Endgame #3
Japan caves in their fight to curb interest rates; Gold jumps higher; China faces fresh problems in the property sector.
Welcome to Endgame, the short monthly newsletter covering the biggest events in macro and how they tie into the Dollar Endgame. Let’s get started.
Japan
On Tuesday, October 31st, the Bank of Japan took additional measures to relax its influence on long-term interest rates by adjusting its bond yield control policy that has been in place since September of 2016. This move is just the latest in a gradual progression toward dismantling the contentious monetary stimulus implemented over the past decade, and lifting the cap on YCC. As anticipated, the Bank of Japan (BOJ) had retained its -0.1% target for short-term interest rates and the 0% target for the 10-year government bond yield as part of its yield curve control (YCC). However, the BOJ introduced a shift by redefining 1.0% as a flexible "upper bound" rather than an inflexible hard cap. Additionally, the commitment to defend this level with unlimited bond purchases was removed.
The Bank had previously lifted the ceiling on the 10yr JGB (Japanese Government Bond) in late July from 0.5% to 1%, in an effort to slow down purchases of JGBs as the upper limit of the band was constantly being tested. Yield Curve Control essentially means that the Bank promises unlimited purchases of bonds to keep yields below a certain target. As bond prices and yields are inversely correlated, thus bond prices moving upwards means yields get pushed down.
As the BoJ runs this program, it prints Yen to buy bonds, boosting Yen liquidity and supply on the open markets and thus driving down the value of Yen versus USD. USD/JPY has weakened significantly.
"Given extremely high uncertainties over the economy and markets, it's appropriate to increase flexibility in the conduct of yield curve control," the BOJ said in a statement announcing the decision.
Rising global yields and inflation is making it increasingly difficult to steer the monetary ship. Japan has for almost a decade pursued accommodative monetary policy, but this has trapped them in a conundrum. With debt to GDP at an eye-watering 266%, interest rate hikes exacerbate the fiscal debt doom loop, and cause widespread pain throughout the credit-laden economy. But, something must be done to slow the falling Yen.
For the 18th consecutive month in September, inflation remained above the Bank of Japan's 2% target. The BOJ stands as a dovish outlier among global central banks- while many others have aggressively raised rates in recent years to counter rampant inflation, the BOJ has maintained low rates, which puts pressure on the currency, since carry traders can borrow Yen at 0.5% (shorting it effectively) and buy USDs earning 4-5%, making money on the spread.
Shortly after the BoJ’s announcement of a soft cap at 1%, the Yen fell to 150 against the dollar. It had previously broken this rate on October 25th, but had quickly retraced. It has remained range-bound around the 150 threshold for the duration of November, as higher yields mean less profit incentive for carry traders. It appears the market is awaiting the BoJ’s next move (or blunder).
Japan has earned approximately $512B USD equivalent in tax revenue this year, per CEIC data, but this amount is needed for government spending and servicing the $9.2T USD of federal debt it owes. Essentially, this means that every 1% rise in interest rates increases debt service costs by $91B, which is 17% of government tax receipts. A few hikes therefore, would put Japanese gross interest expense well over 100% of all federal revenue, forcing the BoJ to monetize all future federal spending.
This is the dilemma policymakers face- save the bond market or the currency. Saving one de facto means sacrificing the other.
It looks like we already know which direction Japan is going.
United States
As Powell and Friends continue this foray into a high-interest rate environment, the debt crisis continues to accelerate. In October, I wrote a piece entitled “The Singularity” detailing the immense speed of the debt growth and how a new QE program could exacerbate the problem.
Zerohedge noted on October 18th:
“Total US Debt is now $33.669 trillion, up $58 billion in one day and up $604 billion in one month... up $20 billion every day, up $833 million every hour.
At this rate US debt will be $41 trillion in one year.”
On Tuesday, November 28th, the national debt rose by $61B overnight, which puts us only $173B away from $34T. As the Fed hikes, Treasury debt rolls over and begins to get re-financed at the higher rates. This forces interest expense to increase on the Treasury, increasing the speed of debt growth exponentially. The maturity profile of U.S. Federal debt means that this year, 2024 and 2025 are particularly crucial as trillions of debt rolls over during these two years.
Interest rate hikes are having downstream effects on other areas of the economy. Per figures released yesterday, in October, the sales of new single-family homes in the United States experienced a larger than expected decline, due to high mortgage rates that diminished affordability. According to the Commerce Department's report on Monday, new home sales saw a 5.6% drop, reaching a seasonally adjusted annual rate of 679,000 units. Sales for September were revised downward to 719,000 units from the initial 759,000 units.
Furthermore, prices have fallen as well. Last month, the median sales price for a new single-family home was $409,300, a fall from the previous month's figure of $422,000. In a broader perspective, the average sales price was $490,000, declining from the same period last year when it was $515,000.
Cars have also been affected. In June, the average cost of a new vehicle was $48,808, a reduction of $865 compared to the mean transaction price in January, as reported by Kelley Blue Book. This reflects a 1.7% decrease in prices since the beginning of the year. I also should mention, this is the first instance of a sustained decline in car prices since the industry encountered supply shortages in 2021, leading to a surge in prices of 10-20% YoY depending on the make and model. EV sales have been even harder hit, with a drop of 19% from last year according to Yahoo Finance.
The consumer is also getting hit. The Commerce Department's Census Bureau reported a 0.1% decline in retail sales last month, the first decline in seven months, due to reduced purchases of motor vehicles and lower spending on hobbies. This decline suggests a slowdown in demand at the beginning of the fourth quarter and reinforces the widespread market belief that the Federal Reserve has finished its series of interest rate hikes.
In October, US inflation remained flat from the previous month, offering a promising sign that the persistent surge in prices is finally slowing. This potentially signals an opportunity for the Federal Reserve to halt its series of interest rate hikes. Year over year, inflation was at 3.2%, still well above the Fed’s target of 2%. In order to achieve this, the Fed had to hike interest rates at the fastest pace ever from 0.08% to 5.33%, causing a bond market meltdown and the indirect bankruptcy of 5 banks back in the spring of this year.
So far, we seem to be in the doldrums; the worst effects of rate hikes haven’t hit yet, the consumer is still somewhat strong, equities are still trading sideways (due to stealth QE, which we can cover in a later post), and bank collapses seem to have stopped for now due to new Fed programs like the BTFP.
Gold
Gold has been range-bound this year, whipsawing up and down until late October when a strong rally began, pushing up the price of the yellow metal. Astoundingly, without QE or significant rate cuts, it rallied to a new closing high of $2,040 an ounce on Tuesday, November 28th. The rise in the value of gold has been reinforced by a weakening dollar, which has decreased by around 3% against a basket of six peer currencies in November. This means it is a more affordable option for investors using other currencies to purchase the precious metal.
Central banks remain large contributors to gold demand, having acquired a record-breaking 1,136 tonnes of gold last year and an additional 800 tonnes during the first three quarters of 2023, as reported by the World Gold Council - an industry group. The People's Bank of China has been the primary buyer this year, acquiring 181 tonnes, followed by Poland with 57 tonnes and Turkey with 39 tonnes.
Gold demand is typically tied to mistrust in risk assets and negative real rates- acting as a safe haven and a potential reserve asset in the case of global monetary breakdown. Although gold is technically demonetized, historically it still has acted as an inflation hedge, although with spotty success since the 1980s when we entered Eurodollar dominance.
The yellow metal typically has acted as a warning sign for global monetary debasement. In February of 2008, gold had ripped to an all time high, right before Bear Stearns collapsed and was rescued by JP Morgan, and months before Lehman in September 2008. A similar process played out in 2020, where gold had a muted response right after the pandemic but soon rallied to new all time intraday highs at $2,075 in August 2020. This short-lived bull market correctly predicted the massive QE program that the Fed undertook for the next two years- unfortunately, gold retraced and remained range-bound below $2k until recently.
Typically, gold leads monetary debasement by around 12 months, so if this is any indication, the Fed could restart QE as early as Q4 of 2024.
China
China was expected to account for 35% of global GDP growth in 2023, surpassing most other nations- however, a series of poor data releases during the summer revealed a structural slowdown. The country faces challenges such as subdued consumer spending, a lackluster private sector, growing youth unemployment, significant shortages of capital for local governments, and a significant downturn in the property market, which we covered in an earlier substack piece here.
There is a widespread consensus that foreign direct investment (FDI) has experienced a significant decline in China. But, there is a lack of agreement on the extent of this decline, and this ambiguity exists even within China itself. China's distinct approach to “economic statistics" basically means the government often leads to attempts to derive more precise data by reverse-engineering information from other series, i.e. gerrymandering the outcome they want by picking and weighting the variables as they see fit.
Despite efforts to improve its appearance, the provisional third-quarter FDI data remains horrible. According to early balance of payments data released by the Administration of Foreign Exchange earlier this month, inward FDI experienced a decline, reaching negative territory for the first time since the series commenced in 1998.
Basically, this means that the foreigners are no longer investing in China on net, and a withdrawal of capital has begun.
China’s real estate market is still feeling the pain.
Shenzhen, among the priciest cities in China, has introduced new directives aiming to reduce down payment ratios and ease other regulations starting Thursday. Additionally, Beijing is hoped to offer increased financial assistance to developers facing challenges in the weeks ahead, which are many as the entire sector is in crisis. Buyers are withdrawing, borrowers are participating in mortgage strikes, and developers are grappling with a liquidity crunch. In July, the value of new home sales witnessed a staggering 29% decline compared to the previous year. Country Garden, China's largest developer, has disclosed a significant profit downturn and characterized the market as having swiftly descended into a profound state of depression.
In an effort to control the property market, the government implemented restrictions on borrowing by developers two years ago, commonly referred to as the "three red lines." These reforms bore the approval of Mr. Xi, who emphasized that "Housing is for living in, not for speculation." The initial idea behind these stringent regulations was to force property firms to exercise more restraint, discourage speculative buyers, and bring about a slower pace of building. However, the reforms have crimped new cashflow in a sector that desperately needs it, and thus has worsened the ongoing crisis.
China has intensified its effort to compel its major banks to support distressed property firms, exacerbating the challenges facing the massive $57 trillion sector. In the face of surging bad loans and historically low net interest margins, prominent lenders like the Industrial and Commercial Bank of China (ICBC) may soon be tasked, for the first time, with extending unsecured loans to developers, a significant number of whom are in default or on the verge of collapse.
ICBC and 10 other major banks may in 2024 need to set aside an additional US$89 billion for bad real estate debt, or 21 per cent of estimated pre-provisions profits in 2024, according to Bloomberg Intelligence. In contrast to many Western banks, Chinese state-run banks operate under government directives that dictate the extent of lending and target sectors, particularly in economic downturns. Beyond public directives, authorities frequently convene unscheduled meetings with bank executives, issuing verbal instructions—referred to as "window guidance"—to steer lending toward preferred sectors or impose restrictions on certain businesses. They are “private and independent” commercial banks in name only.
The PBOC (People’s Bank of China- central bank) has been doing its best to support the banks, injecting liquidity in the form of medium term policy loans.
On October 16th, Reuters reported:
“The PBOC said in a statement it conducted medium-term lending facility (MLF) operations worth 789 billion yuan ($107.96 billion) to keep liquidity in the banking system adequate. It held the rate on the one-year policy loans at 2.50%, unchanged from the previous operation.
With 500 billion yuan worth of MLF loans maturing, the PBOC is injecting fresh liquidity into the banking system. Market watchers polled by Reuters last week predicted no change to the MLF rate.”
On November 15th, China's central bank increased liquidity injections but maintained the unchanged interest rate. As 850 billion yuan worth of MLF loans approached expiration this month, the operation led to a net injection of 600 billion yuan in fresh funds into the banking system.
As China’s property crisis worsens, the PBOC will be forced to increase liquidity, putting even more pressure on the weakening Yuan, which was trading 7.3 to the dollar, the limit of the previous range. As covered in our previous piece, China has ordered state banks to dump USDs to help defend the currency in the event it weakens to this level.
That’s all for this report, I will see you next time!