“A crook is a crook, and there’s something healthy about his frankness in the matter. But any guy who pretends he is enforcing the law and steals on his authority is a swell snake. The worst type of these punks is the big politician.” – Al Capone
Looking at the US Congress holding a hearing on UFOs, FOMC’s recent 25bps hike and with many financial pundits pushing on the inflation receding narrative, when it came to selecting our title analogy and given our fondness for behavioral psychology (aka Jedi tricks), we decided to go for the “Decoy effect”. The “Decoy effect” can be used to manipulate people into making choices that benefit the decision-maker (politician or central banker) rather than the person making the decision. It is a classic “marketing” tactic to steer people towards certain products or services, and in continuation to our most recent musing about “Overton windows”, this tactic has been used for decades helping shaping “narratives” as well as “consumer behavior” or “elections”. It was first researched in the early 80s. In 1981 Joel Huber, John Payne and Christopher Puto described the phenomenon in a paper that challenged traditional marketing principles such as similarity heuristics and regularity conditions. When choosing between two alternatives, the addition of a third one, less attractive option (the decoy) can influence our perception of the original two choices. This of course plays well into not only our previous analogy related to the Overton window but, as well with our Al Capone’s quote we used as a tongue-in-cheek. Of course, as per 1969 film Z’s disclaimer, any resemblance to actual events, to persons living or dead, is not the result of chance. It is deliberate, but, we are rambling again.
In this conversation we would like to look at the Japanese yen with the gyrations surrounding the tweak in the Yield Curve Control policy and the impact on US yields, Quasi Fiscal Deficit issues in both the US and the United Kingdom. Also, we want to touch on why we do not think that the inflation beast has been vanquished yet and will likely make a return in the second part of the year.
The awakening of Bondzilla (Made in Japan)
In our previous conversation we mentioned the relationship between the US 10 year yield and the USD/JPY. Both have moved in lockstep during the course of 2022 and continued to move in sync in 2023. On our twitter feed for those who follow us we pointed out the growing divergence on the 7th of July when we indicated that more Japanese yen was coming and following the decision of the Bank of Japan, this small bout of strengthening reversed accordingly once the Bank of Japan decision was known:
As pointed out on our Twitter feed by Douglas Orr, CFA, what happens in Japan is paramount:
“JGB yields spike another +5bps to 0.6% => further pressure on US Bonds
=> major source of Global Funding of Carry Trade
=> major source of support/ buying of US Treasuries
Just as US Budget Deficit starts blowing out to Fund $T’s for “Inflation Reduction Act
BOJ – reduces suppression/ YCC of JGB Yields – major source of global funding
10years + of QE/ YCC to boost inflation worked now need to tamp down like all CBs
Seismic Pressure on Carry Trade => higher real yields, risk premia
=> headwinds for Bonds, Banks, REITS & Tech
2012 & 2013 saw QE3-US & Japan QE-Infinity: a major tailwind for REITS & Duration
2023: Global QT competition real yields to rise => expect headwinds ongoing for “reach for yield”, REITS & Duration => not Bullish $NASDAQ”
We discussed in recent musings the dilemma facing Japan relative to its desire to fund a large expansion of its defense budget in our conversation “Tacitus Trap” back in May this year. Japan needs to invest an additional 3% of GDP on top of planned increase just to offset one decade of underspending. As well as we pointed out in our March conversation “The Cheshire Cat”, if the Bank of Japan allows Japanese yield to rise, Japanese investors would most likely repatriate their cash and liquidate their foreign holdings, meaning drawing down on its net foreign assets:
The most recent tweak in the Yield Curve Control by the Bank of Japan has led to global funds selling Japanese debt:
Could that be seen as somewhat as a partial “unwind” of the Yen carry trade so dear to global macro players around the world? We wonder.
We are nonetheless seeing tectonic shifts at play given that pressure on Japanese “repatriation” does not bode well for European Government bond sales as pointed out by Althea Spinozzi from Saxo Bank on our Twitter (X or whatever the name these days):
“More reasons for Japanese investors NOT to buy German Bunds
Japanese investors buying 10-year Bunds would record a loss of -1.46% once hedged against the Yen.”
One thing for sure, Mrs. Watanabe and her double deckers are back into play through Uridashi and Toshin funds:
In October 2011, the reason behind the large depreciation of the Brazilian Real that specific year was because of the great unwind of the Japanese “Double-Decker” funds. These funds bundle high-return assets with high-yielding currencies. “Double Deckers” were insignificant at the end of 2008, but the Japanese being veterans of ultralow interest rates, have recently piled in again we think. Japanese Lifers, but also for retail investors such as Mrs. Watanabe, in the popular Toshin funds (which are foreign currency denominated and as well as Uridashi bonds aka Double Deckers) are significant players in global markets hence our reference to “Bondzilla” being “made in Japan”:
Double-decker products use non-deliverable forward contracts for foreign exchange to leverage returns and pay monthly dividends, catering to Japanese individual investors who want a regular income, such as retirees. The Brazilian real in 2011 had been preferred by Japanese funds to other emerging-market currencies because it’s was more actively traded in the global foreign-exchange market:
Both the Brazilian Real and the Mexican Peso are “outperforming” the US Dollar. As pointed out by our astute friend Geoffrey Fouvry:
“There is no “strength” in the MXN. It’s just the USD falling. Both MXN & BRL doing the same. Also apparent in Soft commodities. MXN vs Soft commodities. There was a spike due to Russian invasion. Other than that? The Common denominator? USD falling / being demonetized in “trade”.” – Geoffrey Fouvry
But, returning to Douglas Orr’s comment relative to a “high beta” plays such as the NASDAQ, we do not think it is bear time yet given that earnings have been more than decent and a softer dollar is helping EPS growth:
No wonder we are still seeing “irrational exuberance” from “mister market”. Sentiment about equities against bonds is the highest it has been in 24 years:
As well in US High Yield, the US CCCs credit canary is having a bumper year in terms of YTD Total return performance:
Those who expect a sell-off coming from credit cracks à la 2008, should continue to enjoy the “bear market rally” pointed out by many pundits.
Both the MOVE index and VIX index have significantly receded:
But, if we take a 5 years view at MOVE index relative to VIX index, it looks like the ongoing issue is more on the “bond side” of things rather than on the “equities side” of things:
Bond volatility in Treasuries has dropped to levels seen last December whereas the VIX, it has reached a level last seen in January 2020.
If you are feeling nervous about the current market set up, then indeed it has never been that cheap to set up some downside protection:
The source of concerns we share with our good friend Geoffrey Fouvry from GraphFinancials comes from growing “Latam woes” when it comes to US “twin deficits”, or when Developed Markets turn into Emerging Market, bond trading wise. As per our previous conversation the United Kingdom is a base case as per our last conversation.
In “Tacitus Trap” back in May this year we commented:
“The United States is facing a QFD situation (Quasi Fiscal Deficit), which is, traditionally as we pointed out in our previous musing an Emerging Market Central Banking disease. Given the rising probability of a US recession in the light of various economic indicators, then to repeat ourselves, the fiscal position of the United States would be expected to deteriorate further as growth weaken and unemployment rises” – Macronomics, May 2023
But returning to US woes in particular and the “Latam” playbook in general, we recommend you dear readers to read John H Welch research paper from the Federal Reserve Bank of Dallas entitled “Hyperinflation, and internal debt repudiation in Argentina and Brazil” published in 1991:
“The consequent increase in internal interest bearing debt further deteriorates the fiscal situation of the government adding inflationary pressure especially in the context of indexed government debt. The higher the inflation rate, it is argued, the lower will be real cash balances and tax receipts (the so-called “Oliveira-Tanzi” effect). Once the (operational) fiscal deficit as a percentage of GDP becomes greater than the maximum attainable with the inflation tax, the government will have to continuously accelerate the rate of money growth and thus push the economy into a hyperinflation.” – John H Welch
As such the United Kingdom situation is worth mentioning given its high issuance of inflation linked bonds as they amount to 25% of UK’s debt:
This is akin to be “short gamma” and any sensible trader absolutely never wants to be “short gamma” and have this kind of negatively convex trade on. As per John Welch, internal interest bearing debt further deteriorates the fiscal situation of the government adding inflationary pressure especially in the context of indexed government debt! Historically, inflation helps governments reduce their debt burden. This time it is having the opposite effect thanks to “linkers”. As a reminder from our last post, many utilities companies such as Thames Water (which is in need of a bailout) issued linkers as well.
As such this is why both Geoffrey and myself believe you need to brush your Latam bond trading playbook when it comes to trading “UK gilts” in the foreseeable future. The interest payments alone on British debt now account for some 10% of government spending (GBP 110 billion). On top of that the Bank of England is negative equity and has estimated that it will require the UK Treasury to transfer a total of £150bn by 2033 to cover expected losses on its bond-buying quantitative easing program, if interest rates follow the path implied by market pricing. For more on the Bank of England losses please read Chris Marsh analysis in his Money Inside and Out post entitled “How big are Bank of England QE losses”.
When it comes to US woes and its twin deficits, we reminded ourselves with what has been recently pointed out by Tavi Costa:
“The US will need to refinance almost half of its national debt in less than 2 years. As a reminder, interest rates were at 0% just 15 months ago.” – Tavi Costa
We pointed out to the work of Geoffrey when it comes to QFD, but, when it comes to “Fiscal Dominance” we read with great interest Charles W. Calomiris paper from the Federal Reserve Bank of Saint Louis entitled “Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements”:
“As the result of the high current US government debt-to-GDP ratio and continuing projected deficits, we face a possible dollar inflation uncertainty nightmare: Continuing deficits, if unchecked, eventually will lead to a fiscal dominance problem. This problem seems likely, given the way Congress has behaved in recent years. A significant rise in long-run real interest rates also seems quite possible, given that the three decades of decline in real interest rates are poorly understood and may reflect temporary demographic influences. Such an environment would hasten the triggering of a fiscal dominance problem, leading to a messy monetization in the US, with ramifications worldwide.
Many things would likely change in a fiscal dominance scenario to make the inflation tax base larger to facilitate the funding of continuing deficits with less of a rise in inflation. Interest on reserves would likely be eliminated—otherwise, monetization would do little to relax the constraint on the government.
Inflation would rise, potentially by a large amount, if that is the only policy used to create inflation taxation. If the elimination of interest on reserves were accompanied by a new large reserve requirement, inflationary consequences could be much lower.
If the bond market does not anticipate a fiscal dominance shock sufficiently far in advance (where the definition of “sufficiently far” is determined by the duration of bonds held by the public), then bond investors would be caught with losses on high-duration bonds. All of these changes imply that the effects on banks and mutual funds and pension funds and others would be potentially quite dramatic.
In the 1970s and 1980s, major financial disintermediation from banks accompanied the rise in inflation taxation because rising inflation reduced the real rate earned on bank deposits. Similar pressures to disintermediate banks could rise again as the result of a rise in inflation taxation. If that occurs, however, banks and their political allies will redouble their efforts to use regulation to protect the banking system from innovation and competition, as they have already been doing (see Calomiris, 2021).
Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness.
What bearing does the most recent debt ceiling agreement have on the prospects for fiscal reform to avert monetization and inflation? The agreement was largely beside the point because it focused on government expenditures that are not related to Medicare, Social Security, or defense spending. Indeed, by doing so, it reinforced the view that there is no appetite for addressing the exploding deficits that are being driven by those categories of spending.” – Charles Calomiris
We have highlighted the part relating to the elimination of interest rates on reserves given that the UK government would save about £1 billion a year if the Bank of England copied the ECB according to Numis analyst Jonathan Pierce as reported by Bloomberg recently. The ECB will stop paying interest on reserves to bank. This surprise move obviously was not well received by Deutsche Bank CFO as reported by Bloomberg. No more free money, $6 billion equivalent that is. This led to some European banks shares falling on the announcement. By lowering the interest rate on minimum reserves held by commercial banks at the ECB from the previous 3.5% to 0%, this is a step to limit central bank losses in the hiking cycle but, as indicated by Charles Calomiris:
“If the government wishes to fund large real deficits, that will be easier to do if the government eliminates the payment of interest on reserves. This potential policy change implies a major shock to the profits of the banking system” – Charles Calomiris
So if indeed the US government wishes to fund ever growing large real deficits, it will have to eliminate payment of interest on reserves. Pay attention to the Saint Louis paper because as well, recently the Federal Reserve’s top regulatory official laid out a sweeping plan to increase capital requirements for the nation’s largest banks in the wake of recent bank failures:
“It is quite possible that a fiscal dominance episode in the US would result in not only the end of the policy of paying interest on reserves, but also a return to requiring banks to hold a large fraction of their deposit liabilities as zero-interest reserves” – Charles Calomiris
As discussed in the aforementioned paper from Saint Louis Fed, imposing high reserve requirements for zero-interest paying reserves may seem quite “attractive for policymakers” interested in reducing inflationary consequences of “fiscal dominance” less so for the banking industry:
“The history of inflation taxation around the world has shown that when governments become strapped for resources, they often use zero-interest reserve requirements to tax banking systems and remove their spending constraints. For example, in Mexico during the 1970s and early 1980s, inflation taxation of banks became increasingly relied on as government expenditures rose; eventually, as fiscal problems mounted, the government expropriated first bank depositors and then bank equity holders by nationalizing the banks (Calomiris and Haber, 2014, Chapter 11). The general problem of impecunious governments taxing banks with the inflation tax, credit controls, or other means—which can have major adverse consequences for efficient capital allocation and growth—is the theme of a very large literature, which goes back at least as far as Gurley and Shaw (1960) and includes such landmark contributions as McKinnon (1973), Fry (1988), and Acharya (2020).
Taxing banks with reserve requirements and zero-interest reserves is convenient for two reasons. First, instead of new taxes enacted by legislation (which may be blocked in the legislature), reserve requirements are a regulatory decision that is generally determined by financial regulators. It can be implemented quickly, assuming that the regulator with the power to change the policy is subject to pressure from fiscal policy. In the case of the US, it is the decision of the Federal Reserve Board whether to require reserves to be held against deposits and whether to pay interest on them.
Second, because many people are unfamiliar with the concept of the inflation tax (especially in a society that has not lived under high inflation), they are not aware that they are actually paying it, which makes it very popular among politicians. If, as I argue below, a policy that would eliminate interest on reserves and require a substantial proportion of deposits to be held as reserves would substantially reduce inflation, then I believe it would be hard for the Federal Reserve Board to resist going along with that policy.” – Charles Calomiris
Of course the banking industry have called the effort “misguided” and added it could “hinder lending”.
On as side note we heard this music before relating to “raising equity” and increasing “capital buffers”:
“More equity… would restrict [banks’] ability to provide loans to the rest of the economy. This reduces growth and has negative effects for all.” Josef Ackermann, CEO of Deutsche Bank (Nov. 20, 2009).
Anat R. Admati a professor of finance and economics at Stanford University is the co-author of “Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive. She debunked extensively the assertion made at the time by the CEO of Deutsche Bank:
Also on another subject given we discussed in our previous conversation the attractiveness of Alibaba (BABA) since our last conversation, the stock’s performance has finally been moving in the right direction for the stock (ETF XLK vs ETF KWEB vs BABA, one year chart):
One month performance chart (ETF XLK vs ETF KWEB vs $BABA):
Our friend Geoffrey has realized an augmented media presentation relating to Alibaba valuation for those who wants to investigate more thoroughly this “value” proposal.
As we repeated again in our conversation “Willful blindness”, those of you who have been great at deciphering our musings over the years know about our “contrarian” stance and the not so subtle “hints” (such as the one we gave on the luxury sector on China re-opening theme back in November last year) we sometimes like to “give”.
Let’s move on to our final point of conversation, namely oil and the inflation beast.
Gamers like ourselves would have fond memories of Nintendo May 1982 Game & Watch release as part of its Multi Screen series called “Oil panic”. In the early 1980s, soft world oil markets were accompanied by two important and unforeseen economic development, which was stagnant economic growth and an appreciating dollar. This experience in conjunction with large shifts in oil inventory holdings by consumers led to excess capacity and increased downwards pressure on oil prices which ended when recession stopped the inflationary trend which started with the oil shock of 1979.
Given we are contrarian as you already know by now, we believe that this time around and that regardless of what some pundits think, war in general and warmongering in particular remains “inflationary”. As such we continue to believe on a downward pressure on the US dollar. As such we think that oil is already showing signs of upwards acceleration (some of the reasons explained above).
In our conversation “Willful blindness”, we indicated that the energy sector was currently being “neglected” flow wise. We told you that for us it was indicative that it is getting cheap and therefore “enticing”:
Regardless of the ESG and the Just Stop Oil crowd, demand is still growing:
We chuckled on this very subject thanks to William Lacey in our Twitter feed:
“An interesting chart looking at Norway and energy consumption. Despite almost 80% of car sales being EV, oil consumption in Norway remains fairly flat. The narrative of shutting in oil has more challenges than the anti-hydrocarbon crowd may wish to acknowledge.” – William Lacey
As such we agree with the recent bullish “Energy” call from fellow blogger “Gordian Knot”. We also remind ourselves of a paper from the Bank of Israel we have quoted on numerous occasions “Oil prices, inflation expectations, and monetary policy”, Bank of Israel DP092015. Since the Great Financial Crisis of 2008, their paper argues that a 10% change in oil prices moves 5Y5Y expected inflation by nearly 0.1% in the US and 0.05% in the Euro area:
Therefore, given the recent significant surge in oil prices and our current views for their trajectory, we think we will get a rise in inflation expectations in that context in the coming quarters. In conclusion the inflation receding narrative “Jedi trick” or “Decoy effect” doesn’t seem to have much impact on our thinking but we are ranting again…
With Geoffrey’s help, we endeavor to touch more on various subjects through GRAPHFINANCIALS:
“Banks employ too much debt, because they know that they will ultimately be bailed out. Governments do exactly the same thing.” – Dr Jochen Felsenheimer