Blain’s Morning Porridge – July 31st 2023: What Japan tweaking rates means for global markets.

“If you understood what I said, then I mis-spoke.”

Japan says it is not tightening? Nope. It “eased” yield curve control which is normalisation by any other name. It will have profound global investment flow consequences. Time to buy a new copy of the Japan Company Handbook and put your buying boots on.

It’s the last day of July. The skies are leaden, and there are a series of storms passing up the channel. So much for sailing at the world famous Cowes Week regatta this week.

Back to markets…

August and September tend to be dangerous months. I reckon that’s because traders and investors expect August to be thin and data driven so they take holidays and reflect on what’s been driving prices. They come back in September (surprised by their foolishness and gullibility), promising to be more considered, better risk takers, and less driven by the madness of crowds and FOMO (Fear of Missing Out – the most powerful financial force in the Galaxy). The result is September (and often October) are the months most prone to financial cyclones and trigger moments like Black Monday and the Fall of Lehman. Hey-ho…

This year, I suspect summer introspection will be particularly thoughtful – there is plenty of “stuff” to figure out in terms of soft-landings, recession risks and rates. All weekend I’ve been getting calls and emails about asking what the noise around The Bank of Japan doing something to interest rates actually means..…. Well, that’s an interesting question. Immediate short-term? Very little.

Long-term? Japan normalising will be critical for global markets.

Perhaps the most famous quote in central banking is from Alan Greenspan (ex-Fed Head back when I was young): “ I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.” Even more succinctly the Greenspan quote book also has: “if I turn out to be particularly clear, you’ve probably misunderstood what I said.”

Kazuo Ueda, Governor of the BOJ gave a masterclass in central bank obstification while not explaining very much last week. He dodged the tightening vs easing question – saying it was about flexibility. Strip out the noise and it’s a key step in the long slow path to Japanese financial and monetary normalisation. I admire Ueda for actually saying something as ridiculous as “enhancing the sustainability of monetary easing rather than tightening” by raising rates and getting away with it.

The reality is the BoJ can say it “didn’t” tighten policy, but that is exactly what it did. It presented a “tweak” to its long-standing Yield Curve Control (YCC) policy by announcing it would allow JGBs (Japan Government Bonds) to trade at higher yields – effectively 1% vs 0.5% last week. Forget the BOJ saying its “not yet ready to tighten monetary policy”! Japan is normalising – and that is a critical opportunity. And on the balance that are global markets and relative value, when one market rises… others have to…. correct.

Why the BoJ subterfuge about what they are doing? They couldn’t really admit the BOJ is tightening rates to address inflation – that would undermine the consensus and the current moves underway to reform and rejuvenate Japanese corporate behaviours and bounce up the stock market. Comments are very measured because Japan is famously about consensus. Market instability as a result of central bank comments would be “undesirable” in a nation that prefers everything to be a little less shouty.

Many Morning Porridge readers will be wondering why it matters the BoJ is normalising. Well.. it does. Japan bond rates have effectively been zero for 3 decades. The BoJ owns 52% of the JGB market – over $4 trillion in dollar terms. (It owns lots more of Japan assets.) As a sidenote, raising rates by 50 basis points, (effectively doubling them), means the BoJ is going to post a spectacular unrealised loss when it announces results in September.

Whatever… the bottom line is that Japan is becoming a relevant investment destination again!

Ultra-low returns, and a stock market left comatose by the excesses of the 1980s, means that for the last 30 years, and particularly since 2012, Japanese investors have pumped trillions of dollars into foreign markets – nearly $3 trillion in last 10-years. Effectively, it’s the last major Western nation where QE monetary distortion is still fuelling speculative stock and bond prices.

The QE monetary distortion era ran from 2010-2021 – designed to boost investment post the Global Financial Crisis. During that time it is estimated that QE purchases by the leading Western Economies pumped some $21 trillion of new money into markets which almost entirely went into global financial assets (stocks and bonds) rather than financing real assets (factories and infrastructure). It created the most massive monetary market distortion of all time, which many market participants still don’t understand or acknowledge. (When challenged I always ask the same question: “Explain to me why the US stock market rose 270% when the economy grew only 40%?”)

Incidently, the reason global central banks printing $21 bln of QE did little to drive inflation is because it all went into financial asset inflation, leaving lots of investors thinking they were investment geniuses because they bot stocks that went up – but only because of financial asset inflation!!! (As a further sidenote – watch what happens if China slashes rates to boost the economy? Don’t be surprised if Chinese corporates go on a massing investment binge into Western financial assets and M&A to garner access to western markets!)

Japan accounted for about $5 trillion of global QE. 60% of that was invested overseas in search of returns. Pulling $3 trillion from stock and bond markets is bound to have an effect. Although it will take time, one of the few things I can guarantee is that when money gets more expensive – speculators become more careful. Japan investors hold over $1 trillion of Uncle Sam IOUs (Treasury Bonds). As Japan starts to strengthen – Japanese stocks looking greater value as the economy ticks up and new policies persuade corporates to create shareholder value… suddenly the whole market is waking up to just how cheap Japan looks. Its already well underway.

As the dollar starts to tumble on relative rates, normalisation will push the yen higher.  The carry-trade of borrowing yen at 0% to invest in US treasuries at 5% takes a tumble if the yen strengthens from 140 to 80 again (as it was just 10-years ago.)

Japan’s economy has its problems – not least demographics – but its effective and could be on the edge of an innovation surge. Consider Toyota. Biggest and perhaps best auto-firm on the planet. I’m told their new battery tech will overturn the current electric vehicle paradigm with new light weight BEVs with fast charging long-range energy dense solid-state tech that will leave Tesla looking like a brontosaurus (and largely solve the motorway charging crisis and range anxiety.)

• Toyota trades on a 13x PE.
• Tesla trades on…. hot air and a PE of 87 times… Just saying.

Toyota is not the only Japanese corporate that’s been quietly getting on with the business of better business over the last decade.

Decisions like which corporate to own, or where the Yen and JGBs go from here will be fascinating. The bottom lines is new money is likely to flow from US and European financial assets into what till look cheap Japanese markets  – and not just Japanese money being repatriated – but new foreign investment. In terms of the balance… it means money that would have been frothing US markets is now going elsewhere..

Five Things To Read This Morning

BBerg                          Niall Ferguson: The Death Of Summer

FT                                Investment flows poised for historic shift after giant leap by Bank of Japan

WSJ                             While everyone fights inflation, China’s deflation fears deepen

Torygraph                    Britain tests “the kindness of strangers” as Gilts lose their lustre

WSJ                             Everyday Investors Are Thriving In a World Awash in Yield

Out of time, and back to the day job..

Bill Blain

Strategist – Shard Capital