HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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March 19, 2023

The Duration Bubble Unwind – Does it end in Tokyo?

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Economic progress in a capitalist society means turmoil. Joseph Schumpeter 

 

Canary Moment

The events of the last couple of weeks indicate that the UK’s LDI moment was indeed a canary in the world’s financial coal mine. In the teeth of the fastest increase in interest rates ever, energy and inflation crises which appeared insoluble, and a fractured political consensus, Truss and Kwarteng boldly launched a Reaganomic bid to grow the UK back to economic health.

 

Liability Driven Ejection

What the Trussites learnt to their cost was that making radical economic policy changes takes political consensus, communication and, critically, a functional and liquid capital market. It turned out they had none of these things. But the proximate trigger of their political ejector seat was an unknown fault line in the UK’s capital market posed by the over-geared and illiquid Liability Driven Investment strategies pursued by many of the UK’s largest pension funds.

 

In Their Best Interests

After several well-intentioned policy changes aimed at de-risking pension funds to avoid the meddling of the unacceptable faces of capitalism, such as Robert Maxwell and Phillip Green, and the impact of changing life expectancy, pension funds were directed to sell equities and buy bonds to better match the maturities of their assets and liabilities. Funding a person’s retirement liability by buying a 20-year bond and waiting makes sense. What could possibly go wrong? The answer is a bubble in the price of time and the requirement to unwind it to slay the risk of runaway inflation.

 

HTM

The precursor to the Great Financial Crisis was a bubble in house prices and the subprime onramp to homeownership for the uncreditworthy. The precursor to the banking crisis of 2023 was the Great Duration Bubble of 2020 and the unintended consequences of its unwind. Unfortunately, the UK’s pension funds and the American regional banks were the unsuspecting collateral damage. Both sets of institutions had been following regulatory guidance to reduce risk by holding pristine quality assets to safeguard against risk to their stakeholders, their pensioners and depositors. To minimise risk, they bought and held long-term government debt, which was not available for sale (AFS) but held until maturity (HTM).

 

Pristine Collateral

The foundation for the regulatory control of UK pension funds and US regional banks is that risk equates to volatility and credit quality. Through this lens, bonds are less risky than equities, and government bonds with zero credit risk are the “pristine collateral” to ensure the interests of depositors and pensioners. However, these regulations did not allow for the impact of QE and its consequent Great Duration Bubble.

 

Collective Delusion

What the policymakers allowed to happen over recent years was a duration bubble. The ensuing era of free money destroyed the relative valuation of capital assets. It allowed the collective delusion that the value of a $ or £ was worth as much in 30 years as it is today. Just as the mortgage-backed securities (MBS) and credit default swap (CDS) traders at Lehman’s had vested interests in not sensing the changing mood in the markets for their assets, the management of SVB saw no problems being banker to thousands of unprofitable dog walking apps backed by long-dated US Treasuries. In both cases, they needed to hold their assets to maturity, and it would all sort itself out. But unfortunately, solvency issues become liquidity issues when confidence is shaken.

 

Unstable Table

The saying goes that “nothing is as unstable as measures to stabilise prices.” And the main aim of monetary policy over the last fourteen years has been to stabilise the price of financial assets by controlling the government bond markets. However, 2022 was the year that this policy changed, and the priority of monetary policy became the taming of inflation. Just as Lehman Brothers was slow to reposition its balance sheet to the prevailing realities of 2007-9, SVB and UK pension funds were either too slow or unable to adjust their balance sheets to the new reality.

 

Inflation Fight or Flight?

Markets respond more quickly to paradigm shifts than policymakers. Last year the BoE announced a £65bn temporary facility for the UK pension funds, just as last week, the Federal Reserve and FDIC backstopped their regional banks’ bond positions. The bond market now says the world’s financial system is at a significant juncture—a pivot point where the priority will no longer be fighting inflation but restoring financial stability. Central banks love to reassure us that they have the necessary tools to do what it takes. True to form, they invent new tools to combat their latest problems. However, in both cases, they must tie themselves in knots to explain that they are not stepping back from their fight against inflation by standing behind the recipients of their largesse.

 

Needs Must

The rise in the price of 2 yr Treasuries over the last week is the biggest in thirty years, a more significant fall in yields than during the onset of COVID and the aftermath of Lehman Brothers and 9/11. What investors registered last week was a warning sign that the Fed’s tightening policy is now over. Its bluff has been called. Powell can carry on fighting inflation and risk a 1930s depression or pause to see what else the “long and variable lags” to his policy bring to the surface of our indebted financial institutions. As investors wait for news of the Fed’s response, with its rate decision due this week, the crisis has escaped to Europe. As I write, the Swiss National Bank is strong-arming UBS into acquiring the remains of Credit Suisse, bypassing shareholders, and bending its own competition laws to get it over the line before markets open tomorrow.

 

Meanwhile, in Tokyo ...

Although it is impossible to know what comes next, this crisis may have yet to play out fully. To this end, I offer you to consider the case of Japan. From a Western lens, Japan is an enigma in many ways, but none more so than its economic and monetary policy.

 

Not Long Ago

In the late 1980s, Japan’s stock market accounted for 60% of the world’s total. (Today, the figure is 6%). It led the world in car and semiconductor manufacture, consumer electronics and banking. The real estate value of the Imperial Palace in Tokyo was greater than that of California.

 

QE Origins

Over the last 30 years, Japan’s GDP has been unchanged, its stock market remains  c30% below, and its currency is less than half its value versus the dollar. Furthermore, based on current demographic trends, the Japanese population will be extinct in 300 years. Over this period, Japan has had a deflation problem. In the early 2000s, as an essential strand of Abenomics, BoJ Governor Kuroda introduced the novel monetary policy of Quantitative Easing to try and create inflation.

 

Reflation Failure

Economic policy is not a science, as there are no counterfactual experiments to test hypotheses. But despite its two-decade QE policy, Japan’s inflation rate has remained very low. However, Japan’s CPI rose above 4% last month for the first time since 1980. The Bank of Tokyo’s policy rate is currently -0.1% and has averaged zero for over 20 years. This a land where free money is baked into everyday life and reinforced by the exceptional tenure of its architect-in-chief Karoda, who remains the BoJ’s Governor.

 

Careful What You Wish For

On April 8th, Karoda hands over the reins of the BoJ to the unknown academic Kazuo Ueda. And it is instructive to see what Mr Ueda will inherit. In the period Koruda has been in office, Japan’s national debt as a percentage of GDP has grown from c100% to c250%. (The US is 129%, the UK is 97%, and Italy is only 145%). According to Tokyo-based market commentator Weston Nakamura, more than 25% of Japan’s government spending goes on debt servicing. And this is when 10yr Japanese bonds yield just over 0.3%, less than a tenth of the US 10yr Treasury yield. Japan would be insolvent if its new central bank governor normalised interest rates.

 

Hobson's Choice

Weston Nakamura and others say this is precisely why Mr Ueda will retain his inherited policy of QE and yield curve control. Indeed, the new governor is an unknown precisely because no other candidate would take on a role where the policy so completely controls the policymaker. Japan, they say, is where procedure trumps people. It is good news that Liz Truss and Kwasi Kwarteng weren’t on the list of candidates.

 

Duration's Lehman

Understanding the insection of the global economy with geopolitics and monetary policy and how it impacts financial markets is like playing 3D chess. Not being able to think far enough ahead to play in two dimensions, I will not make any predictions of how this current banking crisis ends. But if you want to consider the worst potential casualty of the unwinding Great Duration Bubble, this crisis’s Lehman moment, then Japan might offer the answer.

 

Jeremy

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