Further Along the Japan Story

Further Along the Japan Story

As talked about last week, Japanese troubles seem to matter. Their yield curve control (YCC) adjustment has caused their bond yields to rise notably, along with global sovereign bonds. While US Treasurys (USTs) bounced back some on Friday, they’re still sharply lower on the week. If nothing else, we’ve certainly seen elevated bond volatility.

This has helped us to also see an increase in US equity volatility, with VIX at levels we haven’t seen since May. That’s not the end of the world, but the big question is if this recent stress is the start of a trend or just a bump in the road.

Of course, Japan isn’t the only big news on the week. Another unsurprising ‘surprise’ was that the US has to fund their large deficit and they will be issuing more coupon debt than originally expected. One ‘feature’ with a market that only prices in concerns for the next 24 hours is that future bad news, even if widely expected, can be poorly priced in. This certainly helped USTs, particularly in the long end, hit a new YTD high.

Ultimately, though, I think it’s worth spending more time on Japan. As Weston Nakamura points out, the big change in global finance last week was that Bank of Japan (BOJ) policy suddenly became a lot less clear. That causes volatility, something the market has been starved of for a while.

Japan is the source of a lot of global funding. Because of that, when we get major BOJ announcements, we see global bond and forex markets move. We saw just that happen last week.

Simply put, JGB yields are going up to 1%, over time. That strongly implies that US yields are also likely to go up over time. What the yen does, in my mind, is much harder to call. Will it weaken as the BOJ buys bonds or will it strengthen as it does the opposite of what it did in the YCC era?

For what it’s worth, yen futures have been getting stronger since the announcement. That gets us to the concerns of Julian Brigden from MI2. While I’ve been concerned about structured products creating a combustible environment, he points to the fact that a lot of money has flowed into the US. With a weakening yen, it’s been easy to use carry trades sourced from Japan to invest in US assets, including stocks.

That’s worked out great so far, as a better-than-expected US economy and soaring tech stocks have led to great gains. A strengthening yen is a much tougher environment, as suddenly, the currency effects are working against you. If the yen continues to appreciate, presumably that capital will leave the US stock market.

Could we have seen the leading edge of that worry? I think it’s impossible to say, but it does bear watching. The beautiful trend of lower volatility and higher stocks broke, last week. Is that just the pause that refreshes or the end of the trend? We’ll have to see.

Another ‘unexpected surprise’ is CPI on Thursday. Energy prices have gone up sharply, as have food prices. The Cleveland Fed expects Y/Y CPI to hit 3.4%, vs. a current 3%. While higher inflation seems very likely, the stock market doesn’t seem all that concerned. Worse, the current estimate for August is 3.9%. Is the market prepared for inflation to rise almost a percent?

To underscore, I don’t mean to say disaster is definitely coming. Thus far, we’ve just seen a worrisome little bobble, like we saw in February. Maybe this, too, is just meaningless noise, but I do think it’s worth being aware of potential trouble, particularly when so many seem so complacent. This week’s activity should tell us a lot about how concerned we should be.