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2023
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Japan Is Perhaps the Most Important Risk in the World
The news caught markets off guard: On December 20th, the Bank of Japan surprisingly extended the target range for the yield on ten-year government bonds to plus/minus 0.5%. A move that not a single economist had expected. This week, the Bank of Japan could announce a major policy shift amid rising government bond yields and a strengthening yen. Although barely a month has passed since the BoJ’s last meeting, the bond market is already testing the new upper limit of the yield curve control regime. «To us, Japanese interest rate policy resembles the Berlin Wall of the late Cold War era, a stale anachronism that must sooner or later fall,» says Jim Grant. For the editor of the iconic investment bulletin «Grants’ Interest Rate Observer,» recent developments in Japan pose an underestimated risk to global financial markets. Not least because virtually no one is talking about it. In an in-depth interview with The Market NZZ, which has been slightly edited for clarity, Mr. Grant explains what it means for financial markets if the Bank of Japan is forced to scrap its yield curve control policy. But first, he says why he doesn’t believe inflation will end soon, why bonds may be at the start of a long bear market, and why he believes gold is the best choice as a store of value.
What do you observe when you look at the financial world today? Well, it’s always the same, and - here’s the catch - it’s always a little different. The trick is to identify the unique or unusual feature of a familiar cycle. In this regard, it helps to know a little bit of financial history, and to just that extent it helps to be a little old. But what is not helpful is to mistake the past for a certain roadmap to the future. What are currently the most important developments from a historical perspective? The essential driver of so much of today’s news are the consequences of the monetary regime in place worldwide. That regime has given us artificially low, indeed suppressed rates of interest, and it has given us the consequences of those false rates which include rampant misallocation of capital and great gusts of speculation; some of which are a lot of fun, and some of which are quite lucrative to the clever people who can get in on them. However, in the wake of the surge in inflation last year, interest rates have risen rapidly. Now inflation seems to be subsiding. Was the rise in prices only temporary after all? Plainly, the rate of change has subsided, but what is often ignored is the level of inflation. The rate of change is everyone’s preoccupation, but the loss in purchasing power is never recovered. This is the nature of a fiat currency regime. Way back under the gold standard, prices would rise on average and they would fall on average, but at the end of very long cycles, they would be unchanged. In contrast, a fiat currency regime is characterized by the fact that prices ratchet ever higher and never are allowed to correct to the downside. So what we have is a very elevated level of average prices and a somewhat lower rate of rise in these prices. Then again, the tension in the markets has eased somewhat recently. Stocks have made a surprisingly good start to the new year. Certainly, the slowing rate of the rise in inflation is to be celebrated. It’s nice, but we are still left with a system that is inherently inflationary. Here in the United States, it’s a system given to very free and loose public spending, given to great entitlements for one and all, and it’s a system that has flourished in recent years with very low, suppressed rates of interest. To me, that’s the essence of an inflation generating system: Politically, inflation is kind of something for nothing, and that seems to be part of the political zeitgeist. That’s why I would be a little bit guarded in pronouncing the end of this inflationary episode. Why do you think the issue of inflation could keep us on the edge for some time? Inflation in such a system resembles one of these inextinguishable long-burning underground coal mine fires. I’m not sure if you have them in Switzerland, but in Pennsylvania for example there has been such a fire that’s been going on for around fifty years. You don’t always see it, but it flares to the surface from time to time. It’s always there, it’s always latent, leaking smoke, warming the soles of your shoes. To me, that is a good analogy for inflation in a free spending and paper currency issuing social democracy. So are we at a fundamental inflection point heading into a new cycle, characterized by higher inflation and rising interest rates? Yes, and I say that with well deserved humility because «Grant’s Interest Rate Observer» was calling the end of the secular bull bond market at least a decade before it ended. Looking back, the last great secular bond bear market began in the spring of 1946 in the US and most of the world. It ended in the fall 1981, 35 years later. What followed, of course, was the still greater and more prolonged bond bull market. It began in October 1981 and perhaps ended in 2020 when the ten-year treasury yield got down to 0.5%. What kind of scenario could now be in store? If the past is prologue and if the great bond bull market is over, then on form, we are looking at what could be a very prolonged and perhaps gradual move higher in interest rates. We ought to remember that the first ten years of the last bond bear market were characterized by a very gradual increase. It was hardly noticeable. Yields on long-term bonds rose by about ten basis points a year. The treasury yield started off at 2.25% in 1946, and then in 1956 it was at around 3.25%. So with all these qualifications: Yes, I think the bond bull market is over and a bond bear market has begun. Why do bond market cycles last such a long time? I’m a little weary of saying that the bond market does these things as opposed to that it has done them in the past. But it has exhibited that tendency. At the risk of being pathetic, I would say that since at least the middle of the 19th century bonds have exhibited the tendency to move up and down in yield over the course of decades or generations. I’m not sure anyone can fully explain why. And, because we can’t explain it, we can’t be dogmatic about it continuing in just this way. But again, if past is prologue, we are in for a very long phase or cycle of rising interest rates. However, supply chain problems seem to be largely resolved; in the semiconductor industry, for example, there is already overcapacity and full inventories. What are the drivers of inflation in the next few years? One of the things I’ve learned in the fifty years in this business is to be a little bit less doctrinaire about such things as the cause of inflation. Milton Friedman famously said it’s «always and everywhere a monetary phenomenon». At some trivial level, that is undeniable because inflation involves money. Then again, you could also argue that it cannot be a monetary phenomenon because the purchasing power of money by definition is a casualty of inflation. As to the cause of inflation, there is a whole new school now arguing that it is a fiscal phenomenon. I think there is something to that, as there is something to the Friedmanite view. There is something to the idea that it is a political phenomenon, it’s a characteristic of politically weak societies. But the Federal Reserve assures us that it can bring inflation under control. I think that we have not seen the last of this inflationary outburst. But one needs to be quite humble in the face of something that very few central bankers anticipated or even could have imagined. It wasn’t just that the Fed didn’t predict it, but when the Fed saw it, when it saw the whites of inflation’s eyes, it still couldn’t believe it and continued with its QE program until the end of March 2022. It looks like markets are now gradually shifting their focus to the threat of recession. Does Fed Chair Jerome Powell have the stamina to «get the job done» in curbing inflation, as he says? Hardly a day passes without one regional Fed president or another declaring that the FOMC will most definitely push the funds rate to 5% or higher and hold it there for six months or a year or maybe two. What I object to these pronouncements is the unseemly certitude that they convey. The Fed seems so sure of itself. It was so sure of itself when it was predicting just as confident in 2021 that a 10 basis-point funds rate was a lock through 2023. Their cocksureness does not become them. The future is a closed book, not an open book. Especially, it is a closed book to people who mobilize pseudo-scientific mathematical models of the workings of the financial economy because they really don’t understand it. Usually, the Fed raises interest rates until there is an«accident» somewhere in the financial system or the economy. Is that going to be the case this time as well? The Fed is not a believer in the likelihood of accidents. I’m not sure that it understands the risks its previous QE regime has introduced into the financial system, specifically the heavy leverage in Corporate America, and still more particularly the leverage in private equity for example. Of course, a lot of speculation has been wrung out of the system already, certainly in cryptocurrencies, in SPACs and such things. Where could such an accident occur? I think Japan is perhaps the most important risk in the world, not least because it is among the least discussed risks, certainly in the Western press. Mostly, it’s very much an afterthought. The risk is this: Every business day, the Bank of Japan is spending tens of billions of dollars worth of yen to enforce governor Kuroda’s yield curve interest rates suppression program. To put this into perspective: In the UK, when the little crisis over liability driven pension investing in late September happened, the Bank of England spent around $5 billion. The BoJ does that before breakfast. The Bank of Japan already introduced its policy of yield curve control in the fall of 2016 by keeping the yield on ten-year government bonds within a target range through direct interventions in the bond market. Why should it change its monetary policy now? Governor Kuroda, who’s term is up on April 8, insists that yield curve control is here to stay. But to us, Japanese interest rate policy resembles the Berlin Wall of the late Cold War era, a stale anachronism that must sooner or later fall. And why specifically now? What’s different is that the market is on to something. I say that because the Bank of Japan has already lifted the allowable ceiling on ten-year JGB yields to 0.5% from 0.25% at the end of last year. Kuroda said it was nothing more than a means to the end of ensuring the success and stability of a permanent regime of yield suppression. But the market is like a very ill-behaved dog at the end of a leash. It’s wheezing and frothing, and the Bank of Japan is yanking ever harder and tighter to control this beast. Why do you think this beast will finally break free? Kuroda stated that the Bank of Japan is not going to stop until there is inflation. Well, Tokyo’s consumer prices which precede the national CPI rose to 4% in December versus expectations of 3.8%. What’s more, Uniqlo and other corporate leaders are out announcing that they are raising wages significantly. You will find other stories to this effect, signs and precursors of a change. Some former governors of the Bank of Japan are now venting their views that this has gone far enough and the consequences will be devastating. So I think this is a huge risk just offstage and the world has to pay closer attention to it. What’s the risk if the Bank of Japan gives up control of the yield curve? What makes it a risk for everybody, whether you are Swiss, American, German or Japanese, are two things. First of all, suppressed rates prompt leveraged individual and corporate balance sheets which at the shock of a rise in interest rates will get into trouble. There are troubles buried in the financial statements of Japanese companies that have borrowed too much. Sure, Japanese businesses are not as inclined as, say, American ones to borrow excessively, but there are also risks regarding a lot of bank saving schemes or structured products in Japan. For instance, you get a yield of 0.75% for five years, but in the fine print there is some caveat that if rates go above a certain level then the duration of this product extends to ten years. I’m making these numbers up, but it’s essentially what the risk is. And what is the second risk? The Japanese are a frisky nation. They have an immense amount of net savings, and some $3 trillion of Japanese assets are invested in non-Japanese markets, of which half are domiciled in the United States. In other words, the Japanese, the proverbial Mrs. Watanabe, search the world for yield opportunities. According to Bloomberg, expressed as a percentage of the GDP of the country in which they are invested, Japanese stock and bond holdings break down to 7.3% of America, 7.5% of France, 8.3% of Australia and 9.5% of the Netherlands. What is going to happen if suddenly Japanese yen denominated rates become rather attractive? Well, a lot of this money may be repatriated and the result of that repatriation will be a rise in volatility in markets we can’t really identify now. So the risk of a volatility upsurge is considerable. I think the time is getting ripe for a big change in Japanese rates structure and therefore in interest rates and in the risk presented to bond holders worldwide. What is your advice to investors in this environment? Having just mocked the central banks for their pretending to know what they can’t know, I’m in a very compromised position if I were to say what is going to happen. But allow me to suggest that I’m somewhat of a broken record on gold. I’m going to continue with this broken record and observe that people have not yet come to terms with the essential inherent weaknesses of the monetary system that has been in place since 1971. We have all gotten used to it. I mean, you have to be a person of a certain age, indeed you have to be as old as I am, to really recall the debates surrounding the abandonment of Bretton Woods. People have grown up with the idea that money is what they print, and if the Japanese can print $50 billion a day with which to suppress interest rates, that doesn’t shock many people. But I think such shocks do lay ahead. And gold can help protect a portfolio against such shocks? I think that the strains that are already obvious will become more so. People will be looking around not for a better brand of paper or digital money, but rather for the real McCoy. In every issue of «Grant’s» we have something to say about a stock, so I don’t want to sound too much of a nutcase. We do live in the real world. But when I look at the very big picture, the money the central banks produce in such profusion is unsound. It may not be now, but in time, people will look around for an alternative and that alternative may just be gold - the thing that has been more or less a shadow cast by Bitcoin, Ethereum, and all the other crypto currencies. Against this background, how do you assess the general outlook for the stock market? The market has come down from extremely overvalued to nearly expensive, and my observation is that an extremely overvalued market does not normally bottom out at nearly expensive. So I’m not sure that’s the end of things. I don’t find a whole lot of compelling values in the stock market. Sometimes, one has great conviction, but not now with regard to stocks for me. Are there any exceptions that appear attractive from a value perspective? In one of our recent issues, we had a story on Transocean. The stock had a little move, it’s gone up from $2.50 to $5 or something in that order, but we’re still bullish. It’s a high-tech story. The technology happens to pertain to fossil fuels, therefore it’s beyond the pale for «properly sensitive fiduciaries» to put it this way. But it is a very impressive business which happens to have the flaw of a highly leveraged balance sheet. So there is considerable risk, but I think the risk is less compelling now than the reward. So if you ask about something to be bullish on, I would suggest Transocean.
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