Capital Flows and Asset Markets

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Lets talk about macro. There are lots of big macro questions to answer, but I think we now have enough data, and market action to answer them in a coherent and simple way. There are two (or three) big macro conundrums which I think we can answer with a single model. First of all, why did JGB yields fall from 1990 onwards, and Yen strengthened when the US economy weakened in that period? And why are Chinese government bond yields so low now. I think people struggle with the deflationary signal from China, and inflationary signal from Japan, but they make sense to me.

Japanese 10 year bond yields look to have entered a bear market to me, after a 30 year bull market. But why now - and not in earlier? What has changed?

And Yen has obviously broken out of the range it was in from 1990 onwards. Why can Yen weaken now, and not before?

And we have Chinese 10 year bond yields collapsing, while US remain fairly high. Why are this formerly highly correlated assets not correlated any more?

I think there is a good answer to all of these questions, and happily they fit in exactly with the title of this substack - capital flows and asset markets. There is one big difference - when I named this substack, I was thinking about portfolio flows to and from Japan. Now I think we should be thinking about a different type of capital flow.

Markets have had a rough month in August so far. The favourite reason given is the unwinding of the carry trade - precipitated by rising interest rates in Japan. For most investors in the market, the idea of Japan ever being able to raise interest rates seems like a fantasy - and the episodic unwinding of the carry trade is seen as one reason.

One popular carry trade has been long Mexican Peso funded by shorting Yen. Mexico is paying nearly 11% on deposit, while Japan had negative interest rates for until recently. Not only has carry been good, Mexican peso has been very strong against Yen.

A lot of people think they know what a carry trade unwind is. But I was born in it, moulded by it. I made my name by trading both sides of it. The carry trade belongs to me. In fact I even made a trading rule for carry trade unwinds. When an unwind occurs in a carry trade - like in 2008 or 2015, then the fall in higher yielding currency should equal the gain in carry earned in the years before. Or in other words, there is no free lunch. Today in JPYMXN, as seen above, this would imply a move of 50% or more from where we are today, and would be very negative for markets. Do I fear the carry trade now?

For me, I loved the simplicity of the unwinding of the carry trade. I used to explain it as the flow of capital back to Japan. This helped explain one important feature of the unwinding of the carry trade - the collapse in Japanese bond yields. All that capital leaving Mexico, Australia, Brazil, Russia, Korea etc had to go somewhere. Typically you would see 30 year JGB yields collapse in periods of carry trade unwind, like 2008, or 2015 or 2019.

For me, the carry trade unwind was the full economic and financial representation of the “pro-capital” policies. This may seem odd give how much capital tends to be lost in carry trade unwinds, but pro-capital policies place economic adjustment on workers. When an economy becomes uncompetitive, and wages have risen too high, then the easiest possible route out of stagnation is to devalue. This cut real wages, and tends to be positive for asset owners. And in a world with low tariffs and free movement of capital, the lack of wage growth in Japan would make it a natural currency to appreciate, and Mexico with its inflationary tendencies, a natural currency to depreciate. Carry trade unwinds and currency crises are not a bug in the pro-capital system - they are a feature.

But we are now in a pro-labour world politically speaking. For me, the recent appreciation in the Yen is belated political realisation that workers will no longer tolerate falling real wages that a weak Yen implied.

There is also another big change in the world. US trade policy now naturally favours Mexico over China and Japan. In pro-capital world, the most profitable place to invest got all the capital. Now its the safest place to invest. Nearshoring is a real thing, and tariffs favour more investment into Mexico. While a carry trades come and go, industrial policy is forever (or at least a couple of electoral cycles). In a free market world, you should fear the carry trade unwind. In pro-labour world of tariffs and industrial policy - carry trade is nothing but a boogeyman, conjured up to scare investors, and force them back into bonds, before pro-labour polices destroy them again. The JGB market knows what’s up - it has barely moved despite a spike in Nikkei Volatility to over 70.

Pro-capital policies are dead, and so is the destructive ability of carry trade unwinds. Capital or assets will take the adjustment going forward, not real wages.

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I had been fairly relaxed about markets. Nothing much looked like it was unwinding, and yet we saw Nikkei VIX touch 70 this week, a level seen during the GFC and Covid. Current levels have tended to be associated with crises of some sort.

The move in VIX is even more surprising to me as leading indicators like Japanese banks and JGBs were pointing to continued wage growth and inflation in my mind. When Japanese banks roll over, then problems are more likely, and they rolled over in 1999, 2006, 2015, and potentially now. That is historically, Japanese banks roll over - AND then VIX spikes.

A lot of the spike in volatility has been ascribed to the unwinding of the carry trades. Classic carry trade pair such as AUD/JPY looks to have rolled over. Again historically speaking, carry trades tend to start unwinding BEFORE the spike in VIX.

Looking at JGBS, they also tended to see yields fall BEFORE a spike in volatility, and then see yields collapse as volatility spikes. So the behaviour of markets is very different this time.

So what happened? For me, historically Japanese market has led the US. In bonds, JGBS correctly called the treasury bull market, and the beginning of the treasury bear market in 2020.

This has also been true in equities, with the MSCI Japan in USD leading the S&P 500. Why could this be true? I suspect that as Japan has a strong manufacturing sector, they tend to pick up order slowdowns earlier.

So the big surprise in markets has been the US bond market signalling recession before either the Nikkei or the JGB market, driven largely by the NFP number last week.

The US bond market is the real surprise here. A second Trump presidency promises more Tariffs and more tax cuts - which are bond bearish. My gut feeling is that the JGBs are right here, and treasuries are wrong. So why have markets reacted so violently. I suspect the answer is clearinghouses. They have no forward pricing ability, and price everything backward looking. There is another problem with clearinghouses. Before clearinghouses became the central party to all trades, when there was a big move in markets, you would have winners and losers. So lets say a tail hedge fund was long Nikkei volatility in July and August. They would see a 40 print - say job well done, and cover their position. These days, when volatility spikes, the clearinghouse goes - “oh volatility is higher now - everyone needs to pay more margin” - so winners and losers have to stump up more collateral, starving the market of liquidity, and causing it to fall more. Clearinghouses are volatility creating structures. Despite all these shenanigans, GLD/TLT continues to trade fine.

When I look at US politics, and UK riots, and geopolitical situation, my best guess is that governments will keep spending, and they will be working very hard to maintain rising wages and full employment. I think we are in red pill territory - that is no recession, and more inflation. I will change my mind when JGBs tell me to.

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As I write this, markets have gone for a good old growth scare. It has also happened at a time when the BOJ is beginning to tighten policy. We are getting big moves. Yen has rallied substantially.

Markets are pricing in much more rate cutting from the Federal Reserve. The two year yield has fallen substantially.

While the market had been pricing in a BOJ tightening, the real surprise has been weaker employment numbers out of the US. Non Farm Payrolls was surprisingly weak. Weak is 114k - which is actually sort of in line what he have seen since the GFC, but was weaker than expected..

More spooky was the underemployment number, which came in at 7.8%, and has seemingly inflected higher.

What is surprising about this number is that usually rising underemployment is easy to forecast. In 2000 internet stocks were going to the wall. In 2006 it was home builders and then finance people, and in 2020 it was Covid. Where is the unemployment coming from today? Higher interest rates has had no noticeable effect on property markets. The difference between Toll Brothers today and 2005/6 is night and day.

Even auto sales are holding up.

Going through the non-farm numbers, the weakness in employment is in information and business services. Traditional cyclical businesses such as manufacturing and construction seem fine.

Looking at total employment over time for information sector, I don’t really see a bubble unwinding, at least nothing like the dot com bust.

Finance employment could be elevated but also look okay to me.

The biggest shock I was worried about was a China devaluation. Weak dollar has made that seem less of a worry.

The employment number is a surprise, but both Political parties have placed emphasis on blue collar over white collar, and these numbers are in line with these policies. But with oil now down on the year, the US dollar weakening, and long dated yields lower, all should be stimulatory on what still looks a decent labour market. My guess is that the curve steepens from here.

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Only a week ago I asked if it was time to bet on deflation again? As I pointed out, the biggest lead on inflation and deflation has been JGBs, which correctly pointed to deflation from 1990s onwards, and correctly pointed to inflation from 2020 onwards. With JGB yields at highs, I was of the view inflation was still the go. Recent moves have seen JGB yields fall, but still in an uptrend I think.

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I spent most of July on the road in Europe. 11 days in Sweden, karting with my oldest son and then 9 days in Portugal with the entire family on a bit of rest and recreation. I try and avoid coffee when I am on holidays, and I find it allows me to think more clearly, if more slowly.

Markets are heavily politicised these days, in both that government policy affects markets, and that the dominant companies in markets are affecting policy. For that reason, July was a tricky month politically. The failed assassination made Trump look like a shoe in for the 2024 election, but then Biden stepping down has changed the political calculation dramatically. If Harris wins, would she copy Biden economic policies completely? Probably is my guess - but it does add uncertainty.

My key trade GLD/TLT continued to move sideways over the month.

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Apologies for the radio silence, which has been driven by two things. First of all, US politics is in such a state of flux, it felt better to refrain from any “hot takes”. Secondly, I am currently in a state of caffeine detox. I drink a lot of coffee - the shirt I am wearing above was GIVEN to me by local coffee shop… so every year I take a week off coffee - which tends to lead to severe caffeine withdrawal headaches. The only cure I have found is alcohol - so I swap coffee drinking for day drinking. Not ideal for writing a substack, but today I am in good enough shape to write a post.

Before the advent of Trump and American Firstism, before industrial policy and tariffs, in an long lost era of free trade and the easy movement of capital, I think the BOJ was by far the more important central bank. All the major economic and financial crises of the 1990s onwards coincided with the BOJ raising interest rates. Below is the unsecured overnight borrowing rate from the BOJ. The high rates in early 1990s cause the Japan bubble to burst, spike in 1997 caused the AFC, spike in 2000 burst the dot com bubble, and 2006 was the Us housing market. Having learnt their lesson, the BOJ basically went all in since 2013.

Using a slightly more forward indicator of interest rates in Japan, 1 year deposit rates have risen.

While Japanese interest rates have risen, we have yet to see much balance sheet contraction at the BOJ.

Pre 2020 at least, the movement in Yen and US credit spreads where highly correlated. That is if Japanese investors began to pull credit lines, the yen would appreciated and credit spreads would widen.

Yen appreciation (using Yen versus Won here to get rid of any China political influence on currencies) would coincide with credit spreads widening.

If you believe that we are still in a free trade, free capital world, then the movements in Yen and Japanese deposit rates are a huge bearish signal. Politically I think free trade is dead, but a week is a long time in politics, so I keeping an open mind on the matter.

In the UK, Labour has the opportunity to introduce pro-labour policies. Given that the election was more about the rejection of the Tories than embrace of Labour, the new government should be under real pressure to deliver results in its 5 year term. If we assume a “neo-con” policy like the US is not possible in the UK, then what should we expect? Labour winning the election has been widely expected, so unlike with Brexit or Trump’s election in 2016, there were no wild gyrations in bond or currency markets. But Labour does have some clear policy objectives that it needs to achieve it hopes to be re-elected. One of this areas is to get house prices under control.

With recent rises in interest rates, affordability for first time buyer has worsened. With mortgage payments taking 36.5% of take home pay.

This has led to mortgage volumes being lower ever since the GFC.

The recent reduction in housing affordability is driven by rising interest rates. a 2 year fixed mortgage has from from 1.5% in 2021 to 5.16% today.

Let make some reasonable assumptions. First, Labour want to avoid the fall in house prices that happened in 2008, and any rise in unemployment. That means, they basically want house prices to stay flat. If interest rates stay at 5%, how much do wages need to rise by in 5 years to get back to “reasonable” house price? So lets say, 25% of income is used on mortgage payments - and also assume that house prices stay flat. What would the rise in income needed to be? Well using available data, we can see that the cost of a first time buyer has risen significantly as interest rates have risen. (For anyone trying to replicate below, I use BOE Base Rates + 2%, and a 25 year mortgage, at 75% LTV)

UK Wages have risen recently, but not as fast as mortgage costs have risen.

If we assume that house prices stay flat, how much would wages need to rise to get back 2000 levels of affordability? In 2000, wages were £16300, mortgage rates of 8%, and house prices were £90,000, or 5.5 times wages. Assuming similar mortgage costs, wages would need to be £51,500, or 46% higher. Over the five year term of parliament, would imply 8% increase in wages annually. Real wages in the UK have risen around 2% a year since 2000. This implies 6% inflation.

Politically, it hard to see how inflation does not return to the UK, even if recent numbers are suggesting a return to disinflation.

One thing I think Labour is trying to do is to crash the first time buyer market for housing, by greatly increasing supply. If they can achieve this, then wages will not have to rise so much, but I suspect would make winning the next election harder. Lower interest rates that push up house prices would not be beneficial either. Another option would be to reform council tax, to encourage empty nesters to downsize to a smaller home. But absent a recession, I would pencil in 8% nominal increase in wages in the UK. UK 10 year gilts at 4% look a sell to me.

One complicating factor I left out of this analysis was the effect of higher inflation causing interest rates to rise, requiring more rapid wage increases, leading to an inflation spiral. I think that is possible, but is not my base case. Lets see if Labour can work for labour.

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When I was 17 and learning Japanese, I read the entire series of Dragonball in Japanese. As a manga aimed at young boys, all the difficult Chinese characters would have the pronunciation written out in small characters next to it, so you would now how to read it (furigana). The recurring theme of Dragonball was that the hero, Goku, would face an enemy, lose, and then find a way to evolve into a stronger fighter. I suspect the story of Super Saiyanjin has moved on from when I read it when I was 17, but whenever I see anyone continual evolve to be unbeatable, I think of them as a Super Saiyanjin. Usually I do this with sportspeople (think king of clay, Rafa Nadal winning at Wimbledon), or sometimes politicians (Boris Johnson was a ebullient pro-capitalism Mayor of London, before effortless evolving into a Brexit loving Champion of left behind areas of the North). As I gaze at the S&P 500 effortless knocking out new all time highs, despite interest rates at 5%, I am amazed at its ability to evolve - it is a true Super Saiyanjin. When I first started thinking about pro-labour shifts, and changes in interest rates, I really expected the S&P 500 to struggle. Even with the highest interest rats in nearly 20 years, the dividend yield on the S&P 500 is back at close to all time lows.

Higher interest rates did destroy “speculative” investing, like the ARKK Innovation fund.

Even away from the speculative side of American capitalism, I expected higher rates to have a more negative effect on the S&P 500. Looking at one of the most American companies you can think of - Coca Cola - has been doing share buybacks since at least the 1990s.

Looking at Coca Cola earnings yield, and US 5 year treasury yield, you could have argued Coke was a sell in 2000, and a raging buy in 2009, when its earnings yield touched 8%, and 5 year treasury yielded 2%.

And the share prices did dip 50%, and the earnings yield never went back to 2%.

I expected the S&P 500 to have a similar dip to Coca Cola as interest ratse went higher. But in 2024, despite higher interest rates, the stock market still has a distinctive tendency to return capital.

Coca cola “only” has a market capitalisation of USD 270bn now. What about leading stock, and fellow Berkshire Hathaway holding, Apple? Well for the first time since 2008, its earning yield is below a 5 year treasury yield.

Despite this, there is no meaningful slowdown in share buybacks. And this is true across many of the leading stocks.

I think the final, and most surprisingly evolution of American capitalism is tax practices. While every major government has high levels of debt to GDP, and is looking to increase defence spending, while also de-risking their China exposure, US corporate tax practices are seemingly untouchable.

This for me is the true Super Saiyanjin aspect of American capitalism. When did US corporates become untaxable? How is such an outcome possible in a democracy? Many aspects of American capitalism seem improbable to me, but continue to happen. I do wonder if “government” as we know it is coming to an end. The idea of state provision of education, health care, security, pensions are all in the process of being wiped away, and replace with only “for profit” corporations. The ultimate aim seems to be a return to the 1920s, and a very limited role for government. The signs in the US are already there. Life expectancy is falling.

While wealth to GDP is at close to all time highs.

I have always been pro-capitalism. Its the only system that works. But the problem with this super-capitalism is that it radicalises those that miss out - a tendency that we see every day in the news. From assassination attempts, to the return of communists to political mainstream. The foolishness of Super Saiyanjin capitalism is that every day it creates and radicalises more opponents. I keep hoping that we are in a period of 1970s, when excessive power of labour was curbed without to many problems.

What I was hoping for was that American capitalism would evolve again to deal with the issues that face the US. But I am starting to wonder if the political system may well be broken. I think a lot of people are coming to the same conclusion as me. Gold continues on its quiet bull market.

I wish the Fed and the US government took the message from gold more seriously - but seems unlikely to me. GLD/TLT still looks good to me.

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I am big believer in developing a theory on assets have traded - particularly when they trade in a way that surprises you. A good theory should produce forecasts than you can then apply. My first theory was “Japan as Saudi Arabia of savings theory” which basically showed that Japan had all this capital, and wherever it invested wold boom, and when it pulled its capital it went bust. This worked well with Asian Financial Crisis, Dot Com Bust and GFC - basically whenever BOJ tightened monetary policy, a big bust ensued. It is a very deflationary theory - and explained why JGB yields were so low. With this theory, whenever Japan tries to normalise interest rates policy (as proxied by 1 year deposit rates) the US market implodes. According to this theory, that should have been in 2022 (correct) and now (not correct).

The second theory that I began to use was “the pro labour” theory. In essence this argued that from 1980 onward we have had a pro-capital policies, which is free trade, freely adjusting currencies, and anti-union policies. This puts all the economic adjustment on labour. With real wages stagnating in Japan and elsewhere, pro-capital policies are bad for commodities, and good for bonds. With Brexit, Trump and populists everywhere, I argued that politics was shifting pro-labour, and was leading to policies that pushed up wages and inflation. That is inflation would be entrenched, and bonds would be in a pro-longed bear market. The biggest supporting data point here was the trend change in gold versus treasuries.

This theory would imply flat to falling real returns to financial assets, which we have not seen in 2024. We have also seen yields falling in China, which is not in line with this theory. So what about using a “neo-con” theory? Does it explain markets since 1980? And does it offer any usable forecasts?