The current market behaviours suggest something is broken and we suspect a lot of it may be to do with Japan as the end of Zero Interest Rate Policy means the Japanese economy is coming back to life which means in turn that we can’t take its savings for granted any longer. The following piece is one of a series that we have contributed to external publications over the last week trying to put together the pieces of the jigsaw.
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 and also impacts from much that went on in the background over the last three years that it has been easy to lose track of. However, the current financial market landscape bears the scars of all of these.
The Covid policy induced inflation finally broke the spell of QE and ZIRP
The most obvious aftershock from Covid policy has of course been inflation, which while coinciding with the supply shocks of both the collapse of the global supply chain in 2021 and the commodity sanctions in the wake of the Russian invasion of Ukraine in 2022, was really down to the dramatic expansion of the Money Supply during Covid. Put simply, as governments borrowed and spent billions, if not trillions, of $s during lockdown, the Central Banks facilitated this by expanding the money supply dramatically. And the result was the same as it always is. Inflation. The second order effect of Covid therefore was to bring about the end of 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, breaking a large number of business models and financial strategies along the way.
The sanctions on Russia had a short term impact on inflation, but freezing their FX reserves has accelerated de-dollarisation outside the West
As US long bond yields finally move to flatten the yield curve by catching up with short rates, and with ten year yields hitting levels not seen since the pre GFC and thus pre QE era, it is perhaps easy to think that, once again, everything is about the Fed. While this is true to some degree, it is also important to consider some of the other things that were happening in the background over this period and which are now making their presence felt. For example, while the sanctions that followed the Russian invasion of Ukraine undoubtedly contributed to the spike in inflation (particularly in Europe), we would suggest that the more profound long term impact will have come from the freezing of Russian foreign exchange assets that has dramatically heightened the pace of de-dollarisation. Equally, while it is easy to forget about the US withdrawal from Afghanistan in 2021, it is even easier to overlook the long term impact of the announcement by Xi the same week, when his comments on Common Prosperity not only took down the widely held China Education Stock ADRs, but critically wounded the ADR market as a whole.
The ending of ZIRP has woken Japan from a self induced 30 year coma
Finally, we would throw into the mix the dramatic changes to Japan itself since that last Rugby World Cup as the end of QE in the US has triggered an end to the equally crazy but far longer lasting Zero Interest Rate Policy (ZIRP) that has had an equal and opposite effect than intended for almost three decades. Meant to stimulate growth and inflation though higher spending, instead it brought about higher savings, almost zero growth and dis-inflation due to a mis-interpretation of the nature of Japanese households. Ending this policy is now having the desired impact that ZIRP was supposed to achieve such that Japan is now waking from a 30 year coma.
De-dollarisation and higher Japanese rates together with high US short rates mean nobody wants US long bonds
In our view, all of these factors are as important as the Fed in explaining the highly volatile markets at the moment. First, the beginning of normalisation of Japanese policy has already brought about growth, inflation and higher Japanese Bond yields, with systemic effects on the Japanese life companies and other parts of the financial sector. Combined with the already 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. Second, the 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.
The conveyor belt recycling eastern savings into western fixed income and back into eastern equities has broken.
Meanwhile, in response to a combination of the 2021 Common Prosperity announcement that killed the Chinese ADR market and the latest 2023 anti Chinese rhetoric, we see widespread di-investment from China by western investors in an equal and opposite move to the Chinese dis-investment from US fixed income markets – both worried about sanctions and geo-politics rather than fundamentals of any kind. In effect, the circulation of developing markets savings into US fixed income markets and then back out via direct investment by International investors buying into developing market equities and real assets is winding down. The West is buying western assets and the East is buying eastern assets. Except at the moment, everybody is doing the selling part first. And everybody is buying US cash to keep their job until the year end. As such the world’s largest and most liquid market appears to have run our of liquidity.
As Western investors ‘de-risk’ from Chinese Equities, Eastern savers are ‘de-risking’ from US Long Bonds. The Globalisation of savings is fracturing
Originally published on Livewire.
The awakening of Japan is not the only factor behind markets at the moment, but we think it is a significant one, not least because with Japanese bond yields at their highest levels for a decade, balance sheets are going to be under pressure as they have to mark to market. In Yen terms however, US Treasuries and Gold can still be sold at a profit. Sometimes you have to sell what you can, not what you want to.