SPECIAL UPDATE
A BIT OF A BOJ JOB
Someone just sabotaged the Japanese economy – authorities have issued the following images of two men believed to be running international economic terror gangs-
The Bank of Japan (“BoJ”)[1] yesterday announced a widening in its interest rate policy bands (an effective interest rate increase of up to 0.25%).
This was unexpected and sent shockwaves around the markets
The Yen moved 4% higher against the US Dollar (described as “huge numbers for a major FX pair” (https://www.dailyfx.com/usd-jpy)
Japanese Government Bonds (JGBs) fell in price, with 30-year bonds falling by more than 5% in price (a quite extraordinary move by Japanese bond standards).
What are the broader implications?
JGBs – In view of the unpredictable actions of the BoJ, we’d view their policy behaviour from here with suspicion. This makes us cautious about JGBs in the medium term, but once we’re sure that it’s safe to go back in the water, JGB pricing may offer an even better opportunity.
Yen – We’ve been advocating Yen exposure since it went to 140 to USD. We targeted a rebound to 100-110 partly based on UST-JGB yield convergence (the idea that the interest rate differential between much higher US interest rates and Japanese interest rates would narrow, largely because of the need to cut US rates more than Japanese rates). This theme remains in place. Prior to yesterday’s announcement the spread between them was 3.4%. By the end of the day it had narrowed to 3.3% (even though this was because of higher JPY yields, not lower USD yields).
USD – Despite the fall against Yen, USD was relatively unmoved against western currencies and only fell slightly against other Asian currencies. Greenback may still be the tallest dwarf among western currencies but Asian currencies continue to have considerable appreciation potential (albeit not without risk). The key takeaway is that Asian investors need to be aware of currency risk. We had highlighted this prior to yesterday but now everyone should have received this memo
Precious metals –Gold (especially miners) rallied yesterday, and silver rallied even more so. The long-term outlook remains positive. In the short-term we expect increased volatility in both directions.
US treasuries – US bonds fell in price as yields increased due to the perceived threat of reduced Japanese carry trade demand for treasuries (Japanese investors have been the main international buyers of US treasuries, largely because of the yield differential referred to above in the paragraph about the Yen). While this fuelled the volatility yesterday, it probably doesn’t make much difference in the long run. We wouldn’t be surprised to see US yields rise more in short-term but mid to long term this could be a buying opportunity following the recent profit-taking opportunity).
Risk assets – This BoJ JoB could be very bad news for global growth. The real canary in the global economic policy coal mine was that the global reserve currency policy interest rate once again broke back above long-term inflation/growth expectations in August. Although there’s typically a delay before this shows up in capital markets, the signs of duress must have been increasingly apparent since then to policymakers (being reflected across the yield curves of JGBs and the bonds of the other sovereigns that have followed a different path to US policymakers). We suspect that Fed determination must have further alarmed BoJ JoB Governor Kuroda to double down on further hikes. However, the chart below shows previous instances of policy rate exceeding expected long-term growth/inflation expectations:
The main economic risks are threefold
- This additional tightening makes ultimate slowdown/recession in Japan more likely.
- It also creates a feedback loop that increases capital cost globally, making global slowdown/recession even more likely if not inevitable and increasing the risk of such a slowdown being deeper and longer lasting
- The feedback loop places pressure on policymakers in other countries, particularly within Asia, increasing the odds of policy-driven mistakes that cause lasting damage to risk assets.
It’s unclear how other asian policymakers will respond but any contagion from Japanese policy encephalitis would be bad news for Asian economies and for risk assets. Asia’s biggest economy, China, will likely ultimately influence its own outcomes more than Japanese policy will but, having sold ChinTech / Chinese Smaller Companies recently on fears that the re-opening bounce was getting ahead of reopening risks, a decent reversal could signal a buying opportunity here.
All of this begs the question of why Governor Kuroda shook the markets with his BoJ JoB. We suspect that it was most likely a combination of Kuroda wanting to leave his mark on history (which sadly he will, just not in the way he intended) but also feeling pressured to tighten (and being given cover to do so) by irresponsible FOMC aggression/determination to overtighten, which was causing unwelcome ripples in the JGB curve due to outflows from (or lack of inflows into) JGBs as Japanese investors and carry traders have chased US treasury yields.
How did we get here?
Revolutionary industrialisation and the accompanying wave of globalisation exacerbated national rivalries in a way that fuelled the conflicts of 1914-18 and 1939-45.
Policymakers conspired to address the post-WW2 challenges on terms that interwove geopolitics and socioeconomics, dominated by American self-interest.
This initial wave unravelled in the 1970s as the unintended consequences of Bretton Woods outweighed the apparent benefits, but the abandonment of the no longer practical structures of the quasi-gold standard, created a boom after the mid-70s oil crisis until, in the 1980s fractures were appearing in the global economy, that brought about the tinkering of the Plaza Accord and Louvre Accord, in response to American (and other) threats of trade interventionism, as well as increased reliance by policymakers, especially in the USA, on using interest rates as a policy tool.
The Fed created the bond crash of 1994 by hiking (doubling rates from 3% in Feb 1994 to 6% a year later) into the rebound that followed the Gulf War recession, despite claiming a soft-landing for the US economy.
However, from the mid-90s policy rate exceeded long term break-even inflation/growth expectations
“In the 1980s, financial deregulation and a reversal of tight monetary policy (the US Federal Funds Rate fell from 20% in 1981 to 8.5% in 1989) enabled rapid growth in credit that increased consumption, indebtedness, corporate profits, inequality and asset prices.
A normal person might see problems with this.
Policymakers however are not normal people and were shocked at the ultimate inability of people and businesses to service ever increasing amounts of debt. By the start of 1990s economies were falling into recession as capital and property markets bubbles crashed around them pricked by the sharp pin of higher oil prices.
A normal person might deduce that encouraging rapid debt build-up hadn’t been sustainable (and that exogenous price shocks might be something to be aware of going forwards).
Policymakers however are not normal people and resolved to combine the miracles of financial engineering with even easier monetary policy (the Fed Funds Rate fell from 8.25% in 1990 to 5.75% in 2000) in order to continue and massively inflate the boom, especially in the most liquidity sensitive assets like the 5,000 or so predominantly technology and growth stocks that had somehow found themselves listed on the NASDAQ. By early 2000, the rapid debt build-up had once again created vulnerabilities that led to a brief recession but a severe day (or 2 ½ years in the case of bubbly dot.com assets) of reckoning.” - MBMG IA – In Lehman’s Terms (https://www.researchgate.net/publication/364336125_In_Lehman's_Terms_A_high_level_review_of_causes_and_consequences_of_financial_crises_and_events_from_the_1980s_to_2022_and_the_resulting_legacy_implications_today)
In short, policymakers created the bubbles in Japan in the 1980s and in the west in the 1990s – which they then pricked by raising policy rates above long-term inflation/growth as an attempted response to the imbalances
Following the bubble bursts, policymakers resorted to aggressive stimulus (US policy rates fell to 1% in 2004, well below implied growth/inflation rates and to zero in Japan), which created additional unintended consequences (sub-prime in USA), so that by 2005 policy rate once again exceeded growth/inflation rates and we all know what happened in 2008.
Again policymakers stimulated aggressively, cutting policy rates to zero, creating the post GFC bubbles. By 2018, they attempted to redress this by raising policy rates above long-term inflation growth rates which, hand in hand with COVID/lockdown created the crash of 2020, following which policymakers again resorted to arguably the most aggressive stimulus in history – which again had unintended consequences and which last year resulted in tight Fed policy rhetoric and this year in tight Fed policy action.
It remains our contention that much of this is driven by the perceived need to tighten monetary policy to the extent that, having created a policy-driven slowdown, western policymakers could ride to the rescue by policy easing, that involved cutting back to previously normal policy rate levels (e.g. 2-3%). There are all sorts of reasons why this might have seduced policymakers. None of them are defensible.
Asian policymakers have been much less aggressive in tightening which led to:
Depreciation of Asian currencies
Lack of appetite for domestic bonds
Carry trade outflows
In terms of market function and economic performance, BoJ/MoF had handled the situation pretty well (consider the JGB market versus Andrew Bailey nuking the GILT market) until yesterday, when BoJ announced a widening in the YCC bands (potentially an effective hike of 0.25%).
Although there’s an eerie calm following the initial shock, the dust may not settle for some time on the rubble of the BoJ JoB and we might never find out whether it was an act of final seppuku (hari-kari) by Kuroda or a violent economic attack by Powell and the Fed.
Governor Kuroda is no doubt thinking that he’s pulled off a master stroke and that next year he will hand over to his successor an economy with normalised inflation and something closer to normalised interest rates.
If the brown stuff hasn’t really hit the fan by then, the BoJ staffers might even cheer him out of office.
History however will probably not be so kind (although if Kuroda is lucky, his unfortunate successor could be the one to bear the brunt of the blame)
[1] For the purposes of this Flash Note, it appeals to my childish mind to refer to the Bank of Japan as BoJ JoB which is an alternative version of bodge job or botch job, “A job that is completed quickly and carelessly, possibly with one's mind on other things, or without using the correct tools.” (www.wiktionary.com)
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About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment planner.
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