The Taiwan Banker

Economists know that regular recessions are not guaranteed or necessary in any sense. When traders hear that “this time is different,” on the other hand, they wonder who is on the other side of the trade. This is especially true in the US following the longest period on record without a recession, from the 2008 financial crisis up until the pandemic, which clearly did not originate from financial markets. If that brief downturn is excluded, it has been a full 16 years since the last recession. Furthermore, the past two years since the start of 2022 have been exceedingly unusual, featuring the only sustained decline in M2 money supply in history (following the 2020 surge which was historic in its own right). That period also marks the first time Japan has experienced sustained inflation since the 1990s. As a result, its central bank has embarked upon the country’s first rate hike cycle since just before the financial crisis. In fact, that timing may not have been coincidental: Bank of International Settlements research indicates that due to the yen carry trade, that hike may have contributed to the collapse of banks in the US.Flash crashWith all these idiosyncratic elements, the current situation is delicate for both central bankers and markets. If the past couple of years were defined by supply chain recovery, it appears that the upcoming period will be defined by market volatility associated with a gradually unwinding Japanese carry trade.Japan’s persistently low interest rates have given local borrowers a unique opportunity. They borrow yen without collateral at low rates, and buy risk-bearing assets overseas which earn much higher returns. Even though they must buy foreign exchange in the process, the yen does not collapse because Japan’s trade balance remains stable. The only downside is the risk of occasional margin calls, forcing fire sales. Japan’s extensive position in international markets can lead to contagion, which contributed to the 2008 crisis.In August, that risk appeared to re-emerge. The sequence of events started on July 31, when the Japanese central bank announced a rate increase to 0.25%, in a surprisingly hawkish move which can be attributed to Japan’s declining terms of trade, particularly energy imports. That same day, the Fed kept rates unchanged in anticipation of a September cut.On August 2, July US unemployment numbers were released, showing an increase in the unemployment rate from 4.1% to 4.3%, and calling the Fed’s earlier decision into question. With the subsequent decrease in US yields, combined with the increase in Japan, the yen-to-US dollar exchange rate appreciated from 154 to 145 within a week.On August 5, after the weekend, markets experienced a flash crash of sorts. The Nikkei 225 plunged over 12%, before recovering 11% the next day, in moves widely attributed to temporary liquidity crunches. Bitcoin showed a similar pattern and magnitude. Other Asian markets were also strongly affected, and the US stock market also declined around 3% before recovering. Nailing the landingThe most anomalous indicator during that period may have however been the CBOE volatility index (VIX), which spiked to 38.57, its highest level since the pandemic. (Earlier reports indicated 65.73, its third-highest reading ever, but that was due to a calculation irregularity.) The VIX remains elevated as of mid-August. There are two reasons that volatility looks set to persist. First, the US is in the final delicate stages of a “soft landing,” featuring all the accumulated effects of previous tightening, without the benefits of the anticipated upcoming liquidity infusion. These lagged effects have hit different market participants differently, causing the market to be increasingly concentrated in a few AI concept stocks, while unlisted businesses and regional banks suffer. One of the triggers of the recent sell-off was the release of earnings figures which called the AI growth story into question.Despite the extreme fanfare and rapid adoption of LLMs, truly transformative applications still appear far off. It appears to have eliminated many junior software developer roles, without creating much threat to senior positions. In this sense, the current situation might be compared to the dot-com bubble, notwithstanding the transformative potential AI still holds.Meanwhile, questions persist about the meaning of the recent unemployment figures. The July unemployment release triggered the so-called “Sahm rule,” a guide for real-time monetary policy-making named after economist Claudia Sahm. The rule states that if the three-month moving average of the unemployment rate is more than 0.5% higher than in the previous 12 months, a recession is already underway. The rule is based on the empirical regularity that labor markets tend to exist in two regimes: either stable or rapidly deteriorating. The post-pandemic period however shows a different pattern of stable deterioration. That new pattern reflects a different driver of unemployment: a growing workforce expanding the denominator of the unemployment rate, driven by a higher participation rate. Thus, even Sahm herself has cast doubts on the validity of the indicator named after her for understanding the current situation. (Perhaps then a squared Sahm rule will be required, looking at the rate of change in the original Sahm rule.)Fig. 1: Sahm rule indicatorA political hot potatoThe second source of volatility is Japan. The yen has maintained its higher level, apparently the only major market indicator besides market volatility which has not yet returned to its previous level. 10-year Japanese government bond yields dropped sharply following the recent market episode to the levels of before the start of the end of negative rates in May, reflecting diminished market confidence in the future trajectory of the rate hike cycle. “I believe that the Bank needs to maintain monetary easing with the current policy interest rate for the time being, with developments in financial and capital markets at home and abroad being extremely volatile,” said Deputy Governor Uchida Shinichi of the Bank of Japan in an August 7 speech.An additional source of uncertainty appeared on August 14, in the wake of the market turmoil, when Prime Minister Fumio Kishida announced his decision to step down. The leading replacement candidates have taken positions on further rate hikes, mostly supporting continuation following the current pause due to the unpopularity of food and energy price inflation. At the same time, because Japanese mortgages are usually floating rate, allowing monetary policy to be transmitted directly to individuals, rate hikes could also prove just as unpopular in the end, after voters become more attuned to the tradeoffs of inflation.The forthcoming question will be whether the central bank will be willing to contravene the expectations of the bond markets to resume the cycle – and the implications for the currency if it does. Even if it does not raise rates, capital might move back overseas, helping depreciate the yen, due less to rate differentials than changing risk perceptions. Growth remains sluggish, despite a strong quarter; the IMF projects only 0.7% GDP growth for the year.The beginning of a Japanese rate hike cycle in earnest may serve to relieve some of the underlying stresses in the global financial system. Nevertheless, the big issues of world-record debt and demographic aging remain, with different implications in an inflationary rather than a deflationary environment. Due to its overseas assets, Japan’s net debt situation is not as severe as its gross debt, but if Japan eventually needs to sell its assets, that would put pressure on those target markets.Non-systemic failureThe US and Japan, the world’s first and fourth economies, respectively, are important origin points of global market trends. They are also important to watch in this cycle because of their misaligned monetary policies. The resolution to this imbalance will form an important part of the disinflationary cycle.The “dry tinder” folk theory of this business cycle is not inconceivable. Because various central banks took a decade to respond fully to the financial crisis, more debt has been built up than might have been otherwise necessary. Nevertheless, this does not mean financial system will fail in systemic ways. If movements like this are the extent of the trouble, global central banking will have passed an important test.