Japan has awoken and more things are going to get broken

As the latest Rugby World Cup unfolds in France, it is shocking to think how much the world has changed in the four short years since Japan. Covid, most obviously, turned the world upside down – or more accurately the policy reaction to it did - and while that particular crisis is now over, there are continuing aftershocks. In financial markets, we would suggest that one of the most profound impacts has been to break the spell of QE that has shaped the investment landscape since the Global Financial Crisis (GFC) in 2008 and also the much longer term policy mistake in Japan that has been Zero Interest Rate Policy (ZIRP). Indeed, we would say that it looks like Japan has woken from a 30 year (self induced) coma and that much of what is going on in markets at the moment may well be a consequence of this awakening.

At the time of the last Rugby World Cup, Japanese interest rates were actually negative and western Central Banks remained wedded to the flawed notion that ever lower short rates would eventually bring growth and modest inflation, seemingly unshakeable in their belief despite all evidence to the contrary – and much evidence of unintended consequences including asset price inflation, capital misallocation and in fact continued dis-inflation.

Thus while we might note that the most obvious aftershock from Covid policy has been inflation, in many ways the second order effects have been more profound, as the spike in inflation brought to an end the crazy 14 year experiment that was QE, as the Fed, duly followed by all the other ‘independent’ central banks, moved hard and fast to raise short term interest rates last year, breaking a large number of business models and financial strategies along the way.

The Japanese have been last to the party, only starting to ditch their Yield Curve Control (YCC) policies in the summer, perhaps because their own failed experiment with Zero Interest Rate Policy has been going on for twice as long, making the authorities twice as reluctant to acknowledge that their policies have had an equal and opposite effect than intended for almost three decades. Meant to stimulate growth and inflation though higher spending, instead they brought about higher savings, almost zero growth and dis-inflation due in our view to a mis-interpretation of the nature of Japanese households.

The beginning of normalisation of Japanese policy has already brought about growth, inflation and higher Japanese Bond yields, which has had systemic effects on the Japanese life companies and other parts of the financial sector. The apparent ending of Yield Curve Control has seen bond yields not only turn positive but jump from 0.2% to 0.8% in the last six months, still low, but a four fold increase. As with the US tightening, this is starting to ‘break things.’ For example, because of the high cash rates in the US, the ability of Life Companies to currency-hedge purchases of US long bonds has been compromised, removing a key source of demand for US long bonds and other high yielding assets. Given that the comatose Japanese economy has been yield chasing around the world for the last three decades, the fact that this liquidity may now stay at home is extremely important. With US politicians running ever higher deficits and the Fed holding short rates high and not printing money like they did during Covid, fixed income managers are running to the short end of the curve, making the benchmark 10 year bond very vulnerable.

Meanwhile, the freezing of Russian FX reserves following the Ukraine invasion has accelerated de-dollarisation by not only China, but much of what is now called BRICS+, not only involves using fewer $s for bi-lateral trade and using domestic currencies instead, but also involves less recycling of current account surpluses into the US financial system. Since Xi came to power, Chinese holdings of US long bonds have been in steady decline and are now down around 40% from their peak and as the anti-China rhetoric soars, there is little sign of that reversing. This is not to say however that they aren’t holding $s at the very short end. Indeed, the real problem for markets is that everybody is holding nothing but US cash as the moment.

Covid broke global supply chains, many of which won’t be replaced because they depended on ultra low rates to fund working capital and no longer make sense and while this, together with the sanctions on Russia has been blamed for the spike in inflation, we see that as having really been driven by ultra loose monetary policy. Policy that has now reversed. This means that, while it will be higher, inflation is unlikely to be the real issue, that will be the fact that the global money supply chain has broken. The rise of BRICS+ and the awakening of Japan means that the supply of cheap money in the form of ‘eastern’ savings going into ‘western’ capital markets is over. Currently 5% short rates in the US are sucking global capital into the US, but that is the wrong price for the borrower in the same way that 0.5% used to be the wrong price for the lender. More things are going to get broken.