BOJ and the potential bigger switch in investment flows

The ultra-low rates and loose monetary policy of the Bank of Japan has had a tremendous impact on global markets. Money will seek higher returns around the world, so Japanese cash moved offshore to cash in on the gains.

Of course, the real story is more complex. Japanese investors will sell foreign assets when the yen depreciates, global yields rise, and the cost of hedge increase. The cost of hedging is high given the inverted US curve. Yields have risen over the last year, and the yen has seen a round of depreciation in 2023. Last year Japan was a net seller of foreign assets. Now, we have deal with BOJ adjustments that may add more selling pressure. Higher rates in Japan will inhibit foreign buying of assets.

The change in monetary policy last week changes the landscape albeit in the short run we will see more ambiguity. The central bank kept its formal target for the 10-year yield at close to 0, while saying that the .5% ceiling will become a reference point and not a rigid cap. The BOJ will offer to buy 10-year debt at 1% which sounds like the new cap that effectively doubles the range for 10-year bonds. 

Nevertheless, the BOJ intervened in the bond market today to stop bonds from moving higher. The range has been increased, but the central bank does not want the market to trade at the high end of the range. The central bank communication is ambiguous. Policy is changing, but the goal is not clear.

Inflation transitory story - it just took longer

The Fed's preferred measure of inflation, the PCE price deflator, continues to move lower with both the headline and ex food and energy indices showing a strong downtrend. The transitory story seems to make sense albeit it took longer than expected. The supply shock disruptions from the pandemic are done. The demand shock from the excessive stimulus also looks to be done. 

The decline in inflation was achieved to some degree in spite of the Fed increasing rates. It is not clear, at this time, that financial conditions have been tightened to offset demand and create a recession. Financial condition indices are not indicating overly tight conditions.

The question is whether inflation will get to the 2% target in the near-term and how much more does the Fed have to raise rates to help that process. The last mile is always the toughest. 

Will a recession occur? It is likely, but the story of a soft landing is gaining more followers and there is little evidence in the near-term of a recession. The recession story is being pushed into 2024. 

 

Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria. 

- John Templeton

Great quote and everyone will likely agree with it, but what does it mean as a predictive tool. A quant is always looking for some indicator or number that can be used to describe the state of the market. How do we measure these terms: pessimism, skepticism, optimism, and euphoria?  We could use survey information, but it depends on the question. We are forced to find proxies and those are not easy to create.  Quotes are like candy - taste good but empty calories.

BlackRock return assumptions tells us about uncertainty

 

There are traders and investors. Traders take short-term risks and look for changes that will impact stocks from one day to at most a few weeks. Investors hold assets for months to years. Investors can change their allocations over short horizons, but their objective is to capture long-term premia and returns. They must think about the span of returns over years not weeks. 

The BlackRock asset assumption graph provides a good range of what type of uncertainty investors will face both for the upside and the downside. See BlackRock Investment Institute capital markets assumptions. Private equity and debt have a lot of return potential, but the risk is much greater than liquid equity and debt markets. You may get paid for the upside, but you may also lock-in downside returns. 

Don't just think about the mean return. Explore the range of returns and what will happen to your portfolio if you fall within the lower tail.