By Michael Every of Rabobank
There is a tune for the market to hum today as the ECB raises rates for the first time since 2011, i.e., just before the onset of the Eurozone crisis; which followed hikes from 2005 to late 2008, i.e., just before the global financial crisis; which followed hikes until late 2000, i.e., just before the bursting of the global tech bubble. It isn’t the grandiloquent theme to the UEFA Champions League. It isn’t ABBA’s ‘Take a Chance on Me’. It might be The Verve’s ‘Lucky Man’. Or it might be The Vapors’ ‘Turning Japanese’.
Obviously, the latter is not because the ECB is hiking, which the BOJ gave up a long time ago. Rather it is what lies on the other side for a European economy already looking Japanese in terms of negative deposit rates, low structural GDP growth rates, poor demography, and a reliance on external demand (i.e., exports) and central-bank liquidity support to keep things together. Now add massive supply-side inflation to boot.
It’s an old cliché that we are all ‘turning Japanese’ even if many of us really think so. Indeed, the more important thought right now is what Japan is turning into, because that is where we are all about to follow too.
As JPY hits a new 20-year low of 134.40, with the former ‘Mr. Yen’ still saying it can go to 150, Bloomberg says, ‘BOJ’s Rock-Bottom Rates Are Crucial for Kishida’s Spending Plans’. Indeed, it notes the Prime Minister…
“appears to be counting on the BOJ to keep borrowing costs near rock- bottom lows as his government paves the way for continued spending even after a record-breaking splurge during the pandemic. The premier, seen as fiscally cautious before he became leader, has signed off on changes to an annual fiscal policy plan that loosen rather than tighten the corset constraining the nation’s spending plans. And this is for an economy that already has the developed world’s largest public debt load…
The government has dropped its reference to a target to balance Japan’s books by the year ending March 2026 and its language on inflation is sounding a lot more aligned with the BOJ as it seeks to achieve price growth “in a stable and sustainable manner.”…
While there are still no price tags on Kishida’s New Capitalism measures or his ramped-up spending on defence, the changes to the policy plan suggest he is maximizing scope for flexibility if he wants to splash out and the central bank will need to play its part by making further borrowing affordable…
Regarding the role of the BOJ, [former PM] Abe recently described the central bank as a subsidiary of the government, signalling no need for concern about public debt. The former leader has also helped drive the calls for increased spending on defence. The government said it would considerably strengthen defence over the next five years in the policy guideline. The debt servicing costs account for more than a fifth of this fiscal year’s 107.6 trillion yen annual budget. The finance ministry has estimated that those costs would increase by as much as 3.7 trillion yen by fiscal 2025 if interest rates in Japan go up by 1%.”
So, obviously Japanese rates can’t go up; the BOJ will peg 10-year JGBs at 0.25% wherever inflation sits with Yield Curve Control (YCC), printing money to buy public debt; and, because Japan is running an external deficit that requires inflows of foreign capital to cover, the JPY can only go down.
Back to the ECB, where rates are about to rise, most likely by 25bps, but with an outside chance of a 50bps step, and we wait for what promises are made to ensure Eurozone peripheral yields do not widen too much over core, which is a version of YCC. That, as the Eurozone current account position in March was -EUR1.6bn vs. a EUR10bn surplus in January and EUR40bn in early 2021. Keep up that trend, and YCC, and see what happens to EUR too.
But the main question is ‘What is Japan turning into?’ If you visit it, hardly the ‘Weimar’ some might project. However, something clearly needs to change. Either commodity prices fall; or interest rates rise; or fiscal spending falls despite ‘New Capitalism’ and the need for massive defense budgets; or the current account must get back into surplus via higher exports of goods and services, or lower imports of non-commodity goods and services. That is not New Capitalism, just old Military Mercantilism.
Back to Europe, where defense spending needs to increase massively too: Germany just allocated EUR100bn to largely imported military supplies, and it’s still only a small step towards what will be needed ahead. The geopolitical situation is only going to get worse, as Algeria suspends its 20-year-old treaty of friendship, good neighbourliness and cooperation with Spain, perhaps portending more gas pipeline problems ahead. At the same time, the energy transition will require war-time expenditure, whether public or private in origin.
Europe too must either see commodity prices fall; or interest rates rise to where markets want them; or fiscal spending fall despite the need for massive defence budgets and green transitions; or its current account move back into surplus via higher exports of goods and services, or lower imports of non-commodity goods and services. That is again Military Mercantilism, just a Chelsea pensioner version rather than a hussar.
The second key question is if the US is also turning into whatever Japan is turning into. Traditionally, the answer is ‘no’, because for all of its problems, the US is more flexible and dynamic than Japan or Europe, and the US dollar is the world’s reserve currency. That Eurodollar power grants it extraordinary privilege – at a price. It means the external deficit constraint, and so the fiscal constraint, does not apply. Many times people have cried out that higher US deficit spending would see structurally higher US bond yields – and many times they have been wrong.
That is until there were active steps taken to undermine the Eurodollar system. As we relatedly see, commodities and supply chains are now weaponized against it. As such, the US too is now arguably constrained in what it can do – by commodities, supply-chains, and resulting inflation. That’s what happens when you let others run a policy of military mercantilism for decades, and you respond with free trade, tax cuts, and moving all your production there.
So, what can the US do? Well, they can flap around uselessly. For example, Treasury Secretary Yellen just reiterated to Congress that the Biden administration is looking to reconfigure some tariffs on Chinese goods to make product-specific exclusions. Yet the underlying dynamic is similar to Japan and Europe. The US must also see commodity prices fall; or, given it the US, rather raise interest rates to a level where commodity prices fall; or fiscal spending fall despite the need for massive defence budgets and green transitions; yet its current account cannot move back into surplus because it is the global reserve FX, and so must run trade deficits to allow those that want them to be able to earn US dollars. That is again Mostly Military Mercantilism.
However, it is also financial militarism. As they say in Southeast Asia, ‘kill the chicken to scare the monkey’. As they say in the US, as some talk about sacrificial lambs – “Lehman”.
If this was the script for Margin Call 2, right about now a cabal of shady bankers is meeting in the dimly lit conference room on the 18th floor of the BIS tower in Basel to decide who will be this cycle's Lehman
— zerohedge (@zerohedge) June 8, 2022
The point is that geostrategic logic says something needs to crack, or be cracked by the US, in commodities – just without a cascade into systemic failure as in 2008, or at least not *in* the US. Yes, there would be big casualties. Yet the US would be there with dollar swap lines and bailouts… for its friends. Geopolitically, everyone else would be hung out to dry. It’s good to be the king.
That does not mean this will happen – and it isn’t something the US is going to say out loud. Yet the alternative is a permanently constrained US, where China (on supply chains) and Russia and friends (on commodities) can indirectly do unto D.C. what D.C. did unto London and Paris back in 1956 during the Suez Crisis, i.e., make clear that there is too high an economic price for certain actions. Tell me, of the US trying to blow some markets up, or being told it can no longer blow whatever physical thing it wants up, which is the less improbable? In short, the US will likely have to choose: Wall St or Main Street; hedge funds or hegemony?
Of course, there is the “because markets” argument – and it’s always a very strong one. But even beyond the geopolitical consequences that economists don’t get, there are economic consequences they do. Australia’s AFR has an interview with former RBA governor Macfarlane, who says that despite the largest Aussie rate hike in 22 years, inflation is unlikely to get back to the long-standing target of 2-3% in Australia or the US, and is more likely to settle as high as 5%.
Specifically for Australia, McFarlane says, “The market is expecting… the cash rate to be 3.05% by December… that’s a lot in a short period of time. It could happen. The other way of looking at it is that wherever inflation settles, you want the cash rate to be higher in real terms. If it were to settle at 4%, you’d want it to be higher than 4%.”
He also had a brutal warning for housing: “You can’t allow the marginal mortgage borrower to determine the central bank’s ability to change interest rates. They can’t be held hostage by the most recent mortgage borrower.” Of course, the RBA might then turn Japanese or European, and buy declining-quality MBS to prop up its housing market. Except while the BOJ can sell YCC politically if it funds New Capitalism and national defence, the ECB if it sees rearmament and prevents Eurozone fragmentation, and the Fed monetising US debt if it means remaining Team America: World Police, the RBA would have to argue: “We urgently need high house prices.”
Macfarlane adds that if inflation becomes “stubbornly stuck” at 4%, in theory that would be an okay, but would carry a substantial risk of businesses factoring in regular price increases and consumers becoming pre-occupied with the cost of living. Indeed, imagine a world with 4-5% CPI for 4-5 years. Imagine what pay rises would have to be. Imagine what bond yields would need to be. Imagine what would happen to countries running external deficits that refused to allow rates/yields to rise.
Finally, consider the only policy alternatives would be pacifist austerity or military mercantilism. That is what we are all turning into.