IN-DEPTH: TRANSCRIPTION - LONGWave - 08-07-24 - AUGUST – The Japanese Carry Trade
SLIDE DECK
TRANSCRIPTION
SLIDE 2
Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussions purposes ONLY.
Always consult a professional financial advisor before making any investment decisions.
SLIDE 3 – COVER
For those following our weekly newsletter you well know we have been on a number of market themes for awhile now.
FIRST is the economic reporting from the Bureau of Labor Statistics or simply the BLS has become in our opinion nothing more than a vehicle for political manipulation and distortions in the Labor markets seriously hiding the rapidly decaying US Economic situation. This became highly blatant as we continuously reported examples since the beginning of the year.
Then on Friday the Labor report abruptly “came clean” for some calculated reason and through the markets into a panic convincing everyone the Fed was now 100 bps behind the curve.
SECONDLY, the critical importance of the Japanese Carry Trade in its support of US Treasury Bond Demand as China and other countries have stopped buying US Treasuries. Last weekend we continued in talking about the problem in two sections of our weekly newsletter entitled:
- “A LOOMING JAPANESE FIRESALE OF US TREASURIES?” … and the
- “BOJ RAISES RATES & REDUCES JGB BUYING”
SLIDE 4
This Monday morning as we sit down to put together the August LONGWave video we suddenly find the world in the throes of a full scale scare, bordering on panic in Japan and certainly forcing massive margin covering and global portfolio movements - all apparently stemming from the destabilizing shock of Friday’s Labor Report.
Who would have known – right?
Therefore it seemed appropriate to once again talk about Japan, the Japanese Carry Trade and what it is likely to mean to US consumers going forward.
As such I want to discuss the subjects outlined here.
SLIDE 5
I think the balanced thinking of Bloomberg’s John Authers perception of the opening drama in the Tokyo markets is a good way of beginning as he best thinks of it as chaos theory at work. To quote him:
“A butterfly flapping its wings in Wall Street (with some help from Warren Buffett, the Federal Reserve, and innumerable retail investors) has created a Tokyo typhoon (or morphed into a giant, markets-destroying Mothra, if you’re a fan of Japanese monster classics)”.
To explain why, he suggests – and again I quote him:
“We must start with the expectations embedded before prices started to churn. The July survey of global fund managers produced by Bank of America Corp. showed high confidence in a soft landing for the global economy (expected by 68%). The chance of a hard landing was put at only 11%, although this did represent a rise from earlier in the year.”
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For financial assets, that confidence in a soft landing created the risk of a hard one for prices which now seems to be happening. While the consensus was running on the notion that any slowdown would be a gentle one, the idea of an economic weakening was taking hold. The proportion expecting a strong US economy in the next 12 months dropped to a seven-month low.
SLIDE 7
Meanwhile, US data have been disappointing prior expectations for a few months - a trend that reached its worst early in July. Shown here is the widely followed economic surprise index, maintained by Citi.
SLIDE 8
Two weeks ago we detected the early shift in attitude towards “no recession” in its belief that we would face a hard landing in the following fashion as shown here.
The market was indicating an increasing shift to a potential "Soft Landing" scenario from a "No Landing" growth scenario. The US shift is confirmed by key measures shown in the dotted box.
We wrote:
It’s increasingly hard to see the recipe for cyclical reacceleration with China export focused and domestically slowing, peak US capex, slowing consumer spending, still high real rates, slowing fiscal impulses and a global uncertainty into the back half of the year due to US election.
The likelihood of a soft landing for the economy and preserving US economic exceptionalism would be considerably higher if the Fed were not encumbered by:
- An outdated inflation target,
- An ill-suited monetary policy framework, and
- An overly data-dependent mindset.
SLIDE 9
Instead, the probability is only in the 50% range in my assessment. And that is not a sufficiently comforting level, especially given:
- High debt,
- Worsening inequality and
- The range of non-economic uncertainties facing the US and global economies.
Q2 GDP and June income confirm 2.5% real growth with 3% inflation, making a 5.3% Federal funds rate too high -- 4.3% is the right number – a 100 points lower.
The Markets knew it, the Fed knew it, and Powell should have signaled this in last week’s FOMC meeting (with caveats of course) – but he didn’t!
Critical to Powell has been whether enough cracks in the economy are evident to suggest accelerating the pace of cuts.
- New home construction is cracking, often the coal-mine canary presaging recession.
- Real discretionary consumer spending remains on track (the savings overhang continues – an inflationary warning for 2025).
- A greater reason for lowering policy rates -- the structural problems with US growth.
Even the flows were signaling this as shown here!
SLIDE 10 RECESSION
Everything has been screaming that the market was completely offside on its”No Recession” belief – except the BLS’s data reports.
Remember and I have written about this - Markets always make the biggest corrections when everyone suddenly discovers a widely accepted core belief is in fact wrong!
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Our data which we laid out in our bi-weekly market perspectives report showed a clear picture that we were fairly assured of having a US recession within the next 12 months. However, the magnitude of recession was still in question.
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We personally believe it will be a hard landing in 2025 as the ~7T "sugar high" ends and the hard reality of the dire situation of the US and global economies is fully realized with Geo-Political tensions, trade tariffs and social unrest compounding an already tenuous situation.
With the yield curve steepening it was signaling the strong probability that the recession in fact may have already begun?
SLIDE 13
In June the Retail Sales indicated NEGATIVE 0.68% Y-o-Y NOMINAL growth – not real growth substantially lower with inflation better than 3%.
In the past. Retail sales trended sideways preceding a Recession which we were witnessing but this time seemed to be a particularly long time as we witnessed savings rates and balances plummet, credit debt rise with delinquencies and repossessions increasing.
In a nearly 70% consumption economy this is a potential a very serious problem - all supporting our hard landing scenario.
Especially with a tariff war with China looming – irrelevant of who won the US election.
SLIDE 14
When we examined relative total returns of equities versus bonds on a log basis, then overlaid historic unemployment levels, it was increasingly clear that the manipulation of the US labor numbers was a ticking time bomb.
We wrote that an unemployment rate increase of only marginally higher to 4.2 from 4.1 could be a triggering event?
SLIDE 15
Global PMI’s along with ISM reports continued to deteriorate while Dr Copper supported the fact we definitely had a global economic slowing as the massive fiscal impulses subsided and inflation fighting interest rates levels finally began to take their toll.
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We are strong believers that Credit always leads the markets. As such our credit measures were further confirming our findings.
Our High Yield measures showed and likely August completion of a corrective consolidate before prices began falling and spread starting to rise.
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The last time CCC/B diverged shown on the left was the dot-com warning.
High yield credit has not been confirming the rally in stocks. It is warning there are problems in the underlying credit world.
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The evidence was pretty overwhelming but still not sufficient considering the amount of liquidity sloshing around in the system.
It needed a triggering event.
We got it on Friday with the Labor Report
SLIDE 19
With investors conscious that the US economy was slowing, but still retaining their confidence, Friday’s employment numbers hit. Non-farm payrolls only grew by slightly more than 100,000, and the unemployment rate rose to 4.3% from 4.1.
The numbers came as a surprise to the markets – similar to Joe Biden in his debate with Trump when everyone suddenly realized the mental state he was actually in.
The markets reacted in a similar fashion to how the Democratic Party reacted when the spotlight was focused on the reality of the situation. Action was required!
What might have been mediocre numbers in another context instead came over as just obviously terrible, shocking everyone’s false expectations.
SLIDE 20
If there’s one reason why the numbers were unwelcome, it’s because the rise in the unemployment rate triggered the Sahm Rule – which we have also been writing about.
Sahm herself is on record suggesting that in the bizarre post-pandemic conditions, it’s possible that her rule — which is based on how fast the unemployment rate is increasing, even if from a low base — may give a false positive this time.
Both the inverted yield curve in the bond market and the leading economic indicators compiled by the Conference Board, normally two close-to-fool proof recession indicators, have been screaming for a slowdown for the better part of two years. It still hasn’t happened.
But a new recession warning, just as the Federal Reserve decided to leave interest rates in place even as counterparts were cutting, drove serious alarm.
SLIDE 21
That alarm centers on the Fed. Traders always want lower rates. Sometimes, like now, they’re desperate to avert something terrible. Over the last three months, expectations for cuts had steadily strengthened. Since last Wednesday’s Federal Open Market Committee meeting, the bottom has dropped out of fed funds futures.
Over the next four meetings, they’re pricing 1.5 percentage points of cuts, which implies that the central bank will cut by more than the standard 25 basis points at least twice.
The market suddenly believes the Fed is again (like their Inflation is “Temporary” mistake) behind the curve – again Wall Street thinking is it is likely as much as 100 basis points.
SLIDE 22
The Bond Market is screaming at the Fed - "You are wrong again!"
Friday was the biggest drop in 2Y yield since Dec 2023 (Powell pivot) and the biggest weekly drop since March 2023 (the Silicon Valley Bank collapse). The yield curve has dis-inverted (2s30s now at its steepest since July 2022).
JP MORGAN said publicly what others also felt:
Even if the softening in labor market conditions moderates from here going forward, it would seem the Fed is at least 100bp offsides, probably more. So we now think the FOMC cuts by 50bp at both the September and November meetings, followed by 25bp cuts at every meeting thereafter. From a risk management perspective we think there’s a strong case to act before September 18th. But perhaps Powell doesn’t want to add more noise to what has already been an event-filled summer.
SLIDE 23
Stock market volatility is back, almost topping the levels reached during the regional banking crisis early last year. The alarming developments in Asia can be expected to amplify nerves.
The Fed will not want to admit an error, or risk causing panic, by cutting fed funds before its next scheduled meeting in September, so life looks likely to be tough for a while.
It’s worth making clear for now, however, that payrolls are still expanding, and the trades that have reversed in the last few days had generally looked well overdue for a correction. The concern should be whether such a sudden downdraft will create leveraged losses that could cause a cascade.
SLIDE 24
The foreign exchange currency trade looks the most disquieting, with the popular tactic of borrowing in yen and parking in the Mexican peso suddenly down for the year. As carry trades are often leveraged, this might trigger worse to come.
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And that brings us to Tokyo, where market moves have now gone far beyond a simple correction.
Japan was experiencing significant issues before Fridays US Labor Shock.
SLIDE 26
Friday brought quite a selloff in Tokyo. Monday morning it is delivering an extraordinary sequel. Only last week, the Bank of Japan announced that it would be halving its purchases of bonds.
SLIDE 27
The discontinued policy of Yield Curve Control, which had latterly kept the 10-year JGB yield below 1%, was well and truly over. Yet since the market opened Friday, we’ve witnessed the biggest two-day fall in JGB yields this century.
SLIDE 28
To demonstrate how this was sequenced, here is the 10-year JGB yield since the beginning of last week. The three rings are, in order, the BOJ meeting, the Japanese market’s first opportunity to respond to the FOMC meeting, and the first chance to respond to the US unemployment data. This doesn’t mean that the BOJ didn’t contribute to the accident, but it does mean that other forces were at work.
What were those other forces?
Japanese investors love putting their money to work overseas. Combine the extraordinary performance of the US stock market with a historically weakening yen, and the result for Japanese investors is fantastic, even if it does mean that Japanese companies go without needed capital. (One frustrated investment banker complained that at Tokyo road shows, people ask if it’s time to buy Tesla, not Mitsubishi).
This is how FTSE’s index for the world outside Japan has performed in yen terms since the eve of the pandemic.
SLIDE 29
Meanwhile, foreign investors also like borrowing in yen and parking elsewhere via the carry trade. Like Mrs. Watanabe, the mythical Japanese retail investor, these people will be burned, and their actions as they try to minimize the pain could make the situation worse. By liquidating their foreign holdings and bringing money home, they drive the yen up further.
Put all of this together, and at the time of writing, the Nikkei 225 stock index has opened down 7% — meaning that it has shed 20%, the typical definition for a bear market, in barely three weeks. If there was any reason why the Japanese stock market suddenly cracked Friday morning, it’s that the yen had dropped below the psychological barrier of 150 to the dollar.
Dislocations this big is dangerous. When someone takes a big leveraged loss, others must make forced sales in turn. What is happening in Japanese markets now is more to do with events beyond its borders. Norihiro Yamaguchi of Oxford Economics said:
The sudden reversal in yen, driven both by a drop in US yields and the BOJ’s hawkish stance prevailing in its July meeting, is another idiosyncratic factor for Japanese equity. Though domestic fundamentals haven’t changed a lot since a few weeks ago, Japan’s equity market is unlikely to reverse at least till the US market calms.
SLIDE 30
Jesper Koll, who runs the Japan Optimist newsletter, shows that the country is dependent on the US in economic as well as financial terms. It’s become a vital market for Japanese exports.
He writes:
“In global financial markets, all starts and ends with America: As US recession risks rise, the US dollar up-cycle comes to end,” Koll says. “Don’t fight it. Warren Buffet has just raised his cash holdings to an all-time high — he expects to be able to buy cheaper in the future. Japan investors will follow his lead.”
SLIDE 31
The actions of Japan’s investors taking cover from the monstrous US moth above them could cause accidents elsewhere. For example, getting out of carry trades means selling Mexican pesos. Mexico’s exchange rate with the currency of its huge northern neighbor is crucial to its economy. This is what’s happening to it.
SLIDE 32
This is not a case of a butterfly flapping its wings in Tokyo and wreaking drama elsewhere.
Rather, Japan is being hit by the waves caused by butterflies in New York and Washington. The risk of a major financial accident is evident.
Stopping it will depend primarily on what happens next in the US.
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What can we conclude?
SLIDE 34
The Japanese Carry Trade is estimated to be over $20T in size globally with ~$3.5T invested in the US and ~$1.3T in US Treasuries. Japan is by far the largest holder of US debt and its ability to be financed. The Japanese Carry trade also funds the US Shadow Bank borrowers massive US Private Equity financing
The Carry Trade only works with a weak Yen, a strong target currency and an attractive Yield differential between the two countries.
The Yen has been weakening with near Zero Bound rates making it a very attractive Carry.
SLIDE 35
A weak yen has contributed to a strong Nikkei equity market denominated in Yen.
SLIDE 36
However, as Japan fights import Inflation and a consequential wage price spiral it has been forced to strengthen the Yen (as shown here) while dropping its long held Yield Control Policy which had kept rates low and attractive for the Carry Trade.
BOTTOM Line: Will The Japanese Carry be there to supply the debt demand created by an ever increasing US debt pyramid?
Recently the BOJ has actually been selling US Bonds to defend the Yen from falling in their fight against global Inflation washing ashore – a country dependent on imports to sustain its value-add export economy.
The bottom line is that how this is resolved is a BIG DEAL for all American consumers TOTALLY dependent on Credit to sustain their living standards. The Japanese Carry Trade is a pillar of that credit edifice.
SLIDE 37
As I always remind you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
SLIDE 38
I would like take a moment as a reminder
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussions purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2024 turn out to be an outstanding investment year for you and your family?
I sincerely thank you for listening!
