Posted By: Matthias Paul Kuhlmey
Over the weekend, North Korea launched yet another short-range guided missile, upsetting neighboring nations, but especially her brothers and sisters to the South. South Koreans, these days, have been dealt a “difficult hand.” As the country steps closer to the brink of a conventional war, a recently launched “currency war” by the Japanese is causing the South Korean “export engine” to experience stress. With the Yen down nearly 20% (vs. the USD), the Japanese have created a significant price advantage for their products offered to the global marketplace, leaving other export-driven nations (e.g., South Korea) at a disadvantage.
Thinking of another “rocket launched,” how about Japanese stocks? For the year, the Nikkei is up +48% (in local terms), and about +25% for USD-based investors (accounting for losses in the exchange rate). Along with these outcomes, there are other, possibly undesired, results of the inflation-targeting “Abenomics,” policies (or experiment?) supported by Prime Minister, Shinzo Abe, to free Japan from decades of deflation. More recently, we warned that “… upon announcement of major stimulus (or money creation) by the Bank of Japan, the 10yr yield on JGBs (Japanese Government Bonds, or the equivalent to Treasuries) dropped to an all-time low (0.425%), only to almost double(!) a few hours later.” The problem, however, is that ever since, long-term yields have kept rising, and doubled again, to 0.89%. Not a big deal, one may think, as rates are still below 1%; but, for a nation that is already allocating about 50% of total public spending to debt service and social security, the trend is not pretty. Consider that Japanese Banks (in good recycling fashion) hold a majority of all outstanding JGBs, we can already spot another rocket in the distance – this one “nose down” … According to a recent IMF publication, a “[1 percent] rise in market yields would lead to mark-to-market (MTM) losses of 20 percent(!) of Tier-1 capital for regional banks (not taking into account net unrealized gains on securities).” More simply, small increases in interest rates can have a magnified negative impact on the required capital reserves of banks.
The “nose-down” scenario for banks in the U.S. was clearly averted by domestic Rocket Man, Ben Bernanke. His directed balance sheet expansion has eased funding stress and, on the “flip-side,” created quite the “launch” for U.S. stocks. The S&P 500 is now up 151% (price return) from the dismal levels of March 2009; this is a picture-perfect environment, also considering that U.S. bond yields have not moved “Japanese style,” still marked near historically-low levels at 1.94% (10yr). Here’s the catch: If our friends at mi2partners are correct, we may experience some sort of déjà vu of developments that took place in 2003. Back then, the world encountered a significant decline in global bond prices, preceeded by (read carefully) 1) the Japanese in dire need to bail-out their failed banking system, and 2) U.S. market participants having bet on QE, but caught by a far less accommodative FED … sound familiar?
If our preview is correct, the next “rocket to launch” will most likely be linked to yields in U.S. Government paper. As we cannot be sure if “it’s gonna be a long, long time” before this event occurs (if at all), you may want to check your exposure to long duration investments, and rethink your overall bond strategy.
P.S. The lyrics to the song “Rocket Man” were inspired by Bernie Taupin’s (Elton John’s writing buddy) sighting of either a shooting star or a distant airplane. The moral here: it doesn’t matter what actually triggered the launch of a great composition, a “hit is a hit.”