Financial markets are rebounding on Monday from the worst selling pressure in months. Friday, the Dow Jones Industrial Average suffered its largest decline since June. Gold fell. Oil fell. Treasury bonds as represented by the iShares 20+ Year Treasury Bond ETF (TLT) returned to levels not seen since June.
For investors, it was a very rude awakening from the long, easy, summer doldrums that had kept stocks in the tightest trading range in at least 100 years.
Many broadsided by the selloff have two questions: What caused it? And will it continue? The answer to both depends on the actions of just one country, Japan, and whether it will work to push up long-term interest rates.
First, some context.
The market calm of the last three months has capped a three-year sideways slide in stocks — with the NYSE Composite Index trading near levels first reached in 2014 — as market volatility has been subdued by aggressive central bank stimulus efforts.
Mindful of the unhealed scars of the financial crisis (including over-indebtedness and lingering joblessness), and constrained by the inability or unwillingness of governments to fix the structural source of these problems, central bankers have kept interest rates low, bought up financial assets voraciously and worked to keep stock markets stable and rising.
The medicine has been a palliative but not a cure. Wage inflation here in the United States remains tepid. Growth is uneven in Europe and Japan. China is an overbuilt, over-borrowed mess. Globalists are on their heels, rocked by the rising popularity of Trump-style nationalism in America and elsewhere.
The side effects of these efforts have pushed more than $13 trillion worth of debt into negative-yield territory. The supply of government debt in Europe and Japan is drying up, forcing central bankers to buy other assets, including equities and corporate bonds, while issuing loans directly into the economy.
An addiction to the monetary methamphetamine has formed, making investors and financial asset prices super sensitive to any change in the flow of cheap money stimulus and to any dramatic change in stock or bond prices. You can see this in the way U.S. stocks are still closely aligned with the size of the Fed’s balance sheet. You can see this in the aggressively bullish equities options and futures market positioning of U.S. investors.
Above all else, the growing share of bonds with ultra-low or negative interest rates has led many investors and fund managers (inadvertently in many cases) to assume more and more leverage — or exposure to declines in bond prices caused by a rise in interest rates. This is based on a concept known as “duration,” which basically means the lower the interest rate and/or the longer until a bond matures, the more sensitive the price of that bond is to a change in interest rates.
When rates rise, prices fall. When duration is higher, the drop is much more severe for the same change in rates.
Now back to Japan.
The leadership at the Bank of Japan has been in the vanguard of pushing the limits of monetary policy stimulus. Japan has been in a multi-decade debt-deflation malaise. Tokyo has by far the highest debt-to-GDP ratio at 229 percent (vs. 177 percent for Greece and 104 percent for the United States). The economy has been falling in and out of recession since 2011. And its stock market is down more than 19 percent from the high set last year.
Pushing interest rates below zero hasn’t been enough. Purchasing stocks hasn’t been enough. Using the public pension plan to buy stocks hasn’t been enough. Actively weakening the yen hasn’t been enough. There was some excitement back in June that former Fed Chair Ben Bernanke could convince the Japanese to deploy the “helicopter money” idea he has long been associated with — that is, funding government spending and tax cuts with freshly printed money instead of borrowing or taxing.
Instead, Bank of Japan chief Haruhiko Kuroda seems to be suddenly suffering a bout of self-doubt. Instead of unveiling helicopter money over the summer, he instead said his institution would conduct a self-imposed review of the efficacy of its actions so far. Instead of trudging ahead, Kuroda stopped to look over his shoulder.
Why? Concerns that perhaps more monetary policy stimulus will cause more harm than good at this point. With yields on both short-term and long-term (as long as 20-year bonds) debt now negative, savers, pensioners, investment funds, banks and even non-financial companies are all feeling the pinch.
Back in June, Bank of Japan board member Takehiro Sato warned that a narrowing of the gap between short-term and long-term rates, as well as a general decline in overall rates, would likely force banks to tighten credit standards since net interest margins would narrow, impacting profitability. On Monday, Kuroda flagged worries the drop in long-term yields could hurt returns on pension plans, damage confidence in the economy and weigh on overall growth.
People are reflected in a display showing market indices outside a brokerage in Tokyo, Japan, February 10, 2016.
People are reflected in a display showing market indices outside a brokerage in Tokyo, Japan, February 10, 2016. Thomas Peter/Reuters
As a result, much attention was paid to comments from Evercore ISI analysts suggesting the Bank of Japan could actively work to widen the gap between short-term and long-term interest rates by selling long-term bonds and buying more short-term bonds. This could also be combined, in the analysts’ view, with a pledge to overshoot the bank’s 2 percent inflation target.
The problem, returning to the concept of duration, is that such a move would roil the long-term government bond market globally. The market for Japanese government bonds is the single largest in the world and will thus cause ripples across the globe. According to Bank of America, the correlation between moves in Japanese government bonds and global bonds has risen to 0.86 this year from 0.58 last year. A correlation of 1.0 is moving in perfect lockstep.
This marks a potential sea change.