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How The Bank Of Japan Blew Up Capital Markets...
It’s here. In this piece, we uncover: The Power of The BoJ Now, for those of you who may not understand why I would choose to write on this particular central bank; you need to read this. The Bank of Japan single-handedly plays one of the most crucial roles within capital markets globally, and that starts within the bond market. Japan is the single largest holder of U.S debt in the world, holding roughly 17% of all U.S treasury bonds available, now let me put that into context for you. The U.S treasury market is roughly a $11.2 trillion dollar market place; so owning just under 1/5th of that market shows how important the Bank of Japan is to the U.S market. Let’s take it a bit further and expand on how crucial the Bank of Japan is to both the U.S & global asset markets. Up until now, many of you, including me at a point, believed that U.S treasury yields were priced and dictated by the Federal Reserve’s monetary policy stance and major economic data released from the U.S. That’s not the full picture, the world of U.S treasuries revolves not only on U.S economic data and the Fed but on the large holders such as Japan and China who collectively own just under a 1/3 of the treasury market. If the treasury market was only impacted by the Federal Reserve and U.S data, we would have experienced much higher yields within the U.S as inflation took off throughout the year peaking at 9.1% in June. Effectively, what I’m saying is the Bank of Japan has indirectly capped U.S treasury yields through its lose monetary policy program. Here’s why. Yield Curve Control & Low Rates In 2016 the Bank of Japan initiated a policy known as Yield Curve Control , (YCC), this was implemented to keep borrowing costs at all-time lows in order to prop up an inflation-starved economy. If you’re thinking what is yield curve control here’s an explanation: Yield curve control is the process where a central bank of a country aims to control both short-term and long-term policy interest rates. This creates a framework where the central bank can effectively cap borrowing costs regardless of what shape the economy is in, in order to stimulate inflation within the economy. Japan’s Flaw… Inflation has been a massive problem for the central bankers in Japan as factors such as; a low fertility rate, ageing working demographic and due to the expansionary policy of the Bank of Japan, interest rates have been extremely low. Leading to a continuous outflow of capital to the United States and other countries. Private households, pension funds, life insurance companies and many other institutions have bought US government bonds and U.S assets further decreasing the demand for the Yen. Here’s how the Bank of Japan has indirectly capped U.S treasury yields. Through yield curve control the BoJ has capped 10y JGB’s (Japanese Government Bonds) at 0.25%. If JGB yields are pinned at 0.25% then Japanese investors are forced to seek yield overseas by purchasing U.S bonds as one of the only alternatives to realising positive gains on their investments. Through this process of Japanese investors looking overseas, particularly within the U.S for investments, the yield of U.S debt is less influenced by the factors mentioned above but is now simply perceived as a sound store of capital compared to domestic markets in Japan yielding close to nothing. Let’s play the other hand. What would happen if the BoJ were to move away from yield curve control? Absolute chaos, put it this way. U.S treasuries and global yields/credit spreads would be through the roof, cost of capital would be even more elevated meaning the S&P500 and Nasdaq especially would be hammered to the ground. The main reasons are, tech stocks survive off of low borrowing costs and most importantly higher yields mean tech stocks’ earnings in the future are worth less today. Dollar Yen, Pushed To The Limit? It’s safe to say we know the Bank of Japan has got deep pockets, but this depreciation in the Yen must hurt them, right? YTD the Yen has lost close to 25%, as investors have shifted their focus toward the ever-widening interest rate differential between the BoJ and the Fed among other central banks also on the tightening cycle. If you are a central bank or a large financial institution, say a pension fund or asset management firm and you have FX exposure on your books, the last place you would want to hold that would be in a currency like the Yen where your yield is 0.1%. So for the market participants seeing the purchasing power of the Yen slide uncontrollably, you would probably bet on the Bank of Japan being forced to hike rates and abandon YCC, right? Not so easy. Earlier in May this year, hedge funds had bet that the Bank of Japan would be forced to hike rates and even move away from YCC. Take a look at the yellow region highlighted to the right. Traders began shorting JBG’s in hopes that rates would increase causing the price of existing bonds to decline in value. This trade was met with full force as the Bank of Japan purchased a record amount of JGBs in order to defend its yield curve control and monetary policy stance. This trade is heavily referenced as the widow maker because that’s what the BoJ turned those funds into. Of recent, we saw the BoJ intervene to stop the yen slide after the central bank kept its rates low, abiding by its dovish policy; this intervention was the first in 24 years for the bank where the BoJ sold dollars to purchase Yen. The question one has to ask is, how much suffering until the BoJ is forced to pivot? As the only central bank in the world to have rates extremely low, the exchange makes imports of goods costlier for the nation. What a week, thanks for your attention all the way till now! Hope you’ve enjoyed the articles released this week. Always love to hear from you guys; I’ve got some cool things warming up for the MMH community — just give me some time. Share it! Post it! It’s free to do so! Twitter - @JoeOlashugba Instagram - @Joe.olashugba Until next time, Joe
Sep 30, 2022 · 6 min read
Pounded: Did Someone Say Parity?
Alright, before we start I know what you’re going to say. Where’s the piece on the Bank of Japan? The plan was to deliver that piece yesterday but after an eventful Friday evening and start to the week for the pound, something we haven’t seen in over 50 years , I had to make an exception! BoJ piece will be released on Friday, look out for it. Now, back to it: Is It The “Mini-Budget” Or Uk’s Macro Climate? This is the question on most investors’ and traders’ minds. What is the root cause of this crash in the pound? Now, if you’ve been living under a rock the past few days, let me quickly recap what has been going on within the Uk. On Friday 23rd September Kwasi Kwarteng, Britain’s new Chancellor announced his growth plan, which consists of the biggest tax cut in 50 years . The last time the Uk saw a tax cut of such significant size we were in the 1970s inflation period, where the annual inflation rate averaged 12% on a calendar year basis. An inflation figure we will most likely see this fall if economic conditions continue in their current trajectory. Now, the markets’ reaction to this “mini-budget” was nothing short of dreadful. Immediately after the plans were announced there was an immediate withdrawal of capital from the Uk. Earlier this week, the pound touched as low as $1.03 , and gilts also took historical losses as investors weighed away from any assets associated with the Uk; the factor being investors believing that the new growth plan will only add fuel to the inflation fire, which is currently sitting at 9.9% . Not only are investors weighing on the risk of further elevated inflation figures but also the new ‘mini-budget is set to push borrowing to unsustainable levels. Chart 1 shows the market’s verdict on the government’s fiscal plans, and it’s not a positive one at all. During the trading hours on Monday Andrew Bailey, Governor of the Bank of England delivered a statement that many believed was going to be an emergency rate hike to prop up the pound, however, Bailey shut down all bets that we would see an emergency rate hike saying: Feel like I’m watching Jay Powell’s ‘transitory’ speech all over again… Gilts losses, Government Deficits and Quantitative Tightening If you’re still scratching your head trying to figure out whether this destruction in UK markets is because of the mini-budget or the current macro picture let me put your mind to rest. All that has happened since Friday is a massive acceleration in the downwards direction of where the Uk’s economy was already headed. Let me explain. Prior to the mini-budget, the Office for Budget Responsibility (OBR) forecasted that borrowing would be on a steady decline from 2024 onwards; dropping from roughly 84% of national income to just above 80% , a mere 3-4%. After the mini-budget, we can now expect that number to rise an astounding 10% to 94% of national income. Keep the above chart in mind. Now, when looking at data what’s most important isn’t so much the current data point we are seeing, in this case, the yield, it’s the rate of change over a period of time which tells us more about how an economy is shaping up. The chart below will realise this for you. This should set in stone what is happening within the Uk. Just over a month ago, 10y-gilts (government bonds) were yielding just over 2.61% on an annual basis, rewind six months back and you were receiving only 1.68% on an annual basis. Now, 10y-gilts are yielding up to 4.7%! You may be thinking, what effect will this have on the economy? In essence, the realisation that the supply of debt that will have to be sold by the government outweighs the current demand within the market is what has led markets to plunge. This causes investors to flee Uk debt markets and the currency as a whole. Ray Dalio said it best: As it stands sterling has gained some upside pulling back into the $1.07 mark against the dollar; with the current array of factors at hand within the Uk it is hard to see the pound moving any higher than it is right now. Short bets are looming over the currency with hedge funds applying pressure to benefit from the demise. Such an event only makes the dollar even more of an attractive alternative and investment to the pound, equities, crypto/ alt investment. In the past month alone the dollar ETF is up 5.25%! This has more to do with key commodities/assets being priced in dollars, so the repatriation of assets/currency results in dollar demand rather than the actual economic condition of the U.S. At the end of the day, the saying remains, dollar is King! Hey, thanks for reading all the way until the end, I appreciate each one of you guys/girls — we’re experiencing some serious growth within the MMH community so expect some exciting things ahead from me to you! As always, share, subscribe and send me a message so I know your thoughts/feedback, this is our platform. Twitter - @JoeOlashugba Instagram - @Joe.olashugba Until next time, Joe
Sep 28, 2022 · 6 min read
The "Super Bowl" Central Bank Week
Firstly, what a week, right? Let’s dive into the meat, and as usual, lend me your attention from here onwards. Successive 75bps Hikes, Enough To Solve Inflation? It’s set in stone, if you were anticipating a Fed Pivot, i.e a diversion from their aggressive monetary policy stance, you can say goodbye to that dream. Rates are up 75bs to 3.25% in the U.S , and it’s about to get hotter. Let’s dissect the newly released Summary of Economic Projections (SEP) from the Fed. Now, what’s the first thing you notice when comparing some of the projections to the previous June release? It’s the change in expectations for real GDP growth this year and in 2023. Initially, in June ‘22 the Fed projected real GDP growth to be at 1.7% whereas projections now are showing revisions for real GDP growth to be subdued at 0.2% a whole (1.5%) cut! Fed Jay Powell pointed toward “high-interest rates” as the reason we’re seeing such low revisions for economic growth. The question is, how did markets perceive the initial release and what is the market pricing for the future? To answer that, let’s take another look at the Federal funds rate projections vs the June figures. What markets instantly would have seen is that now interest rates in the U.S are expected to rise higher than previous projections and stay elevated/ in restrictive territory for a longer period of time. And if you’re judging how restrictive rates will be, the neutral rate is 2.50%, and we’re expected to see interest rates climb 200bps above neutral rates. That just goes to show how serious the Fed is about getting to its inflation target. You might be thinking, why does that matter? Here’s why. What affects the wider scale economy isn’t just what interest rates are, whether restrictive or accommodative, it is the duration , the length of time financial conditions are either loose or tight . So, if we experience a tightening in financial conditions only up until mid-2024, a shorter time window as seen in the June SEP revision, you would expect asset markets to take a relatively small downturn as seen, in anticipation that the Fed will have to pivot from their aggressive stance at some point to support the economy, eventually boosting risk assets once again. However, what we’re seeing now with the recent SEP revision, is that the Fed will now maintain a tightly restrictive monetary policy for much longer with rates expected to reach highs of up to 4.75% as shown in the dot plot below. The main point, I want you to take away from this dot plot which simply shows all 19 FOMC member’s projections of interest rates for the years 2022 - 2025, is the level at which members expect rates to be in order to get inflation under control. That being between 4.50% and 5.00% by 2023 vs the June expectation of 3.50% and 4.25% by 2023. That shift only signals more hawkish behaviour from the Fed and further pain for stocks, crypto, EM & G-7 currency valuations which have already taken a hit YTD. In short, I think the Fed has made the correct step in its monetary policy stance which is to bring back inflation to 2% , through successive rate hikes and balance sheet reductions (something we’ll look at later). My central focus will be on how equities price in tighter financial conditions for longer as well as how leading economic indicators will react. Bank Of England Join The Party: 50bps Very similar to what we have going on in the U.S; the BoE stepped up its interest rate expectations after raising its base rate to 2.50% from 1.75% on Thursday . I must say, the narrative in the Uk in regard to where we are headed as a nation is a forever dwindling picture. Amidst all of the rate hikes, cost of living remains the biggest soreness within the economy. A testimony to the current weakness is the rate at which the BoE stepped up interest rates. Remember, at the end of the day what really matters most to central banks, is their credibility . Now onto an even bigger focal point, when assessing the relative strength of a currency relative to the G-7 basket one of the first things you would look at would be the IRD (interest rate differentials). With the Fed recently hiking rates by 75bps, the ECB by 75bps and even the SNB (Swiss National Bank) hiking rates by 75bps , you have to ask. How is the strength of the UK’s economy perceived by the world against other major economies? Especially when the BoE is only able to deliver a 50bps hike unlike its G7 counterparts. Yes, you may be thinking we are ahead on the hiking cycle, having a positive rate differential vs ECB & SNB, but the important factor at play is the ‘rate of change’ and monetary policy stance. Even though rates may be higher in the Uk economy, if the future economic picture is looking weaker, that will translate through to monetary policy conditions materially softening resulting in lower rate hike increases like the one we just saw. That is the ebb and flow of where the Uk is positioned. I know we saw some really interesting action from the BoJ this week as they intervened to stop the Yen from sliding! I will save that for a detailed piece coming out on Tuesday; as for now - thanks for reading and supporting as always. I’m getting heavily active on Twitter and Instagram for Macro-related purposes so be sure to give me a follow and connect! Appreciate the feedback and the love you guys show Twitter - @JoeOlashugba Instagram - @Joe.olashugba Until next time. MMH
Sep 23, 2022 · 5 min read
Strap In, The Fed Is Coming.
What’s going on guys? Had a slight issue publishing on Friday, but back to the usual schedule going forward! Lend me your attention for the next few minutes. In what is set out to be a heavy week of economic releases, particularly rate decisions from the big central banks, the Fed, BoE & BoJ, we look at the most recent CPI release and what that means for markets. CPI Overshoots To 8.3% YoY Yes, it’s the topic of the conversation once again! CPI in the U.S beat forecasts of 8.1%, finding some resting ground at 8.3%. Increases in the shelter, food , and medicare indexes were the largest of many contributors that pushed the CPI readings higher. Luckily, a 10.6% decline in the gasoline index offset the majority of the shelter and food-related increases. The Weighting of Shelter Within CPI In case you didn’t know, out of all the categories that combine to form the CPI reading, the weighted shelter takes up roughly 32% of the CPI print! That’s just under 1/3 of the whole reading, and from observing Chart 1 below we can see the sharp increase from July to August when the shelter CPI reading rose the most since 1991! Commodities Shortage Effect on The Housing Market Now, from as early as 2021, post Covid-19 recessions and amidst several global lockdowns in major commodity/goods exporting countries we saw U.S home buildings drop drastically and a surge in the number of construction backlogs due to shortages. Both on the commodity front foot and also on the transportation side where there was a clear reluctance within the U.S workforce. Particularly in the transportation of goods (truck drivers). Now, I am not pointing to this alone as the main contributor to elevated home prices but if we lay out the facts I’m sure you will see why there’s a direct link. During the wake of the Covid crisis, lumber prices, copper prices, aluminium and all construction-related materials were extremely expensive to attain, (as shown in Chart 2). What is the direct effect of elevated commodity prices? Simple, delays and cancellations of new residential construction and commercial developments . So, the delays in construction projects only did one thing to the available supply/demand distribution; this lowered an already scarce housing market even further to the point where new home buyers’ demands couldn’t be met so home prices elevated to levels not seen in decades. To put this into context, the home price to median household income index shows the average cost of a house in the U.S relative to the households’ income. Historically, an average house in the U.S. cost around 5 times the yearly household income. During the housing bubble of 2006, the ratio exceeded 7 - meaning that for a single household, it cost more than 7 times the average annual U.S household income. Pretty scary to see levels in the U.S above 2006 records by a country mile… Bear in mind this ratio is heavily affected by interest rates within the economy; as a result when borrowing rates are relatively accommodative/cheap the demand and cost of homes increase due to the pent-up demand to purchase at low rates. As rates increase and yields on the U.S 10y & 30y increase, (the rate majority borrowing costs derive from), the affordability of homes decreases and so does the home price index. Fed Rate Decision With inflation still elevated despite hopes that we will see a decline following July’s stagnation, asset markets, in particular, the Nasdaq had a horrific close to the week. Close to 6% wiped off tech stocks; I think it’s safe to say the equity bulls are back to hibernation until further notice. Looking forward, the market is expecting to see either a 75bps or a 100bps hike this week, I see a 40% chance the Fed do a supersized 100bps hike ; if you recall my previous note on CPI’s effect on rates, you would remember me specifically noting that if we see inflation come in above expectations we will see yield curve inversions between 2s&10s deepen further. If you didn’t get to read the note I’ve quoted my comments below for you. For those who aren’t familiar with what an inversion in bond yields means, I’ve linked a previous note on the importance yields play within the economy. Short-end yield curves are pricing in interest rates to peak at 4% in the U.S; so this is a forward look at investors’ expectations of the Fed hiking cycle. As the Fed has said, the unfolding of economic releases will reveal to what extent they will have to hike until inflation is under control; that’s a long-winded journey for both the Fed and market participants. I recently caught up with a friend of mine who specialises in EM (emerging markets) and heard how bad some of these EM funds are down due to interest rate hikes. Instantly this put in perspective the ripple effect that this hiking cycle will have across every single market both developed and emerging. Countries like Sri Lanka recently defaulted early in May ‘22 for the first time in history ; the reason rates play a crucial impact on EM countries is because a stronger dollar makes it more expensive to service debt repayments/infrastructure expenditure and usually triggers capital outflows as investors can now attain modest returns at lower levels of risk holding deposits in the U.S. We won’t dive into EM, but that’s just a touch on the depth and weight the Fed interest decision has on the markets. As always appreciate you for reading. Don’t just stop there, make sure to share this, doesn’t cost anything but means everything & subscribe if you haven’t already! We’ll be back on Friday covering the rate decisions & a look into the BoJ Joe
Sep 19, 2022 · 6 min read
U.S Inflation vs Markets Expectations...
Risk-On Suggests Weaker CPI Figure? If you’re like me, you were probably wondering what on Earth were the markets so excited about yesterday, and for equities the past week? Lend me your attention for a few minutes… Why the optimism in markets you may ask? If we recall inflation within the U.S, up until this point, we can see it has been a very steady rise across the board; we saw a peak in June followed by the first sign of a slowdown in July. This was mainly attributed to the slowdown in inflation across energy prices only rising 32% vs 41% YoY in June , with gasoline seeing a slowdown to 44% from June highs of 59.9% . So now, back to the question. Why the positive shift in markets? Let’s look at this from an investor’s point of view; if inflation is cooling down what does that have direct implications on? The Federal Reserve interest rate decision . More importantly, the level of how aggressive the Fed will be when it comes to tackling inflation, as we heard from the Jackson Hole event a 75bps hike isn’t off the table, in-fact, its back on with greater probability. Since July ‘22 the Fed removed forward guidance acting on a “meeting by meeting basis”. Which, if you would like that translated means, “things might get even more out of hand, so let’s just save ourselves and play it by ear”. Pretty accurate if you ask me. So, the removal of forward guidance means one thing to the market, increased volatility surrounding such economic releases and today’s CPI release will finalise what Fed we will see at the September Fed decision. Now, as you already know, the bond market is a great forward looking indicator into the mind of investors and where they see either near term or long term rates going. Here we have the 1 year treasury bond which has priced interest rates to be at 3.6% in 12-months time. How may this and other debt instruments be affected by tomorrow’s figure? Simple, if we see CPI come in below, which is what the market has already priced in, then we can expect the short end of the yield curve to remain relatively stable/potentially decrease allowing the yield curve to move away from an inversion or a curve flattener. Simply pricing in less hawkish central bank action at following meetings. Now if CPI surprises us to the upside, well, just expect to see the 2s & 10s inversion deepen even more and long end yield curves to take a decline pricing in the aftermath of a deep recession. Notice how yields are pricing themselves ahead of the release. What trade could come off this? Good question, we’ll visit some ideas on Friday! A Cold Winter For Europe What exactly do you do when 40% of your energy consumption comes from one country? You make peace with the Russian’s and come to an agreement; there’s no other way this ends. Figure 5 just puts into perspective how deep in the well Europe is with it’s reliance on Russia for crucial commodities of natural gas and oil. Now, although Europe will bear the brunt of the energy crisis you have to remember that Europe was Russia’s top trade partner before restricting and eventually cutting off Nord Stream 1. Figure 6 shows you to what extend Europe & Russia were engaged. Nearly ¾ of Russia’s total gas exports last year went directly to Europe. Of recent we have seen China & India become particularly close with Putin; trade agreement talks and China receiving more of Russian LNG & gas has been Putin’s execution plan to tighten trade strength with the non-westerners. As the situation evolves, there will be more to analyse and depict but for now a short view on Eur/Usd remains predominantly my bias for the near to long term. Thanks for lending your attention to me! Don’t just stop there, make sure to share & subscribe if you haven’t already! We’ll be back on Friday with a detailed piece — Look forward to it Joe
Sep 13, 2022 · 4 min read