Capital Flows and Asset Markets

Someone asked me about Yen the other day. It was a good question. The old widowmaker trade was shorting JGBs. Short JGBs was a very popular if unsuccessful trade from 1994 to 2016 or so. As Japanese bond yield were so low, hedge fund used to love shorting JGBs and going long higher yielding bonds like US treasuries or Aussie bonds. The problem was that every crisis would see hedge funds gross get cut, and they would all buy back the shorts at the same time, and yields went lower and lower.

As well as selling JGBs, hedge funds also used to love shorting Yen - even though the Yen was generally a strong currency until 2011 or so. Since then, the Yen has lost half is value against the US dollar. In this graph, up mean weaker Yen.

Despite its weakening bias, markets have gotten very long Yen in 2025. CFTC data use to be very useful for working out when to go LONG Yen - such as 2008 or 2015 or late 2024, when the market was extremely short Yen. But as you can see, even with some reduction of late, the market is the longest it has been on Yen since data started. This suggests short Yen is the better trade.

The long Yen position is not due to high interest rates. 2 year yields are among the lowest in the world.

But Japan is running a near 5% current account surplus. This should be bullish. And the Fed being attacked by Trump, should also be bullish Yen.

And many macro traders are looking at the Yen versus the Swiss Franc, and calling for a turn, as it has fallen to life time lows against its safe haven comrade.

So why is Yen not moving? My take is that Japan has moved from being a totally separate part of the Asian financial world, to an integrated part of Asia. And this is probably accelerating under the Trump administration. Yen weakness is completely in line with Asian currency weakness.

So the better question is not why is the Yen weak, but why are Asian currencies so weak. The Trump administration has decided to tariff the two Asian giants, China and India at over 50% (potentially).

The problem Asia has is that Chinese imports are not acting as counterbalance to the US anymore. China imports have been weak last few years, even as US imports have surged.

From my perspective, currencies seem to be in an era of fiscal dominance. The Euro has rallied when Germany began to spend to rearm. Asian currencies probably need a fiscal push from China to move higher. Is there any signs of that? Well Chinese 10 year yields have stopped falling.

And domestic equity market is looking better.

Putting it all together, I think the Yen looks okay. I would say is not your “father’s yen” - its a new currency for a new era. But currency markets have become political. The recent strength in the Euro reflects a belief that Europe is finally at least trying to get its act together. Asian currency weakness reflects a lack of that belief. But perhaps rising yields in China and surging equity market suggest long Yen might be okay? Time will tell.

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A surprisingly good month, despite relative tame macro moves.

Economists really don’t like thinking about politics. If forced to choose between an economic reason and a political reason for something to happen, they will always choose the economic reason. I used to be exclusively “economic” in my thinking, but around 2021 I realised that politics was a far bigger driver. I have tried various different political ideas to make sense of the world, and give a framework for investing with various degrees of success. When I started to think about politics rather than economics, I started to wonder if Japan’s lost decades were driven by a political choice rather than an economic choice. That is in the 1980s trade fiction with the US was rising, and Japan remembering how conflict with the US turned out last time, “decided” to enter a period of weakness. I liked this theory for many reasons, as it would explain the very different tendencies in Yen and JGBs we saw from the rest of the world. While everyone else moved with the economic cycle, Japan chose to lean the other way. Its a nice theory - but for it to have any meaning, it would need to explain why the Yen is no longer strong, and why 30 year JGB yield keep rising.

As we have seen with the AI boom the ability to create and access to cutting edge semiconductor is the key to modern economic dominance. Back in the 1980s Japanese dominance saw them capture fifty percent of global market share. Using semiconductor billing data, we can see that Japanese semiconductor dominance coincided with Nikkei dominance.

What went wrong for Japan? Under American pressure they agreed in 1986 to increase imports of US semiconductors, and to keep prices high in the US. This was good for profitability in the short run, but threatened market share in the long run. With the collapse of Soviet Union in 1989, investing into other parts of Asia became far more possible - which saw the rise of various Asian Tigers. Japanese investment was instrumental in the rise of Asian semiconductor industry. Korea and Taiwan, both former colonies of Japan, have become dominant chip players.

In other words two political changes led to the decline of Japanese semiconductor industry and the rise of Asian semiconductor manufacturers. One was the rising trade tensions with the US and the second was the opening up of Asia after the collapse of the Soviet Union. Japan had become expensive, and geopolitics and economics encouraged Japanese corporates to invest overseas. First in the Asian tigers and then in China. When your most successful corporates choose not to invest locally, then is there any surprise you suffer economic decline? But using a similar analysis, political changes are now favouring Japan again. China is now perceived as the bigger threat to the US and Taiwan is seen as too risky to have nearly all high end semi production. One big advantage is the Yen has materially against the Taiwanese dollar.

Japan also faces much favourable tariff regime relative to China and most of Asia ( of course subject to the whims of the White House).

From a geopolitical stand point investing into Japan makes sense for Japanese corporates again. And just like in the 1970s joint government and corporate cooperation is beginning to take hold.

As an article in this week’s Economist highlights, residents of Kyushu can’t believe the wages that TSMC are offering for cafeteria staff (USD20 an hour). Last time I was in Japan most unskilled jobs were being offer a rate of 1000 Yen (USD 7 an hour). Rising wages is very bullish.

What does this all mean? Well in 1990, Japan was expensive and a geopolitical rival to the US. For reasons easy to understand, Japan chose to become non-threatening to the US (and for easy reasons to understand, China is doing the opposite). They invested overseas, and often licenced a lot of technology to Taiwanese and Korean companies. Japan Inc success became a much more palatable Asia Inc success. But now, China has become the main threat, and the geopolitics of Taiwan being the only producer of high end chips has changed the logic again. Now the US wants Japan to be a competitor to Taiwan and to China. And with such low costs, and great infrastructure Japan is an easy sell. We have become so accustomed to Japan being a big investor overseas - what happens when those flows reverse? It is currently has the largest net international investment position surplus in the world. Something that started to surge from 1990 - unsurprisingly.

Economic analysis suggests Japan is dead. On my preferred measure of market capitalisation to deposits, domestic Japanese banks are priced for no growth and low return on assets. This seems wrong to me.

Geopolitical and industry analysis suggest Japan is at a huge turning point. What is even more exciting is so many domestic stocks still trade at below book. This looks wrong to me. I am uncontrollably bullish on Japan.

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In my last post, I had guessed that something was brewing in markets. What I suspected was a sell off in long term bond yields. I still think that is going to happen, but what the market got was capitulation from Jerome Powell to President Trump. With this capitulation, there are no longer any independent financial institutions left in the US - or to put in another way, fiscal and monetary policy is now fully politicised. The market reacted in a predictable way - gold rallied, US dollar weakened and the likelihood of a recession was cut. One of my favourite indicators is 8mth generic VIX. When it is rising, recession risk is rising, and when it is falling the opposite is true. During the GFC, the Eurocrisis, China Deval concerns and Covid, it moved higher as investors hedge, and then falls as recession risk fades. It fell 3% on Friday, and looks to have turned lower.

In a pro-labour world, weak assets prices are not really a problem. In fact they help reduce income inequality, and reset property markets. I see pro-labour tendencies in the UK and in Mexico. And for a while, I thought Trump 2.0 was a pro-labour politician. The “Liberation Day Tariffs” seemed very pro-labour at the time. But in practice, Trump is not really a pro-Labour politician, he is just a pro-Trump politician. In this respect, he most closely resembles Erdogan in Turkey, and to a lesser extent Putin in Russia. As it happens, I have been around for the investment journey with both these leaders. It starts off with some useful pro-market reform. And then is followed up by taking on unpopular vested interests (the army in Turkey, oligarchs in Russia), but while both were seen as improving democracy to start with, in the end it was to concentrate more power in the Presidency. After awhile, fiscal and monetary policy gets compromised, and corruption flourishes. This is all beginning to happen in the US. As is my way, I made money on the way up and the way down in Russia and Turkey - but principally from shorting the currency. Shorting locally listed stocks in Turkey is a not rational.

But being bearish on bonds in Turkey does work. 1mth interest rates have gone 10% ten years ago to 35% today.

From a simplistic point of view, the GLD/TLT trade should keep working. This looks ready to move much higher in my view.

I have been running a triple track of being bearish dollar, bearish treasuries and bearish US equities. It looks like Donald Trump is very happy to trash the dollar and treasuries to keep equities going, so its hard to be that bearish on US equities here. The question I am asking myself is does the rest of the world begin to adopt US policies to embrace growth? That is debasing their bond markets and currency to get economic growth. It certainly looks that way in Japan. Yields are at a new high.

I find myself drawn to Japanese inflation trades, partly because Japan looks so cheap relatively, but also unlike the US, Japanese households have so much cash. There are signs that deposit holders are realising they are getting fleeced, and money is moving to real assets. We have seen the Nikkei break out.

What does this mean? Well market strategists have called current investment strategies as ABB - Anything But Bonds. Hard to disagree with this. In practical terms, the strategy of long SPX/Short TLT has been very good - even delivering positive returns in 2022. From February to April, there was a brief period where you could think things were changing - but we have returned to normal coverage.

What’s the end game here? Well once people are wise to what is going on, they no longer leave money on deposit. Everything gets put into inflation hedges, and if interest rates are too low, then credit demand surges as people see borrowing as free money. Governments start running out of money, and they use all sort of wheezes to get cash. Current talk of stable coins acting as demand for treasuries remind of this sort of chat. Stable coins are to help people to get away from treasuries - not to support them.

Something wicked this way comes - is still true. But rather than weak asset prices, we are going to see accelerated inflation.

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Every now and then, positioning, sentiment, and technicals all match up to make something wild seem possible. It is starting to look that way again.

One of the effects of a pro-labour world would be that governments would come under pressure to lift real wages - which means avoiding currency devaluation. In Japan, this has meant falling foreign exchange reserves.

The overriding investing theme for me is “pro-labour” politics and the rising cost of capital. The lodestar for this theme has been the inflection of JGB yields higher.

Rising yields has meant for me an inflection in the relative performance of Japanese banks. This has also happened.

One thing about a pro-labour inflationary world that I have been also looking for is reluctance by households to hold deposits, and increasing demand for loans. If this happens, then there should be less liquidity in the banking system, and government bond yields have to rise. There are some signs of this. After years of deposit growth being faster than loan growth, we are starting to see an inflection in Japan.

If we take deposits less loans, we can see the (possible) inflection more clearly.

What about the US and treasuries? Do we see a similar dynamic? Well after the GFC, we can see a clear dynamic of higher deposit growth, and slower loan growth.

Taking deposits less loans, we can see that Covid stimulus pumped a great deal of deposits into the system. When we can see how similar the GFC and the Japanese bank crises were for both Japan and the US. Both caused a huge build up of deposits in the bank system.

What about the UK? It has seen its long term bond yields surge even more than the US.

The BOE data made little sense to me, so I have looked at UK focused lender Natwest. What we can see is that there was a surge of deposits during Covid, which has now fallen back as loan growth has picked up. I can also confirm that the UK has seen significant wage and price inflation.

All of this confirms something that is almost self explanatory. Lower long term yields require government spending to be cut, and higher interest rates. Not to balance the budget - but to encourage households to save. And as I have argued - I think this is a political decision - not an economic decision. And with the rise of populist parties globally - no government (maybe other than the Swiss and the Chinese) will look to be causing a recession with austerity policies. It does look to me like the savings glut is over.

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I was asked the other day what was a good book or film to watch to understand Japan better. I suggested that Tom Cruise’s Last Samurai. Its a movie with some serious problems, but it does manage to capture aspects of the Japanese desire for perfection. I also suggested the Tom Selleck vehicle, Mr Baseball. It is a great movie about foreigners living in Japan and culture shock. My friend told me he was not much into movies, so I said to him, you could read some Mishima. I was shocked that my well read and travelled friend had never heard of Yukio Mishima. He was nominated for the Nobel Prize in Literature five times. But that is probably the least interesting thing about him.

Mishima was an ultra nationalist, and in the 1970, he gained access to Japanese military base, and tried to rouse the soldiers to reject the constitution that America had written for Japan after World War II, and restore the Emperor to his rightful place and reject Western influence. When his attempted coup failed, he committed seppuku at the age of 45. While I am not sure about his beliefs, I like the commitment.

The irony of Mishima was that if he lived another 20 years, he would have seen Japan rise to be the mightiest economy in the world. However, if he had managed to live another 30 years after that, he would have seen Japanese market suffer a decline to be back where it was relative to the world as it was in 1970. No doubt a now very old Mishima would be urging a Japanese revival again. He would celebrate the rise of 参政党 (Sanseito) - a party that mirrors many of his views. I fear Japanese nationalism, but as the chart below suggests, perhaps a “Japan First” mentality is now required, at least financially.

One of the more extraordinary things about the chart above, is that it has not really been driven by poor returns to Japanese equities - at least recently - but more by US exceptionalism. In dollar terms, the Japanese market has just broken out. Below is the US listed Japanese ETF - EWJ US.

Shares outstanding in EWJ US (MSCI Japan ETF) are well below highs. I do not feel like anyone is chasing this trade.

But what would a Japanese revival look like? In one of the great ironies of life, Japanese revival under the Meiji Restoration not only praised the Emperor and the Japanese way of life, but also ushered in the wholesale adoption of Western industrialisation. I think this Japanese revival is adopting Western financialisation.

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I have tended to be a “mean reversion” type of investor - thinking that boom is followed by bust. This has been the pattern in every market I had ever looked at, until this bull market in the US. I look at the returns of the S&P 500 relative to long term bond returns, it was mean reverting from 1975 to 2020 maybe? But since then, it has been unlike anything we have seen before.

On a shorter time frame, the Freedom Day Tariffs hinted at a breakdown, but we have returned to highs.

Interestingly BOA Hartnett has pointed out that Japanese and European equities have broken out versus bond returns as well. Even though Europe and Japan lack the tech exposure of the US, they are exhibiting the same relative move in equities versus bonds. Is this a top? Or are we moving to new paradigm?

The Japanese experience is very interesting. Japan went to deflation for nearly 30 years, but has now broken out it. Food prices are surging - but the BOJ is very reluctant to do anything about it.

I always wondered what the S&P 500 versus bonds would have looked like from 1900 to 1975. I assumed in the 1920s, equities outperformed bonds, and then bonds outperformed equities in the 1930s. From 1940 to 1965, I assumed equities outperformed bonds - but always wondered by how much. A recent article by the Economist provided very long term returns of bonds and equities - so gives us an idea (I tried to get Chat GPT to spit out the underlying numbers so I could present in the same format as above - but it was too hard for it to do).

From 1800 to 1900, bonds did better than equities - particularly when you adjust for risk (or volatility). As you would expect, equities outperformed bonds until 1920, and then equities underperformed bonds until around 1940. All are as you would expect, when you think about the financial world at that time.

I think we are back in my “pro-labour” higher inflation era, when bonds do poorly. From 1940 to 1980, it shows almost no return to owning bonds. But over the same period, stocks were up hugely. How much is hard to tell, as it is log scale. It was only in the 1970s that we saw a return to bond outperformance, but after a long period of equity outperformance, and very high yields on treasuries - much higher than today.

In some ways, the US is like any other country. Devaluing is a way to default on debt - and it naturally makes investors move out of nominal assets into real assets. Gold versus treasuries reflect the same issue. When you feel the US policy is inflationary, then gold does better than treasuries. Gold almost acts a protest vote on US policy.

The above charts seem to suggest the performance of bonds has been the most extraordinary bubble from 1980 to 2020, which is now reversing. US bonds used to be backed by gold. Gold prices were contained until 1970, when it was set free. If gold is “real” money, does it not make more sense to compare gold to the S&P 500? That is treasuries are always likely to deliver negative real returns in pro labour periods, so we need to use a “real asset” that is like money to make a comparison.

So a better analysis of post world War II financial history is that the US took advantage of its low borrowing costs to engineer a boom, delivering negative returns to owners of treasuries. At some point, foreigners got frustrated with US policy, and preferred gold to treasuries. This lead to a political change in 1980s, which was much more bond friendly, what I call a “pro-capital era”. The question then, are we in the 1940s to 1960s era, or are we in the 1970s era? I assumed that the break out in gold vs treasuries we have seen the last few year meant we were closer to the 1970s era.

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Second quarter earnings have advanced a number of themes I am looking at. Here is a quick review.

It is pretty safe to assume that the Federal Reserve will be run by a dovish Chairman in the foreseeable future who will be looking to cut interest rates. Does that make long bonds a buy? If I look at the trend on the US 10 year yield, we have not had a break out in yields since 2023.

Certainly for most of my investment career, if we started to see signs of a weakening US housing market, I would be a buyer of bonds.

And we are currently living through the longest period of equity outperformance versus bonds. The implication would be to favour bonds over equities is you thought this would change.

The final cherry on top would be the rising unemployment rate of university graduates. This has been a bond buying signal historically.

There was a time in my career when the above four charts would be enough for me to go all in on treasuries. But we live in new and uncertain times. For most of my investing career, JGB yields gave you a good tell on where US yields were going to go. Why do JGBs offer a tell? I could be that Japanese corporates tend to be more manufacturing heavy, or Japanese investors were big buyers of bonds. I don’t know the reason, but either way JGBs tended to move before treasuries. This time JGB yields are still in a rising trend.

Probably the biggest problem for buying treasuries here, is that Conference Board Leading Indicator has been screaming buy for treasuries for 2 years already.

The problem with buying treasuries is that we have learnt during Covid that the US government will spend whatever it takes to stop a recession. There is no real reason to think President Trump would be any different. Firing the BLS Secretary seems to send a strong signal that he will act to counter any recession. Conference board inflation expectations are still at very high levels.

My base analysis of “Trump Economics” was that he and his supporters have tired of the US model where its buys other countries goods, and they in turn but US treasuries. The reaction to this would be that former exporting nations would be forced to stimulate, and this would lead to capital scarcity. JGBs show this trend, and so do German bonds.

There was also the knock on effect that governments would seek to diversify away from treasuries to gold. For me, it felt like the 1970s all over again. Which means either gold has to go much higher, or treasuries much lower.

I could see treasuries getting a bid if the capex story from the hyperscalers broke down - but there is no sign of that. One of my theories about the “pro-labour” era is that trend inflation was higher, but it would look “ok” during periods of commodity price weakness. A good example now is US Electricity CPI and Energy Commodity CPI. Energy Commodities are the same price as 20 years ago - but electricity CPI is up 40% and rising.

My best guess is that a new Federal Reserve Chairman might cut rates - but we end up with a steepening curve. The curve is not that steep at that moment, but I could easily see 1% cut at the front end leading to 2% rise at the back end, pushing the curve back to 4% like we saw in 2010.

I struggle to see how a curve steepening like that would be good for housing or unemployed graduates. But then again, maybe that is not the point.

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