The Big Conversation
Episode 145: Japan is now driving U.S. yields
This week Jamie McDonald tackles the question of why U.S. yields continue to rise despite deteriorating economic conditions. The answer possibly lies a very long way from the U.S., in Japan. This week the Bank of Japan intervened once again to stabilize their currency and that means selling treasuries - a lot of them.
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Jamie [00:00:00] The S&P Global Services PMI for October just came in at 46.6. The S&P Global Manufacturing PMI at 49.9. Now, when both of these fall below 50, well that's a pretty reliable signal that the global economy is in contraction.
Jamie [00:00:20] Commodity prices have been retreating, supply chain bottlenecks, by way of shipping rates have been easing, and a long list of other leading economic indicators suggest we're headed for a downturn.
Jamie [00:00:32] Now, historically, this type of an environment has led to falling bond yields. But today, well, they're hitting new highs. So what gives?
Jamie [00:00:41] That's today's Big Conversation.
Jamie [00:00:48] Earlier this year, there was a raging debate - are we experiencing a cooling in economic activity or is a full blown recession on the way? Now, that debate has slowly morphed into a more of an agreement in the recession camp, with the question now being, well, "how severe?"
Jamie [00:01:04] So if a slowdown is in the data; both economic growth, and inflation, as well as investor expectations, then why are yields still climbing?
Jamie [00:01:14] Well, it might have something to do with liquidity and the drama we've seen over in Japan.
Jamie [00:01:20] Now, to give a little context, let's briefly cover what's been going on in sovereign bond and currency markets over the past few months. Specifically, what we're seeing between the United States and Japan.
Jamie [00:01:32] So for most of this year, the U.S. Federal Reserve has been aggressively tightening financial conditions as it tries to combat surging inflationary pressure. And really, the rest of the world has been in a similar boat, that is, except for Japan.
Jamie [00:01:48] Now, to be fair to Japan, they never really saw runaway inflationary figures like we're seeing in other parts of the globe. Its latest CPI report for September came in at 3% - now, that's a far cry from the 8%, 9%, even 10% readings we've seen across the U.S. and Europe.
Jamie [00:02:06] And that's where the divergences in monetary policy have wreaked havoc on currency valuations. Which to some market observers, has been feeding into the recent bond carnage.
Jamie [00:02:16] But how exactly has it affected the bond markets? Well, let me explain...
Jamie [00:02:22] With the Federal Reserve and other central banks raising rates. Global yields have been on the rise, but the Bank of Japan, not faced with the same inflationary pressures, has continued to ease. Now, as you've probably heard, this is Japan's infamous "yield curve control", where the BOJ has committed to buying an unlimited amount of bonds in order to target a specific yield.
Jamie [00:02:46] As global rates rise while Japan's stays stagnant. It incentivises capital to flow away from Japan and towards higher yields. Now this outflow of capital puts additional upward pressure on Japanese yields, which then requires increased buying, by the BOJ. And this is achieved by the BOJ effectively printing money, and thus it dilutes its currency to maintain their yield target.
Jamie [00:03:12] And this is why we've seen the yen come under such intense pressure this year, currently down around 30% against the dollar.
Jamie [00:03:19] Such a weakness in anyone's currency is concerning. And so it prompted Japan's Ministry of Finance to intervene in the FX markets. Now, not only can Japan sell US dollars held in reserve, but they also have a massive war chest of U.S. Treasuries.
Jamie [00:03:34] And the mechanics of it are simple. And they go a bit like this: Japan sells treasuries, they receive dollars, and then they sell those dollars to buy yen, and that supports the yen against the dollar.
Jamie [00:03:49] But therein lies the major problem. These direct intervention attempts are nothing more than a temporary Band-Aid. Monetary policies between the two are still firmly heading in opposite directions. So the incentives for global capital flows are unchanged. And what's more, if the BOJ is selling U.S. Treasuries to temporarily stabilise its currency, that selling only creates additional upward pressure on U.S. yields.
Jamie [00:04:17] And as we just outlined, that widening rate differential to Japan's current yield target only exacerbates capital outflows and thus creates a circular need for more BOJ easing.
Jamie [00:04:30] And that's where some market observers believe the current conundrum between slowing economic growth with easing inflationary pressures and rising yields comes into play. The selling of Treasuries may not be fundamentally driven, but instead it's a crisis response from another global central bank.
Jamie [00:04:48] Now, I know this can seem like some far flung issue that really only affects Japan and sovereign bonds. But in reality, and this is something that you need to be very aware of, especially right now, global assets do not move in a vacuum.
Jamie [00:05:05] As sovereign bond yields rise. They become more competitive to other assets like equities and commodities, corporate credit and real estate.
Jamie [00:05:13] And really, this is something equity investors in particular need to consider. One of the major themes this year has been the horrific sentiment we've seen from a wide range of surveys. We've heard things like, "Investors are more bearish than during the depths of the Global Financial Crisis".
Jamie [00:05:29] Well, that may be what they say. But positioning figures and option activity tell a very different story.
Jamie [00:05:37] Bank of America's recent report shows that global stock funds had inflows of $9.2 billion in the week through October 19th. Within the United States specifically; U.S. funds had a second straight week of inflow at $12 billion.
Jamie [00:05:54] Now, other sources have highlighted that the relative cost of options protection against a 10% decline in the S&P 500 has recently hit the lows last seen in early-2018, late-2018 and late-2019, all before large sell-offs in the U.S. equity indices.
Jamie [00:06:13] So even though the rhetoric is very much doom and gloom, there's considerable evidence out there, that equity investors are starting to buy again. Plus, there seem to be fewer investors that see any further material drops from here, and that's often a warning sign.