trade below the 6.50-6.55 area.

8.0 – the new risk scenario, 20% probability

Back in January (CNY7.50 World) we identified USD-CNY trading up to 7.50 as the risk scenario for the currency. Given ongoing capital outflows, the ability of the market to absorb recent depreciation without negative consequences, the policy decision to weaken the renminbi when the USD has been stable, and our new forecast of 7.10, the risk scenario for CNY is now much higher.

The new risk scenario for CNY is 8.0 (20% increase in USD-CNY). We assign 20%  probability to this scenario. The caveat is that the pain threshold for the market appears to be much higher than before and the implications for the global financial markets will primarily depend on the speed of depreciation. We believe that it would take significantly more pressure on capital flows than what we have seen over the past few years, or an economic hard landing, for our risk scenario to unfold. Note that we have a 30% probability of a hard landing of the Chinese economy. We think that an economic hard landing might not necessarily trigger a sharp devaluation, as the authorities would most likely respond with strict capital controls amid concerns over capital flight.

Within the risk scenario, the path to 8.0 could be abrupt (not likely), slow (more likely), or fast (most likely).  

• Scenario 1: one-off devaluation (<10% probability): A one-off move (i.e. step devaluation) where the PBoC then chooses to defend the new level. There would be enormous political backlash with the  appearance of any active pursuit of devaluation. This would also be too risky for Beijing’s taste given that no one can say for sure how much depreciation is enough to equilibrate supply and demand. However,  we assign it a nonzero probability because the authorities might ultimately decide it is the best way to realign expectations and halt domestic capital outflows.

• Scenario 2 (free float over the next year – >70% probability): The PBoC fast-tracks currency reforms through a big-bang approach to currency flexibility because either: a) capital outflows remain large and the depletion of FX reserves too great; or b) it deems the domestic and global financial markets able to absorb the shock.
• Scenario 3 (slow and steady move – 20% probability): The current strategy of steady depreciation picks up pace and intervention is used to limit overly destabilising volatility. The risk to a steady creep higher in USD-CNY is a build-up in speculative pressures and resident outflows that creates a vicious cycle of depreciation.

Finally, here is SocGen with its best ways to trade the coming Yuan devaluation:

Long USD-CNH: In our view, over a one-year horizon, being long USD-CNH has attractive risk-return characteristics on a 6% spot move, 2.5% negative carry, and limited potential for CNH to strengthen on a sustained basis. However, the entry point is critical to achieving a favourable PnL outcome and it might be prudent to wait until CNH consolidates or strengthens modestly to enter long USD-CNH positions.

Vanilla calls or call spreads are too expensive: Both these structures are too expensive when considering the probability-weighted terminal value of CNH a year from now. For example, a one-year 25d USD-CNH call has a breakeven at 7.37 while a 25d/10d call spread needs to see a move to the 7.50 area for risk-return to be attractive.

Buy 1-year call spread (6.85/7.20 strikes) and sell 1y-year 6.55 put: Under the premise that USD-CNH only retraces a modest portion of the recent gains (similar to past experience) coupled with no strong arguments for sustained appreciation on fundamental grounds, selling downside optionality can cheapen the cost of the call spread quite significantly. For example, the indicative cost of a 6.85/7.20 call spread is 1.43%, compared with a cost of 0.42% in a structure that buys the same call spread and also sells a 6.55 put. The 70% cost reduction entails unlimited losses below 6.55 but the position can be delta-hedged.

But 1-year 6.85 USD-CNH call with a knock-out at 8.0: Owning a 1-year 6.85 call option is quite expensive (indicative cost of 3% of notional) and has a poor breakeven (7.05). Whereas owning a 1-year 6.85 call with a knock out at 8.0 (our risk scenario) entails a 60% cost reduction over the vanilla call. The risk is limited to the premium paid. Positive PnL at expiry accrues above 6.90, but if the barrier level (8.0) is hit at any point over the life of the trade the structure is knocked out and the premium is lost. The structure has risk-reward of 10-1.

Short RMB against an abridged CFETS basket: Whether the CNY stabilises against the USD, depreciates modestly in an orderly and controlled manner (our base case), or experiences stronger depreciation (our risk scenario), the trade-weighted basket will be at best stable and could continue to fall. To mitigate fluctuations in the USD-CNY exchange rate, investors can short the trade-weighted exchange rate. An abridged CFETS index that includes the USD (36% weight), EUR (325), JPY (13%) and AUD (19%) is able to track the larger thirteen currency CFETS index very closely (link). The abridged basket is highly liquid and has similar negative carry as being long USD-CNH (22bp/month).

And with that, good luck in catching up to Kyle Bass.

In a widely anticipated, though purely symbolic decision, just over an hour ago a UN tribunal, the Permanent Court of Arbitration in The Hague, ruled unanimously in favour of the Philippines in its case against China’s extensive claims in the South China Sea. It found that China’s claim to historic rights in most of the South China Sea has no legal basis, dealing a setback to Beijing which, as the WSJ adds, the U.S. fears could intensify Chinese efforts to establish its control by force. And, as was just as expected, China promptly announced it does not accept or recognize the ruling by tribunal, Xinhua reported moments after the decision.

The Philippines first brought the case to the International Tribunal for the Law of the Sea at The Hague in 2013, raising 15 instances in which it held China’s claims and activity in the South China Sea had violated international law, writes Hudson Lockett. In 2015 the tribunal decided it had jurisdiction on seven of those, though it said it was still considering the other eight. The tribunal at the Permanent Court of Arbitration in The Hague said China couldn’t claim historic rights to resources in the waters within a “nine-dash” line used by Beijing to delineate its South China Sea claims.

That was the most significant element of an unprecedented legal challenge to China’s claims that was brought in 2013 by the Philippines, one of five governments whose claims in the South China Sea overlap with China’s under the nine-dash line.

In a second blow for Beijing, the tribunal decided that China wasn’t entitled to an exclusive economic zone, or EEZ, extending up to 200 nautical miles from one island in the Spratlys archipelago, Itu Aba, which is claimed by China and currently controlled by Taiwan. The clearly politically-motivated decision, based on a U.N. convention on maritime law, comes after several years of escalating tension in the region as China has alarmed the U.S. and its allies by using its rapidly expanding naval and air power to assert territorial claims and challenge U.S. military supremacy in Asia.

The Philippines case is seen as a test of China’s commitment to a rules-based international order which the U.S. and its allies say has been undermined by Beijing’s recent military activities, including construction of seven fortified artificial islands in the South China Sea. The ruling on Itu Aba is important because the U.N. maritime convention allows countries to build artificial islands in their own EEZs, and all of the seven structures China has built lie within 200 nautical miles of Itu Aba, which Taiwan calls Taiping Island. It also means that China has no legal claim to an EEZ overlapping that of the Philippines.

In a statement published on a verified social media feed just before the ruling, China’s Ministry of Defense said the decision wouldn’t affect its approach in the South China Sea.

“No matter what the result of the arbitration, the Chinese military will unswervingly protect the nation’s sovereignty, security and maritime rights, resolutely protect the safety and stability of the region, and face down all manner of threats and challenges,” it said. After the ruling, the ministry referred to the comment as its official statement.

China didn’t take part in the tribunal, which it said had no jurisdiction on the case, and Chinese officials have said repeatedly in recent weeks that Beijing won’t comply with the ruling.

In a series of public statements after the ruling, Beijing made it very clear that it has no intention of abiding by the ruling, in the process making a confrontation even more probable:

Most importantly, while the ruling is legally binding for China and the Philippines – and China has already said it won’t be bound – it can only be enforced through international pressure, and/or force.

As the WSJ adds, in the tense buildup to the ruling, a U.S. aircraft carrier strike group and other navy ships have been patrolling in the South China Sea, while China held military exercises in the area over the last seven days. The U.S. and its allies, including all of the Group of Seven large industrialized democracies and the 28 members of the European Union, have publicly expressed their support for the arbitration process.

In another damaging setback for Beijing, the tribunal ruled that China couldn’t claim 12 nautical miles of territorial seas around the two largest of the seven artificial islands that Beijing has built in the Spratlys. That means that U.S. and foreign naval ships can legally come within 12 nautical miles of those two structures, Mischief Reef and Subi Reef, which both have airstrips.

The tribunal ruled that China had violated the Philippines sovereignty in its EEZ by building artificial islands, interfering with Philippine fishing and oil exploration and failing to prevent Chinese fishing boats from operating there.

It said China had interfered with Philippine fishing boats exercising their traditional fishing rights around the disputed Scarborough Shoal. It said China hadn’t fulfilled its legal obligation to stop Chinese fishermen from harming the environment in the South China Sea.  And it said China’s island building had violated the obligations of a state during the dispute resolution process.

The Philippines welcomed the ruling. Foreign Secretary Perfecto Yasay called it a “milestone” in efforts to address regional disputes and called on “those concerned to exercise restraint and sobriety.”. The case was brought by the previous Philippine government. New Philippine President Rodrigo Duterte has taken a different stance, suggesting that he might be willing to negotiate directly with China.

China says dozens of countries—many of them small, developing nations—support its position, although only a handful of them have issued their own statements explicitly backing Beijing’s right to ignore the tribunal.

China’s foreign ministry issued the following statement moments ago in response to the ruling (excerpted):

Statement of the Ministry of Foreign Affairs of the People’s Republic of China on the Award of 12 July 2016 of the Arbitral Tribunal in the South China Sea Arbitration Established at the Request of the Republic of the Philippines

With regard to the award rendered on 12 July 2016 by the Arbitral Tribunal in the South China Sea arbitration established at the unilateral request of the Republic of the Philippines (hereinafter referred to as the “Arbitral Tribunal”), the Ministry of Foreign Affairs of the People’s Republic of China solemnly declares that the award is null and void and has no binding force. China neither accepts nor recognizes it.

The unilateral initiation of arbitration by the Philippines is out of bad faith. It aims not to resolve the relevant disputes between China and the Philippines, or to maintain peace and stability in the South China Sea, but to deny China’s territorial sovereignty and maritime rights and interests in the South China Sea.

China’s territorial sovereignty and maritime rights and interests in the South China Sea shall under no circumstances be affected by those awards. China opposes and will never accept any claim or action based on those awards.

The Chinese government reiterates that, regarding territorial issues and maritime delimitation disputes, China does not accept any means of third party dispute settlement or any solution imposed on China. The Chinese government will continue to abide by international law and basic norms governing international relations as enshrined in the Charter of the United Nations, including the principles of respecting state sovereignty and territorial integrity and peaceful settlement of disputes, and continue to work with states directly concerned to resolve the relevant disputes in the South China Sea through negotiations and consultations on the basis of respecting historical facts and in accordance with international law, so as to maintain peace and stability in the South China Sea.

More here.

Ironically, in attempting to stem China’s territorial expansions in the region, the tribunal will likely just provoke Beijing even more: U.S. officials have warned that China could respond to the ruling by starting land reclamation at another disputed reef near the Philippines, or declaring an air defense identification zone over the South China Sea. China hasn’t announced any such plans, but says it has the right to do both.