What’s going on MMH gang?

Hope you’re all doing great; welcome back to Market Macro Hub.

Quick announcement: I mentioned in my last piece that I will be transitioning to Substack to provide a better service to you all and be able to communicate with you guys, that’s happening in the next two weeks so you will see my market notes coming from a Substack email instead! You won’t need to do anything, just a heads up ; )

Back to markets:

This week and last week, two major events were on my radar:

Last week Thursday U.S CPI print reaffirmed what markets were thinking and Tuesday just gone the BOJ held rates negative and preserved YCC.

As always, welcome all new & existing subscribers, and lend me your attention from here:

Risk Is Back. Global Deflation And Slow Growth

Figure 1: U.S CPI YoY

Last week, Thursday the 12th, U.S CPI print came in line with expectations at 6.5%, now this is positive news for both the economy and the Federal Reserve. Since June of 2022, the U.S has been in a deflationary period, successive declines in CPI prints, leading up to the 6.5% reading we saw last week. In December’s Fed minutes, we heard a very specific statement from Jay Powell, on where his focus would be looking forward:

  • “Goods inflation” - which is expected to decline as supply chains bottlenecks loosen (China reopening etc)

  • “Housing services” - priced in line with rising inflation but “the rate for new leases is coming down”

  • Non-housing-related core services” - A function of the labour market which is very tight at the minute, wages.

An explanation of what this means:

Non-housing related core services are the stickiest component of the inflation figure because that covers wages and labour related costs which are extremely difficult to bring down once they go up. Unlike goods inflation, which are directly affected by supply chains tightening up or loosening, wage inflation isn’t as malleable, so the only way the Fed is able to bring inflation down even further, particularly the non-housing related services inflation, is to break the labour market driving unemployment higher.

— Joe, Market Macro Hub

Alright, so we know what the Fed’s focus will be on. The labour market and driving unemployment 110bps higher to 4.6% from current levels of 3.5%. This is where it gets interesting, historically, the U.S economy has never been able to withstand a sharp rise in unemployment by 100bps or more and not fall into a recession; so it’s clear what the Fed mandate is, even if they’re not saying it.


I know what you’re probably thinking, if the U.S is clearly headed for a recession, then why the risk on mood in markets?

Good question. Here’s why, investors have priced in short term rates exceeding 4.5% in the upcoming months, shown by the UST yield curve below; but what they didn’t price in was the reopening of the second largest economy in the world and the secondary affects of this, neither the BoJ subduing global yields by not moving away from its monetary policy stance.

Figure 2: UST Curve

China reopening its economy isn’t just good for the resumption of trade and global consumption, on the 13th of Jan 2023, we heard from Governor Xuan Changneng at a press conference:

“We will ensure overall social demand gets powerful support. Meanwhile, the magnitude will be reasonable and appropriate and we will avoid flooding the economy with liquidity,”

Chinese Gov Xuan Changneng

Here’s what the market interpreted that to be.

We will provide additional stimulus and liquidity to markets. Cue the bulls.

We all know what stimulus did to the U.S economy in 2020-21, now we’re going to see China’s economy experience “support” from the PBOC, however, it will not be as extreme as the U.S stimulus package. A Chinese support/stimulus package is one of the things investors wouldn’t have been able to price into markets which is why we’re seeing Chinese equities rebound, and developed equity markets in the green.

This could be conceived as a temporary period where risk appetite has returned to markets. Similar to a phase in markets called Goldilocks, where economic conditions are neither too hot or too cold, steady growth and controlled inflation- a perfect environment to be long risk assets. The only difference here is we are not in goldilocks-like conditions, we’re in a deflationary regime within markets, growth outlook is meek, the most recent December PMI print for the U.S hit the lowest readings since May 2020 and inflation is now declining consistently.

Figure 3: Manufacturing Purchasing Managers' Index (PMI)

The Deflation Trade

This table below shines the light on how financial markets tend to perform during the different market conditions and cycles.

For those who may not know, nominal returns is the return before adjusting for inflation and real returns as you can tell factors in the inflation figure to the reading.

Figure 4: Source: Robeco AM

We can see from the annualised real returns, bonds historically have been the better portfolio allocation for weathering deflationary periods, returning 8.4% net inflation annually, outperforming equities and cash. So bonds would usually be the choice of capital but in this climate I feel as if investors still have appetite for more risk in the immediate time frame of H1 2023.

This leads straight into the recent BoJ policy meeting on Tuesday, where Gov Kuroda decided to leave interest rates unchanged at -0.1% and maintain YCC band on 10Y JGBs at 0.5%. Market participants were expecting Kuroda to fold and abandon the YCC policy. As a result the Yen took a 2% dive overnight see figure 5.

Figure 5: JPY Currency

Bold move not to budge, but I believe Japan at some point will have to abandon the YCC policy or widen the band as Kuroda did last December; that time for me is April 2023 when Gov Kuroda leaves his post as the Governor of the Bank of Japan. When the new BoJ Gov is chosen, I suspect they will be faced with a fork in the road, abandon the outdated YCC policy or hold tight.

As many investors & funds believe, the removal of YCC seems most probable, and has a large scale effect on global bond yields and borrowing costs. Due to the low yield of bonds in Japan, institutional investors invest their capital in foreign bonds listed in the U.S and Europe mainly. Total holdings of foreign bonds by private Japanese institutional investors reached c$3 trillion at their peak in 2022. Japan is the single largest holder of U.S debt holding over $1.23 trillion U.S treasuries, accounting for more than 10% of total U.S debt.

So it’s clearly no exaggeration to say that Japanese flows have a huge significance to global bond yields. Take a look at figure 6 to see the size of bond holdings by Japanese institutional investors.

Figure 6

*OFC = Offshore Financial Centre

Drivers of Japanese Outflows:

  1. The positive yield return available on foreign bonds due to low Japanese rates

  2. A steeper yield curve outside of Japan creating an opportunity for a spread trade** - (will research more and break this down)

  3. Access to global liquidity

With all that said, if the new Governor of the BoJ decided to abandon YCC, Japanese bond yields would soar, leaving very little incentive for Japanese institutions to hold foreign bonds when they can receive a yield in local bonds. If Japanese investors were to leave foreign debt, European and U.S bond markets would be in a heap of a mess with yields soaring as outflows from Japan repatriate.

Figure 7: JGB Yield Curve

Looking at figure 7, as long as YCC is in play and yields across all maturities are subdued below 2% we won’t have to worry about that.

Short term I’m bullish on risk assets as markets react to stimulus from the PBOC, lower inflation prints from the U.S and a number of readings such as retail sales which also came out negative for the U.S.

Wow, that’s the end of this piece. I had a lot to uncover and still so much more, but I’ll save that for next week.

As mentioned guys, my new macro guide/economic e-book is in the works; it’s going to 10X better than my previous guide, as it won’t be free. This one is for the serious macro heads trying to get ahead and want a clear connection to macro releases and markets; I’m also working on another mini booklet which will be free so stay up to date!

Until next time