The Daily Spark

One way to better understand the impact of BoJ YCC exit on Japanese demand for US Treasuries is to look at how much of the recent increase in US long-term interest rates has happened during Tokyo trading hours.

The chart below shows that since the BoJ YCC exit surprise in late July, the move higher in 10s has occurred almost entirely during New York trading hours.

This suggests that US rates are not driven higher by Japanese investors during Tokyo trading hours. And hence, BoJ YCC exit doesn’t seem to be the reason long rates have increased over the past month.

Instead, likely drivers of US rates over the past month are the US sovereign downgrade, fewer dollars for China to recycle in a falling exports environment, Fed QT, the significant budget deficit, the large stock of T-bills, and the Treasury’s intention to increase coupon auction sizes.

Despite the unemployment rate being at the lowest level in 50 years, credit card delinquency rates at small banks are at the highest level on record, see chart below. Imagine where these lines will be once the labor market finally begins to soften.

The map below shows the number of new business applications per 1,000 residents, and there are a lot of entrepreneurs in the Southeast, in particular in Florida.

Since the Fed started hiking in March 2022, default rates have been moving higher, and every day there are companies that cannot get a new loan or refinance an existing loan.

This is how monetary policy works. A higher cost of capital makes it harder for firms to get financing.

With the strong uptrend in defaults over the past six months, and the Fed keeping interest rates at elevated levels, the HY default rate could reach 6% by the end of 2023, see chart below.

The bottom line is that a default cycle has started, and markets are not paying attention.

The IMD every year ranks the competitiveness of countries by comparing indicators for Infrastructure, Business Efficiency, Government Efficiency, and Economic Performance, see table below.

Over the past decade, Germany has moved from being the ninth most competitive economy in the world to currently number 22. The current rankings for Germany across the four categories are: Infrastructure (14), Business Efficiency (29), Government Efficiency (27), and Economic Performance (12).

When interest rates increase, holders of fixed income get a higher cash flow. The problem is that the Fed and foreigners own 50% of Treasuries outstanding, and foreigners own 28% of IG and HY credit outstanding, so a lot of the additional cash flow created by higher US yields is not boosting US GDP growth.

The bottom line is that higher interest rates are a net negative for the US economy, see also the third chart, which shows the effects on US GDP as a result of raising the Fed funds rate 5%-points using a model similar to the Fed’s FRB/US model of the US economy.

Interest rates are rising, the annual debt servicing cost of the US government is close to $1 trillion, and the net interest expense as a share of total government revenues is near all-time high levels, see charts below.

The implication for markets is that higher rates are not only slowing down consumers and corporates through higher borrowing costs. Higher rates are also a drag on growth through higher debt servicing costs for the government. In other words, higher debt servicing costs are impacting not only consumers and corporates but also the government.

The bottom line is that when government debt levels are high, it is more difficult for interest rates to stay elevated for a long time because the negative impact on the economy of higher rates is also working through higher debt servicing costs for the government.

The list of downside risks to the global economy keeps growing, see overview below.

Electricity prices for households are up 30% since the pandemic started, see chart below.

The FOMC started raising rates 16 months ago, and there are two different explanations for why Fed hikes have not yet slowed down the economy in a meaningful way:

1) The Fed has not raised interest rates enough.

2) The lagged effects of Fed hikes take longer than we think.

The Fed does not know if the continued strength in the economic data is because it has not raised rates enough or if the lagged effects of Fed hikes take longer than usual. As a result, the FOMC’s approach is to keep interest rates elevated until the economy starts slowing down. Against this backdrop, a soft landing is not an option because the Fed will keep interest rates high until they get the economic slowdown required for them to turn dovish.

Even if inflation comes down and growth is still strong, the Fed will continue to be hawkish because of worries about strong growth causing a re-acceleration in inflation. The implication for markets is that a recession is a pre-condition for the Fed to stop being hawkish.