The BoJ commitment to Yield Curve Control has led to a significant devaluation of the Japanese Yen against the USD.
This could spill over into a wider currency devaluation war amongst exporting countries in Asia.
Whilst recession risks continue to increase, it may be better to generate a recession now so that a recovery process can swiftly follow.
Multi-Decade Trend Breaker
The Japanese Yen has been breaking through a significant number of major, and often multi-decade trends over the last few months.
The breakout initially began last year when USDJPY pushed through the 50-year downtrend (a rising line represents Yen weakness versus the US dollar).
The move accelerated in March with the break of a 30-year downtrend and continued in April with a record-breaking streak of 13 consecutive days of dollar strength versus the Yen as domestic investors repositioned for the start of the new financial year (in Japan, the financial year ends on March 31st).
The catalyst behind the move was the Bank of Japan’s recommitment to Yield Curve Control (reminder – Yield Curve Control (YCC) is a Central Banks attempt at keeping its yield curve, well, controlled, by artificially suppressing rates. It’s also necessary for heavily indebted countries, which Japan is, so that they can refinance that debt at lower yields).
Yields on the 10-year government bond are to be maintained in a 0.25% range on either side of zero. For now, that means they are capped at +0.25%.
This policy is at odds with many other major regions such as the US and Europe, where bond yields have been allowed to reset, often at much higher levels, partially to reflect the heightened levels of inflation (in the US, the 10-Year yield has reached 3%).
By capping yields relative to other regions, the Bank of Japan is encouraging capital flight (capital literally leaving the country to chase a higher yield in a different country), which puts downward pressure on the currency.
A weaker currency usually leads to higher inflation, because it increases the cost of imports.
So why is the BoJ making the choice for a weaker currency over higher yields, especially given the backdrop of what is happening everywhere else in the world? It’s tied to the historical issues of debt and demographics.
Japan is experiencing aging demographics. If the working population of a country is in decline, then, all else being equal, GDP will also fall (fewer people working = less money being earned = less consumption = shrinking GDP). Declining growth has also put downward pressure on inflation, which has remained substantially lower than that of the US for most of the last 20 years.
Additionally, the government has taken on more and more debt, in a desperate attempt to boost economic growth. The current government Debt-to-GDP ratio is around 240%, the largest level of any major economy. For reference, the US is at 123%.
Corporates have also taken on large amounts of debt, which is partly offsetting the losses and the decline in domestic demand that followed the property and stock market bust that began in late 1989.
Therefore, given the choice between higher financing costs for these huge levels of debt (i.e. allowing rates to rise along with the rest of the world which could cause a government default and corporate bankruptcy), or higher inflation (which is still low compared to the rest of the developed world), policymakers prefer risking higher levels of inflation, which is having a material impact on the Yen.
So, Yield Curve Control it is.
How Long Can This Last For?
Extreme policy conditions can last for an extended period. For instance, expectations that Japan’s expanding debt levels would lead to a collapse in bond prices (and a default on its obligations) have swirled around the Japanese market for over 20 years. Most attempts to short JGBs (Japanese Government Bonds) have ended in failure, with the trade dubbed ‘the widow-maker’.
For as long as there will be policy support (YCC), it’s hard to make a compelling case for a market collapse. However, when policymakers do decide to withdraw support for extreme policy, the resulting price action can be dramatic. This is what happened when the Swiss National Bank stepped back from its intervention in the EURCHF (Euro vs Swiss Franc) market in 2015.
There are two major risks to letting inflation run higher (instead of allowing yields to reset at a higher level, similar to the rest of the world):
The BoJ could lose control of its currency. If the Yen weakens dramatically, it could lead to unexpectedly high levels of inflation that undermine consumer confidence (and confidence in the government, with consequences at the ballot box).
More importantly, a lower Yen could have dramatic consequences in regional markets. Many Asian economies are exporters, competing with one another on the international stage. If one country’s currency devalues, it weakens another country’s competitive position, meaning that if it becomes cheaper to buy goods from Japan than Korea because the Yen is now cheaper than the Won, people will buy more goods from Japan, which will piss off the Koreans. This is the currency manipulation that Trump alluded to against China multiple times over. Chiiiina… you miss it don’t you?
This means that the BoJ decision to let the Yen devalue could potentially lead to a competitive devaluation of currencies across Asian exporting economies.
In fact, we have already seen the Chinese authorities let their currency drop against the US dollar in the aftermath of the recent Yen weakness.
The Korean Won (USDKRW) is also testing a long-term trend. Korea is a major exporter and will not want to lose out to the Japanese corporations with which they often compete on the international stage.
Competitive devaluations can lead to economic instability.
In 1997, Japan, by weakening its currency (thus making its exports more attractive), tried to recover from the aftermath of its collapsed property bubble and regain some of its competitive advantages in the global export market.
This was one of the catalysts that put pressure on other countries in the region to weaken their currencies. This, however, undermined their ability to service their US dollar-denominated debts, leading to defaults and accelerated declines in many currencies. (If you didn’t know that foreign entities can and do issue some of their bonds in US dollars, check out our Eurodollar primer here.)
The decline in the Asia Dollar Index (a basket of Asian currencies valued against the US dollar) in 1997 completely dwarfs all the price action of the subsequent 25 years.
Fortunately, the position today is vastly different from the position in the 1990s. Dollar-denominated debts have been pared back and these economies are now much stronger. But, if weakness in the Yen encourages China’s policymakers to devalue the Yuan, then there will be negative repercussions for many of the region’s exporters. Whilst the levels of dollar-denominated government debt have fallen, many corporate dollar debt burdens remain extremely high.
In summary:
If Yen weakness spills over into broad-based US dollar strength, then the dollar wrecking ball could break markets that are already reeling from geopolitical and inflationary uncertainty. (As Tim has tweeted many times - thieving everything he knows about the US dollar from Brent Johnson and Luke Gromen - when the US dollar rises too much too quickly, the rest of the world goes into shock, as just about everything is priced in dollars, and dollar debts need to be repaid in dollars, so if the price of dollars goes up, in order to pay for things and debts, entities need to buy more and more dollars at higher prices, increasing demand, and pushing it even higher… it’s a viscous cycle).
Taken to an extreme, a series of regionally competitive currency devaluations could eventually support a disorderly surge in the US dollar. A stronger dollar would be a major source of tighter financial conditions, putting pressure on global trade and global debts (if they are transacted or denominated in US dollars). The US dollar is, by far, the most common currency in international markets.
The dollar index itself (DXY) is testing a 20-year high. If the dollar surges higher through resistance, it could add yet another dimension to the volatility currently being experienced by global markets. However, for a fully balanced view, the current weakness in the Euro (caused in large part by the Russian war in Ukraine and a decade+ of policy missteps) is a major contributor to the DXY’s rise, as it’s the largest currency pair in that index.
If, instead, the Bank of Japan suddenly decided to step away from its current YCC policy, then the reversal in the recent price action of the Yen would be dramatic. This would also have an intense impact on capital flows, which would themselves be destabilizing.
A general rule of thumb: markets can deal with slow change, but they struggle to deal with sudden and unpredictable moves.
The Bank of Japan has added an extra one, or maybe two layers of uncertainty to global markets.
Recession Risk is Rising
In last month’s note, we highlighted that recession risks were rising, despite many indicators (such as the level of the ISM Manufacturing Survey) suggesting that a recession should still be a couple of years away.
We shouldn’t, however, get carried away.
Preliminary readings are prone to revisions.
All data sets since the pandemic have been subject to volatility and GDP is no exception.
Many of its subcomponents (i.e. consumption and investment) were relatively robust.
The weakness was primarily due to imbalances in the import and export numbers.
But as we argued last time, high levels of inflation can put a completely different complexion on data relationships. Economic outcomes can rapidly unravel, and consumer tailwinds can quickly turn into headwinds. Meaning, higher inflation = less consumption = lower GDP.
Consider this:
The ISM Manufacturing survey is dominated by larger corporations. The bulk of the US economy, however, is serviced by smaller-scale companies and underpinned, of course, by the consumer (consumption accounts for roughly 70% of US GDP).
The ISM remains firmly in expansion territory (50 is the threshold between expansion and contraction), but a combination of the NFIB Small Business Survey and the University of Michigan Consumer Sentiment Index suggests an outlook that’s on shakier ground.
Their current level is only just short of those achieved during the great financial crash of 2008. It’s already below the troughs of the 1991, 2001 and 2020 recessions.
Interpretation: big businesses see expansion; small businesses see contraction.
Besides consumer surveys, we also know that the current levels of inflation are unlike anything we’ve seen for 30 years. Although the ISM Manufacturing Index is in expansion territory, it could deteriorate rapidly.
German manufacturers have been hit by the highest input prices on record. The ZEW survey is already in recession territory (for the domestic economy). ZEW maybe more volatile than the US ISM, but the two tend to ebb and flow together.
Furthermore, during the inflationary period of the 1970s, the US economy often entered recessions with the ISM well above the expansion/contraction threshold of 50.
The ISM and the year-on-year change in the S&P500 have a decent relationship. If Wall Street is leading Main Street, then the negative impact of inflation on stocks could lead the index into contraction territory.
Growth is thus starting to falter, but inflation remains at high levels. Peaks in inflation have coincided with recessions on almost every occasion since 1965.
The Fed has two choices:
Combat inflation (increase rates and end Quantitative Easing) or
Support Economic Growth (lower rates or keep them where they’re at, continue QE)
Capping inflation whilst simultaneously achieving a soft landing is possible, but not probable. For now, the Fed rhetoric is clearly skewed towards capping inflation as the priority.
The difficulty for investors is gauging how much economic growth the Fed will need to sacrifice to control inflation before they can then reverse course back toward supporting growth without driving inflation much higher (many investors expect the old supportive Fed to return – case in point has been the dip buying mentality that has continued in many tech names despite their ongoing declines).
An early reversal in policy, however, could stoke another leg in inflation, accentuating the conditions that were already causing the slowdown prior to the first hike.
All in all, it may be better to generate a recession now, so that a recovery process can swiftly follow.
This would mean that:
The Fed will continue to tighten, even if that continues to upset the economy and the equity market.
If the recession comes swiftly, then the terminal rate of the hiking cycle will likely be lower than that which is currently anticipated (i.e. the market is still expecting a lot more rate hikes, but, if we get a swift recession, that forecast will likely come down and markets may calm down a bit).
All of this is not really reassuring for risk assets.
Thanks for reading through!
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