The yen as finance and as politics

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Good morning. Ugly one on Wall Street yesterday, perhaps in anticipation of a horrific CPI print this morning, to be followed by 50 basis point rate increases to the infinite horizon. But the Treasury curve — the adult in the room — hardly moved. The two-year yield rose by all of 4bp. We tend to trust bonds more, but then nothing about inflation data could shock us at this point. Email us: robert.armstrong and ethan.wu.

We’re taking Monday off. See you Tuesday.

The yen

The yen just keeps on falling. It’s down almost 14 per cent since early March, when it became clear the US was really going to tighten policy and Japan really was not. Here’s the chart:

From the FT:

The yen teetered on the edge of a historic support barrier on Thursday after trading in New York sent the Japanese currency to a 20-year low against the dollar and revived speculation that its fall could deepen.

By noon, the yen stood at ¥134.45 against the dollar, bringing it closer to the ¥135.15 level it reached during the turmoil of Japan’s 2002 banking crisis and approaching lows of more than ¥145 in 1998 during the Asian financial crisis.

The yen, to simplify only a little, trades on the gap between US and Japanese bond yields, which draws capital flows and carry trades in its wake. That gap has been blown open by US inflation and “yield curve control” — the Japanese central bank’s enforced ceiling on 10-year bond yields.

Here is a chart of the gap between the two nations’ 10-year sovereign bonds, plotted against the exchange rate, courtesy of James Reilly at Capital Economics:

Reilly writes:

Given that we expect Fed tightening to push the 10-year Treasury yield towards a peak of 3.75 per cent, we expect the US-Japan yield gap to widen further, even if we are right that the BoJ will eventually be forced to tweak its YCC framework and allow JGB yields to rise to ~0.50 per cent. Overall, we forecast the yen to depreciate to 140/$ over the coming months.

The natural question to ask about any durable trend that is expected to persist is how to make money from it. One could always, duh, short the yen, if your broker doesn’t charge you a fortune to do so. On the stock market, there is also the simple intuition that Japanese exporters should benefit from the weaker yen. Indeed, Bank of Japan governor Haruhiko Kuroda seems to take this view. Again from the FT:

CLSA strategist Nicholas Smith said that a poll of companies covered by the brokerage found that the average forex assumption was fixed at about ¥110.05 against the dollar, suggesting that many companies will announce windfall profits in the quarter ending later this month.

“Retailers are unsurprisingly the main losers, while automakers are the main winners from the weak yen,” said Smith.

Looking at the best-performing stocks in the Japanese indices since the yen’s tumble, exporters do predominate. Some have done well in dollar terms even as the yen has fallen. The big winners:

Most of these companies have lots of international sales — at JGC, for example, 60 per cent of revenues come from outside of Japan.

The problem with jumping on the Japanese exporter train is twofold. First, while many of the best-performing stocks have been winners, not all exporters have performed well. Toyota is down 10 per cent in dollar terms since March, for example.

Next and more importantly, exchange rates are intensely political. This is true both domestically (as Kuroda discovered when he waved away the painful effect of a weak currency on households, and was forced to recant) and internationally (China cannot be amused by the competitive implications of the weakening yen). It will require insight into more than just finance to anticipate when Japan will decide the costs of a weak yen are too high.

What the Fed thinks about QT (lately)

Federal Reserve officials think their current quantitative tightening plans are worth a handful of quarter-point interest rate rises. In public they keep it vague (“a couple”, “two to three”). But a recent Fed research note is more specific.

The paper proposes that letting $2.1tn in assets run off the Fed’s balance sheet through to the end of the third quarter of 2024 is tantamount to raising the fed funds rate by 56bp. Fed researchers get that number by comparing two model simulations of the US economy, one with balance sheet runoff (black line below) and another where the Fed continues rolling over its holdings as they mature (dotted blue line). They also simulate a slightly faster pace of balance sheet runoff (dotted red line). The top charts show the Fed’s balance sheet shrinking, and the bottom charts show what the equivalent rate increase would be:

The key, according to the paper, is the term premium, or the amount of extra compensation investors get for holding longer-dated assets. Because quantitative easing involved buying long-dated assets, it suppressed term premiums. Fed researchers expect QT will do the opposite. By buying fewer long-duration assets, the Fed increases the publicly available supply of them, causing their prices to fall and their yields to rise.

Specifically, the Fed anticipates QT to raise the term premium by 60bp. You can see QE’s downward impact on term premiums unwind over time in the bottom-left chart (the y-axis is all negative numbers).

But, as we have argued before, this mechanism is not the only way QT could affect interest rates. Others we have discussed here include:

  • Signalling. QT telegraphs the Fed’s resolve to tighten financial conditions, and markets react by proactively raising yields.

  • Portfolio balance. As the Fed slows purchases of Treasuries, investors buy more Treasuries and fewer substitutes for Treasuries, such as long-term corporate bonds. So yields on those corporate bonds rise.

  • Liquidity. QT reduces overall system liquidity, pushing volatility up and increasing demand for safe, liquid assets like Treasuries. Treasury prices rise and yields fall.

  • Dash for cash. QT will suck cash out of the system just as everyone wants to get out of stocks and bonds. With inflation persistently high, Treasuries no longer feel so cash-like. The pinch will encourage investors to cash out their assets at a discount, pushing bond (and stock) prices down and yields up.

The Fed’s research note focuses exclusively on term premiums, suggesting the equation of QT with a couple of rate increases is probably an incomplete picture. The last and only time the Fed has shrunk its balance sheet, in 2018-19, didn’t offer a clear picture. Ten-year yields rose at first, but started falling in late-2018 and through the first half of 2019, despite a shrinking balance sheet and rising or flat federal funds rate. Long-dated corporate bonds sold off in 2018 but rebounded in 2019.

No one knows what the balance of forces will be this time. The quip that the Fed is in “tighten until something breaks” mode holds doubly true for QT. (Ethan Wu)

One good listen

The financing of porn deserves more scrutiny. To that end, the FT has just produced an eight-part investigative podcast digging into the business. Give it a listen.

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