Losing Control of Rates

April 19th, 2022

One of the hallmarks of the pandemic response in most countries has been central banks holding interest rates unusually low, flooding the market with cash and making excessive spending possible without serious repercussions.

This space has highlighted that the US could soon lose control of their interest rates, and this statement is met with confusion by many who disagree, or perhaps don’t understand how rates are set. In essence, central banks around the world set rates through auctions after specifying an ‘appropriate’ level. They set rates and expect participants to buy their debt at the specified rate.

This process has a knock on effect on currency exchange rates. The world is a complex web of currencies and the sovereign bonds, along with their associated risks and opportunities. When rates don’t reflect the risks and opportunities, punishment is typically meted out on currencies first and that translates to bonds over time . . . sometimes a very short time.

This is difficult to adequately explain in a short paragraph or two, but then a perfect example presents itself.

Over the past three months the Japanese yen has collapsed relative to many major currencies, and the outcome is uncertain. This is important because the nation of Japan is the most indebted first world country by far, and a rise in interest rates courts disaster for investors in their sovereign bonds, not to mention another inflationary push. (As the yen declines, imports become more expensive. Japan imports a lot of goods, including oil.)

To put this into context, the Japanese yen has declined by 11% this year, and almost 20% since December of 2020 (about 15 months). The chart below tells the story.

Of course Japan isn’t the only country where this has happened. Other economies have suffered similar fates, but it is one of the largest economies to see such a dramatic move. Other examples include Russia just a few weeks ago, although in that case the Ruble recovered quickly. The Turkish Lira has experienced tremendous volatility as well (almost cut in half over the past year), particularly after inflation shot up and the government resolved to hold interest rates (14%) well below inflation (36%).

The Turkish central bank is attempting to slow inflation without causing the economy to collapse with rates that are too high. This is also what the US Federal Reserve is trying to do, and this process is the reason for all of the discussion about a ‘soft-landing’. Some will say it is a pipe dream, others say it is a well crafted plan. There are two possible outcomes. The first is a failure of policy and a break in markets which we will read about and suffer through for many months or alternatively a slow and boring examination of historical data by economists suggesting that the policy was successful. Either way, it will be too late to benefit after the fact. The risk of something breaking is significant and we won’t know if they succeed until it’s too late.

Japan is in a different situation, where they are desperate for inflation to rise (it hasn’t risen substantially since the late 1980’s) to offset the weight of their debt burden.

In the absence of inflation, Japan will need to defend their currency soon, and particularly if the pummeling continues. The way this is accomplished is an increase in interest rates. Essentially debtors may force the country into raising rates to accommodate the risks of holding their bonds.

As mentioned, Japan’s indebtedness is a key piece of the puzzle. It is the third most indebted nation in the world with a debt to GPD ratio of 221%. Sudan and Greece are the top two, and the state of their economies is less than stellar. Inflation will reduce the crush of that debt for government, and as always, transfer the load to the people who will pay more for day to day goods and services.

This Japan story is important because it is another bump in the road for the low interest rate, government funded largesse that is common in the first world. The idea that this could happen in the US is still a silly idea to many when it is brought up with others, but the US debt-to-GDP ratio is now 120%. That (historically, really high rate) is masked by the dominance of the US dollar in transactions around the world. Most major economies sell bonds priced in US dollars and are essentially ‘forced’ to buy US dollars, and US dollar bonds to hedge their purchases of US goods.

Another important aspect is that the divergence in interest rates, if it holds, will support the resumption of the ‘carry trade’ which broadly supports dollar based investments in other parts of the world. The carry trade is where large institutional investors borrow money from a low interest rate jurisdiction and invest it in a jurisdiction providing higher returns. For a significant portion of this century, this approach supported businesses in innovative and/or fast growing parts of the world.

Overall, we are seeing currencies around the world being hit hard by changes in money flows and the problem has reached a first world economy. The idea that rates will stay low enough to avoid shocks to major economies is most likely misplaced. The easiest outcome will result in higher rates around the world, a slower economy and most likely, lower asset prices (equities, real estate, bonds, etc.) as growth and innovation recede.

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For reference here are similar charts for some other major economies:

The Euro has also lost about 12% of its value since December 2020
The British Pound is remarkably stable despite some Brexit jitters in early 2020
The Chinese Yuan remains very strong despite COVID, excessive debt levels and political intrigue
The Canadian Dollar remains strong and appears to be acting as a safe haven currency

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