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Stability is Destabilising Part II

The way price responds to news is often more important than the information itself. Price can also influence fundamentals by affecting perceptions of risk and the required rate of return in a self-reinforcing feedback loop. While the Bank of Japan was deliberately ambiguous at their October meeting, the Committee decided to regard the upper bound of 1.0% on the 10-year JGB as a “reference” in an effective break of the Yield Curve Control (or “peg”). However, the way the yen responded to the news indicated that this was disappointing to positioning and consensus beliefs. From our perch, the response was not surprising given the still enormous yield differential between the United States and Japan in both real (inflation adjusted) and nominal terms. As we noted last week, the time series below might be one of the most important charts in the world (chart 1).

As we have also noted recently, long phases of stability create episodes of instability. Put another way, long periods of stability under a peg like yield curve control encourage market participants to take on more leverage when liquidity is plentiful and misallocate capital. As a result, participants become short convexity and phases of stability lead to episodes of instability.

We are sceptical that the Bank of Japan can achieve a “smooth” path to their inflation target or maintain the stable disequilibrium. The Japanese yen has already experienced a large and rapid depreciation relative to the dollar and on a trade weighted basis. However, the depreciation could extend considerably further (toward 200 on the USDJPY) if it became reflexive or self-reinforcing with imported inflation and the necessary desire to maintain low interest rates given the size of public sector debt. The Japanese yen is meaningfully undervalued on a nominal and real effective basis, especially against major competitors like the CNY and KRW. However, there is a scenario where the depreciation becomes large and very unstable.

Currencies are always a relative price. Yen weakness is also clearly a reflection of US dollar strength which is itself a function of the FOMC short rate expectations and the aggressive US fiscal impulse. The big picture question at the November FOMC meeting today is how much of yield increase at the long end of the yield curve reflects changed expectations on growth and how much could restrain future growth by tightening financial conditions (chart 2). Our sense is that the tightening in broad financial conditions has been meaningful given the rise in mortgage rates and corporate debt tied to long rates. Based on “current” macro conditions (core inflation still well above target, the unemployment rate below 4% and current final demand) the Fed probably ought to hike the policy rate further. However, very little is priced, and the odds of a surprise hike are low given the probable impact of the tighter financial conditions on future growth and inflation pressure.

Pivoting back to Japan, the transmission mechanism and the great stop loss might occur via the currency. However, it is important to note that Japan is also fortunate to have a large amount of net foreign assets and most of its debt held domestically. If there was a disorderly depreciation of the yen, that would likely trigger repatriation by Japanese funds and institutions. Although, that might require a rapid and disorderly depreciation of the yen first. As we have noted previously, the policy error in Japan and elsewhere was maintaining emergency policy measures (ZIRP, QE, YCC) for too long after inflation had persisted. As a result, market participants become short convexity after a regime where low inflation and rates were believed to be a permanent state.

Tactically, an orderly depreciation of the Japanese yen is bullish for Japanese equities given inexpensive valuation and leverage to yen weakness. However, a disorderly depreciation might be very bearish for global assets, especially Japan’s key competitors (China and Korea) in the region. In that context, Japanese yen implied volatility also appears inexpensive compared to the potential risk. As we have noted before, the troublesome aspect of a major dislocation in the yen is that it has often preceded episodes of cross asset volatility. For example, May 1997 USDJPY drops almost 15 big figures in two weeks and a couple of months later the Asian crisis erupts, June 2007 two Bear Sterns credit funds implode ahead of the 2008 crisis or more recently in mid-2015 China devalues the CNY, and a major phase of market volatility erupts with the global growth scare in early 2016. The Japanese yen has often been the tip of the market iceberg (final chart).


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