On a previous blog post I wrote about the “long run” in investing, pointing out that Japan's stock market still hasn't recovered from the asset pricing bubble in the late 1980s. Meanwhile the United States has been on an epic bull run, only to be stopped by the Federal Reserve raising rates.
What I didn't mention is how Japan has tried to heat up their economy: since 2016 they've implemented the unparalleled Yield Curve Control policy, which keeps interest rates at or below zero. For the first time in decades, it appears the ice is starting to melt on Japan's economic ice age.
Adding to the fun is that the Bank of Japan just elected a new governor, Kazuo Ueda, who has the opportunity to end that policy and trigger a heat wave that would send ripples through global markets.
The State of Play
Back in September, I believed that the pending recession was just months away. 8 months later, and we’re still just months away from a recession.
Sure the market dipped in 2022, but it didn’t get the message that we’re supposed to be in a recession. The S&P is up ~8% in 2023, inflation is subsiding and unemployment is still at an all-time low.
Despite the high-profile layoffs, bank failures, and a war in Ukraine, people keep buying stuff.
Last week the Fed announced another 25 bp rate hike, bringing the Fed Funds rate to 5.25%. This is the fastest the Fed has raised interest rates since the cigar-chomping Paul Volcker took over as Chairman in August 1979 and raised rates from 11 to 20% in nine months. The U.S. went into a brutal recession and he didn’t give a fuck because inflation was out of control.
Since WWII that’s been the formula: the economy gets hot, inflation gets too high, then the Fed raises interest rates to cool it back down. People lose jobs, companies innovate less, but that’s a lot better than everyone losing 10% of their savings every year. Then a few years later we’re back to champagne and cocaine until we’re all sweating and don’t even realize it.
💡 When the Fed Funds rate goes up, inflation should come down. Because as the Fed charges banks more, it becomes more expensive for everyone to borrow. That makes people less likely to spend and invest, and makes it tougher for businesses to finance new projects. It would also help if the Fed stopped printing trillions of dollars, but that’s a different talk show.
Current chairman Jerome Powell has been clear: inflation hurts everyone, so he’ll do what’s necessary to stop it. Does anyone else smell smoke?
So far he’s cranked up interest rates to a steamy 5.25% to fight off the dragon of that is inflation. Europe is battling a 10% chimera of its own. But Japan? Their inflation is sitting at a cool 1.6%, and they’re nervously sipping tea while the world burns.
Why the cold feet, Japan?
In a world where growth is still blazing hot, Japan seems to be thawing from an economic ice age.
Sure a 6% inflation rate is bad, but Japan’s frosty 1.6% inflation rate isn’t necessarily a good thing. Conventional wisdom says that a 2% inflation rate is generally healthy to encourage consumers to move money around, which is basically the definition of a “good” economy.
Japan hasn’t had an inflation problem the asset pricing bubble in the late 1980s. Since then, the economy has performed worse than the Cleveland Browns.
The Yield Curve Control Policy
Japan's monetary policy, known as Yield Curve Control (YCC), has been in place since 2016. It's important to note that this policy is an experiment, as no other major central bank has tried it before or since. Japan’s economy was just that bad.
Under the YCC policy, the BoJ sets a target level for the yield on 10-year government bonds at 0%. The BoJ achieves this by purchasing their own bonds in the secondary market to maintain the target level. If the yield gets too high, it'll buy more. If the yield begins to fall below the target level, they sell them to push the yield up.
By committing to keep 10-year bond yields at 0%, even if inflation rises, the BOJ signals that it will continue to keep borrowing costs low in the future, which should, theoretically, raise expectations of future inflation and thereby stimulate spending today.
Also part of this policy is that the short-term interest rate is set at -0.1%, letting banks borrow for free and actually charging them if they don’t spend it. And they’re still not spending it!
This is to stimulate economic growth, or face a more familiar enemy of Japan: deflation. This chart looks bizarre, especially when contrasted with the U.S.
Adding to the drama is that the BOJ just appointed a new governor Kazuo Ueda. The fresh 71-year-old governor will need to decide whether or not to remove their economy from life support.
After the central bank's first meeting he decided to maintain the YCC policy, hoping the economy continue to heat up over time. In typical government fashion he said they'd do a review of his predecessor's monetary policy and circle back in a year or two, but they could also act sooner, too.
"While trend inflation is gradually heightening, it will take some time to achieve our inflation target.” [...] The risk of missing our price target with premature monetary tightening is bigger than the risk of experiencing inflation exceeding 2% due to a delayed tightening. The cost of waiting for trend inflation to heighten is low," he said.
The Rising Tsunami
As America sweats under the heat of high interest rates and rampant inflation, the thought of Japan stoking its own economic furnace might seem like a welcome thought. But don't trade your fire extinguisher for a snow shovel just yet. If the BoJ were to reverse the YCC policy, it could trigger a tsunami that could wash over global markets.
Why the concern, you might ask? Isn't that the central banking equivalent of your neighbor melting some snow? Not exactly, because Japan's stock market is no small iceberg. It's more like an entire arctic shelf, and it's been frozen for a long ass time.
Consider this: the Bank of Japan raises interest rates. Suddenly, those Japanese bonds start looking cold in a good way, like a cold beer during an economic heat wave. Investors, drawn by the promise of better returns, rush in. Just recently Warren Buffet upped his stake in Japanese five trading houses.
Here's where the tsunami warning comes in. Japan's economy is so massive, and its stock market so integral to the global financial ecosystem, that a sudden shift could send shockwaves through global markets.
💡 A stronger yen means that Japanese goods become more expensive for foreign buyers. At the same time, foreign goods become cheaper for Japanese consumers, most likely leading to an increase in imports.
That would mean the Fed, already trying to douse our inflation inferno, would also have to contend with a wave of capital outflow. The result would be a soggy, steamy mess - and perhaps the recession everyone has been talking about.
So, as we continue to monitor the temperature of global economies, keep one eye on Japan. Because some day the ice will melt, and the resulting wave could reach all the way to our shores. Until then, stay tuned for the next thrilling chapter in the ongoing saga of the world's central banks.