The Daily Spark

With yields going up in Japan, the risk is that Japanese investors will now begin to sell US fixed income and start buying higher-yielding Japanese fixed income.  

This is a big deal for global fixed income markets because Japanese investors are the biggest foreign holder of US Treasuries, and they also own significant amounts of US credit.

Our updated BoJ YCC exit chart book is available here, a few key stats:

• Japan is the largest holder of US Treasuries in the world, see the first chart below.
• The BoJ owns more than 50% of all JGBs outstanding, see the second chart.
• BoJ JGB buying has been a dominant force in markets for the past decade, see the third chart.
• Because of the significant yield differences in the front end of the yield curve between the US and Japan, the hedging costs for Japanese investors buying US Treasuries are very high at the moment, see the fourth chart.
• Also, this BoJ illustration of their policy change shows how they will now do “YCC with greater flexibility.”

All other central banks in the world, including the Fed, ECB, BoE BoC, and RBA, have aggressively raised short-term interest rates to get inflation under control. The BoJ has not raised short-term interest rates, and abandoning YCC is the BoJ’s response to high inflation. The BoJ YCC policy started in 2016.

The Fed has used the Taylor Rule framework for decades to understand what the Fed funds rate should be, and inserting the current level of inflation and unemployment into the Taylor Rule shows that the Fed funds rate today should be 9%, see chart below and our Daily Spark here.

The ongoing gap between the Fed funds rate predicted by the Taylor Rule and the actual Fed funds rate raises the question whether the Fed remains behind the curve. In other words, if the economy reaccelerates over the coming quarters with higher consumer spending and a boom in housing, it will increase the risk that the Taylor Rule was right and that the Fed will have to continue hiking. 

In sum, for markets to continue to trade higher, the soft landing must be a soft landing, not a reacceleration, because if housing and consumer spending accelerate from here, the Fed will have to raise rates a lot more.

Fed hikes continue to slow down hiring for both small firms and for the broader economy, see charts below. The labor market is softening with hours worked, the number of job openings, and the quits rate all declining.

This is how monetary policy works; higher costs of capital slow down capex spending and hiring, and with rates staying at these levels for a couple of years, this process is going to continue.

That is why the consensus expects negative nonfarm payrolls for six months from October 2023 to March 2024.

Since the Fed started raising interest rates, we have seen an increase in downgrades of loans and a rise in the share of loans trading at distressed levels, i.e. below 80, see charts below. This is the monetary policy transmission mechanism at work; higher costs of capital are having a negative impact on the economy.

Markets are not taking the ongoing rise in default rates for HY and loans seriously, see charts below, and many investors argue that “this is just a normalization,” or “these are companies nobody has heard about.”

The reality is that more and more companies are defaulting because the cost of capital is higher, and Fed Chair Powell says that interest rates will stay at these levels “for a couple of years,” so tight monetary policy will continue to have a greater negative effect on the economy and capital markets.

In fact, higher costs of capital is precisely how monetary policy works: By making it more difficult to get financing.

In other words, Fed hikes are biting harder and harder, and all investors should have a view on how high they think default rates will go during this cycle, see again charts below.

What could be the aha moment in markets? Once there is a default by some household name in credit, we will likely see an overnight change in market sentiment from bullish to bearish.

China accounts for more than 50% of global coal consumption, see chart below.

What matters for bond markets and the Fed are real variables, including unemployment, real GDP growth, and real consumer spending.

What matters for the stock market is nominal variables, including earnings growth, sales growth, and output prices.

The chart below shows that with inflation coming down, we should also expect to see a slowdown in nominal sales growth and nominal earnings growth.

There are two competing narratives in markets at the moment. 

One narrative is that the global economy is simply normalizing after Covid. As that process continues, inflation will come down, and we will have a soft landing as labor markets, product markets, and supply chains continue to normalize. 

The other story is that the Fed is stepping hard on the brakes, and the lagged effects of Fed hikes and rates staying higher for longer will weigh on nonfarm payrolls, capex spending, and consumer spending over the coming 12 to 18 months, which will cause a recession. 

Looking at a broad range of leading indicators, including rising delinquency rates for credit cards and auto loans, rising default rates for HY and loans, rising weekly bankruptcies, slowing weekly loan growth for banks, and leading indicators for jobless claims (see charts below), we continue to see the recession narrative as the most likely outcome.

Rising rates have already had a negative impact on more leveraged consumers, firms, and commercial real estate. And with the Fed on hold for “a couple of years,” the negative effects of higher rates will continue. In that sense, if the economic data soon starts to re-accelerate, then housing inflation will start to move up again, and the Fed will raise rates even more to slow down the economy.

Let’s not forget that a hard landing will always start out by looking like a soft landing.

Our chart book with daily and weekly indicators for the US economy is available here.

The chart below summarizes the reasons to be bullish on the US consumer and the reasons to be bearish.

In this presentation, we look at the outlook for consumer spending on housing, cars, restaurants, travel, and other consumer goods and services.

About 450,000 new businesses have opened every month since the onset of Covid-19, which is 50% higher than in 2019 when the number of new businesses opening every month was 300,000, see the first chart below.

The main sectors with significant growth in the number of firms are retail trade, professional services, and construction, see the second chart. Within the retail sector, online shopping accounted for 70% of all applications in 2020. 

The bottom line is that the US economy was already the most competitive and dynamic economy in the world, and the level of entrepreneurship and innovation has increased further during the pandemic.