To believe that the world’s experiment with negative interest rates will end with Japan’s recent rate hike into (microscopically) positive territory, one must ignore the political nature of central banking and the unsustainable and growing weight of global debt. In other words, the experiment is not over and negative nominal rates will return and negative real rates still persist in many places despite government inflation data claiming otherwise. The Fed claimed for years that consumer prices were contained while financial assets were hyperinflating. It was wrong as repeatedly argued in this publication. Ultimately higher financial asset prices seeped into consumer prices that exploded these prices were rising all along with the increases disguised by shrinkflation and other gimmicks. While U.S. inflation is struggling to fall to the Fed’s two percent target, consumer prices remain significantly higher than before with wages struggling to catch up.
Japan did, finally, end its negative interest regime but rates are still at zero there and likely to remain at zero for a very long time. On March 19th, the Bank of Japan set a new short-term interest rate target range of 0% to 0.1% and ended yield curve control. It also ended many (but not all) of its interventions into markets that began during the Great Financial Crisis of 2008 including purchases of stocks and targeting long-term bond yields. It will still keep purchasing Japanese Government Bonds (JGBs), which means continued growth in its balance sheet and a moribund JGB market. Bank of Japan Gov. Kazuo Ueda declared that “Extraordinary easing is over.” Now Japan just has ordinary easing.
Despite the exit from negative rates, little in Japan’s underlying economic situation changed. The country still suffers from slow growth, an aging and shrinking population, and high public debt. Population decline will accelerate over the next two decades as the last of the post-second world war baby boom generation hits their late 70s. This means that economic growth will remain sluggish as the desire to save remains high and the urge to invest stays low. Reaching the Bank of Japan’s goal of a 2% benchmark rate is unlikely to occur anytime soon even with small signs here and there of higher wage increases.
Even though change comes very slowly in Japan, the country remains an incredibly important economic and geopolitical power that investors need to understand. Japanese stocks finally reached new all-time highs after forty years in the wilderness and as usual Warren Buffett was ahead of everyone else in investing in large Japanese trading companies a few years ago, generating billions of dollars of paper profits so far for Berkshire Hathaway. Japan also remains a formidable force in technology and is rebuilding its military and other ties with America to counter the threat from China. Japanese-American trade and military relations will play an important role in shaping the world over the coming years.
In the aftermath of the Bank of Japan’s interest rate move, the yen fell to 151.97, its lowest level against the U.S. dollar since 1990. While the Japanese government promised action to support its currency, investors are ratcheting back their expectations for U.S. interest rate cuts which will put more pressure on the yen. At the beginning of the year, markets were pricing up to six quarter point cuts by the Fed but have cut that expectation in half as inflation remains stickier than expected. Hedge funds and other asset managers held near-record bearish positions against the yen in mid-March according to data from the Commodity Futures Trading Commission dating back to 2006, so any intervention will be expensive for Japan and require follow through. More likely market forces will continue to weaken the yen if Japan moves slowly on further rate hikes (highly probable) and the Federal Reserve disappoints on rate cuts (possible but not likely as the rising federal budget deficit and upcoming presidential election place enormous pressure on the highly political U.S. central bank to lower rates).
But the damage caused by negative rates over the last fifteen years has been enormous in Japan and everywhere else. Negative rates don’t stimulate productive growth; they destroy capital and fuel speculation. When the cost of capital is negative, it removes discipline from the system. We’ve seen this over the last fifteen years in the explosion of passive market structures that exploit investor ignorance and favor momentum and liquidity flows. The low cost of capital reduced the intellectual hurdle rate for investors and caused the biggest bubble in history that was about to burst until the pandemic caused central banks not only to zero-out rates a second time but inject tens of trillions of dollars into the system to inflate the value of assets far beyond their fundamental value. The primary reason the system hasn’t collapsed under the weight of all of this new money – which by definition is debt and not equity – is that much of this money is still sloshing around supporting the value of assets that can’t support their values with their own cash flows. As a result, market multiples are inflated and earnings are enhanced by higher prices rather than unit growth.
The cost of money, which was low for many years, is now high for consumers and businesses. It’s not simply that the Fed raised rates by 500 basis points though that certainly was important. Those rate hikes directly affected the mortgage market with the impact primarily hurting commercial real estate thus far while residential real estate remains relatively healthy. But commercial real estate is a financial asset replete with speculation while owner occupied residential real estate is less speculative in nature (though private equity is doing its best to change that). The corporate credit markets were negatively impacted by higher rates with (as noted above) the Financial Times citing Bain & Co.’s annual report on the private equity industry reporting that ~28,000 private equity owned companies globally are waiting. Last year, the combined value of companies sold by private equity firms fell by 44% to a decade low of $345 billion. That figure points to several things. First, it shows how broadly private has infected the global economy coincident with the unhealthy growth of debt financing that drains corporate resources that could be better spent on more productive uses. Second, it shows how important lower rates are for the PE industry that was unnecessarily and undeservedly bailed out by the Federal Reserve during the pandemic. Many PE-owned companies held for sale may have failed but for the Fed dropping rates to zero when Covid-19 hit. Third, the structure of the private equity industry rather than business imperatives are dictating these sales. PE funds have short shelf lives and are under pressure to return capital to partners, resorting in many cases to unproductive financial engineering stunts like borrowing against their already leveraged portfolios, a double-leveraging maneuver that adds no value but takes them temporarily off the hook while they look for buyers. Fourth, the private equity industry (like commercial real estate) was a major beneficiary of low rates since the Great Financial Crisis and is still living off the last bout of extraordinarily loose monetary policy set loose during the pandemic. After just two years of rate hikes, the industry is suffering indigestion though that has yet to be reflected in the stock prices of publicly traded PE firms (in part because they diversified into private credit, insurance, real estate and other businesses that reduce their private equity exposure) or in their portfolios which are not properly marked-to-market. The same is true of the $10+ trillion private credit industry whose valuations are also highly questionable in an environment where corporate defaults are rising. On the brighter side, default rates remain far below crisis levels in an economy held afloat by record fiscal deficits, the Fed’s reverse repo program, and generally loose financial conditions. But this is not a great time to be in the leveraged finance business that has trillions of dollars of investments to digest, much of it worth less than it is telling investors.
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