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What Japan's dry run for a crash tells us about a possible U.S. stock market crash
05/30/2013 11:38 pm EST
Now we know what the crash that we’re all so afraid of once the Federal Reserve stops flooding the financial markets with cash will look like and how it will begin.
The 7.3% plunge on May 23—with a total drop of 13% from the May 22 close to the May 30 close--is a dry run for that future crash.
So let’s not look a gift crash in the mouth. Shall we see what the Japanese dry run tells us about what we might expect in a Fed-ends-QE3 crash? And what it tells us about why it might not happen at all.
First, we have nothing to fear but fear itself—which is the problem.
You’ll note that the May 23 plunge began with worry in the bond market and then spread to stocks. That makes sense since the monetary policies at the Bank of Japan (and the Federal Reserve) have been designed to put to repress yields. When intense pressure like that exerted by the Fed’s $85 billion a month in purchases of bonds and mortgage backed assets lets up, the fear is that the markets will see a huge reaction.
Note that we’re talking about “fear” here. Emotions. Extreme emotion.
Extreme emotion swings to excess.
The trigger here was a move in the yield of 10-year Japanese government bonds to 1% during trading on May 23.
The fear was that this was just the beginning of an uncontrolled and uncontrollable move up in 10-year yields.
Just one month ago, the yield on the 10-year Japanese government bond had been only 0.59%. In rough terms, the yield had doubled in a month. Wasn’t this the beginning of a move that would take yields not just to 1% but also to 2% or even higher?
The halt in trading for the 10-year government bond fed into those fears. Trading wouldn’t have been halted, would it, unless something really bad was about to happen? In the moment no one really focused on retreat in the 10-year yield to 0.86% by the end of the day or the fact that the 10-year yield had been 0.85% a year earlier and the sky hadn’t fallen.
Second, the more everyone feels that we’re in uncharted territory—and the more untested the guides—the easier it is for fear to grow.
Japan’s dry run for a crash—which officially moved to 10% correction territory with the May 30 drop in the Nikkei—offered fear the best of all growth media. The Bank of Japan’s efforts to weaken the yen, increase economic growth, and revive inflation in a country where deflation is deeply ingrained rely upon a program of asset purchases that will pump an unprecedented amount of money into the Japanese financial system. The amount envisioned is roughly equal to the Federal Reserve’s current program of asset purchases, but the U.S. economy is more than three times as large as the Japanese economy. There are doubts about the effects of the Fed’s effort so imagine the doubts about a program three times larger that’s taking place in a country that is accustomed to deflation and to the failure of prior efforts to revive the economy.
And, of course, there’s the over-arching unknown of the exact effect of extreme levels of government debt in Japan. There is a general consensus, of course, that running the world’s highest debt to GDP ratio—215% as of the end of 2012 and a projected 230% by 2014—isn’t a good thing. The Japan bears argue that Japan is bankrupt—a term of limited utility when applied to a country that can print money. The Japan optimists—I’m not sure there are any Japan bulls in any meaningful sense—say that because of Japan’s huge reservoir of savings, the country has more time to fix its debt problem and that the current Bank of Japan effort might even work. No one knows, of course, but the arguments of the Japan bears “feel” right. Saying “No one really knows” isn’t exactly calming.
Plus the guy now running the Bank of Japan, Haruhiko Kuroda, has only been governor of Japan’s Central Bank since March. Kuroda isn’t exactly an unknown in Japan’s financial circles. He was the top currency official in the Finance Ministry from 1999-2003, for example. But he’s never run a bureaucracy as complicated as the Bank of Japan. He has limited experience in speaking to the financial markets. And his track record isn’t one likely to immediately calm the financial markets. At the Finance Ministry Kuroda was in charge of an earlier effort to drive down the yen. That leaves the market wondering if Kuroda is more than just a one trick, drive-down-the-yen pony.
Certainly the inexperience of the Kuroda team has been on full display during Japan’s dry run for a crash. Initial comments from the Bank of Japan suggested that the bank was okay with rise in interest rates as long as the 10-year yield didn’t go above 2%. Noting that the Bank of Japan calculated that a 1 percentage point increase in interest rates would produce mark to market losses of about 20% of Tier One Capital for Japan’s regional banks and a 10% loss for the country’s biggest banks was intended to calm the markets how? (It’s not like most investors know that Japanese banks hold their government bond portfolios to maturity so they aren’t ever likely to mark them to market and take the losses that would impose.) The resumption of the drop on May 30 was triggered when the Finance Minister said that an increase in bond yields might hurt Japan’s banks. That’s on message?
There are things that Kuroda could be saying to calm the markets, but either he’s not saying them or they aren’t getting through to the right people. Kuroda is giving speeches to Japan’s parliament promising to reduce bond market volatility when the big need is for private conversations with the financial powers that make the market in Japanese government bonds and who are worried about liquidity drying up in that market. That’s a legitimate concern since the Bank of Japan is going to be buying about 70% of all new government bonds. But it’s also exactly the kind of concern that a central bank can directly address with a promise to provide all the liquidity the market needs. It’s exactly that kind of conversation—and follow through—that the Federal Reserve has gotten so good at.
And third, for a sell off to turn into a crash, you need a multiplier, something that will turn a problem in one part of the market and for one group of investors and traders into a problem for the entire market.
In Japan’s dry run one multiplier has been banks. The fear went that rising yields on government bonds would produce big losses on bank bond portfolios that would then force banks to raise capital in depressed financial markets or cut back on lending. The latter would be devastating to a Japanese economy struggling toward growth. (I’m skeptical about this as a trigger mechanism since it goes against some of the key features of Japan’s banking/regulatory culture.)
The more important—even if less focused—multiplier has been the market for Japanese government bonds themselves. Here the argument goes that investors will lose faith in Japanese government bonds themselves and stop buying them to a degree that will cause a collapse in bond prices and a spike in yields. In a worst case scenario the Japanese government would be unable to fund itself.
That scenario is very convincing to Japan bears.
What’s curious to me about Japan’s dry run for a crash—and maybe the one thing that most strongly argues that this is correction and isn’t about to turn into a crash—is the behavior of the yen. If the financial markets are about to lose faith in the ability of the Japanese government to pay its debts—or to fund itself—it’s hard to see why that would lead to rally in the yen against the U.S. dollar. In a crash scenario the yen certainly wouldn’t be a safe haven currency and if you’re short the yen, you wouldn’t want to cover but would instead look to go even shorter.
I think that what we’re seeing is a correction in the Japanese financial markets—and if you want a projection on the duration of the correction, I’d point you to the July elections for Japan’s upper house. Right now Prime Minister Shinzo Abe’s Liberal Democratic Party doesn’t control the upper house, but before the current market upheaval it looked like his party was on track to gain a victory that would remove the last obstacle to enacting the party’s economic policy. Before the meltdown in the Tokyo market, Abe’s approval rating stood at 76%. I’d doubt that recent events have done that rating much good. And I’d be really surprised if Abe didn’t pull out all the stops to make sure that the markets don’t endanger this election goal.
But enough about Japan—the goal of this post is to see what lessons the Japanese dry run for a crash offers about a potential U.S. crash. How does the U.S. situation measure up on my three points from the Japanese dry run?
First, on the fear scale, the U.S. financial markets don't seem to be in the same neighborhood. Yes, I think there is an underlying element of fear since we tend to see the future through the past and the past has had more than its share of crashes in the U.S. markets. But we aren’t looking at a U.S. stock market that has climbed 75% on little more than a promise to weaken the yen. U.S. economic growth may be uncomfortably dependent (and unsustainably so) on Federal Reserve cash flows into the market, but the economy is reporting real growth that, even at a downwardly revised 2.4% rate for the first quarter of 2013, is near the top for the world’s developed economies.
Second, on the uncharted scale, the U.S. isn’t quite as far off the map as is Japan. The U.S. budget deficit as a percentage of GDP has actually been coming down recently. That situation isn’t likely to last—on current trends the ratio of debt to GDP starts to climb again after 2015. But for the U.S. the problem is in the medium term and not immediate.
And, whatever you think of the economic stewardship of Federal Reserve chairman Ben Bernanke, the Fed has gotten to be very adept at communicating with the financial markets. Even the current seeming indecision about when the Fed might begin to taper off its asset purchases to me looks intentional. Yes, it has ruffled some feathers in the financial markets, but I think that has been the point.
And third, I don’t see—yet—a convincing multiplier that turns a U.S. market wobble into a crash. Yes, valuations in the junk bond market seem likely to correct—painfully. As mortgage interest rates start to rise, the mortgage-backed securities market is likely to fall—painfully. But I don’t see the connections and feedback loops that would turn even major stumbles in these sectors into the trigger for a general U.S. market crash.
To me that’s the take away lesson from Japan’s dry run to a crash.
Which doesn’t mean that everything is great in the U.S. market and that U.S. stocks are headed to the sky. Stock valuations depend heavily on low bond yields and the recent increase in yields on U.S. Treasuries, if sustained and extended, will take some wind out of this rally. I do worry about stock prices and the possible over-optimism about earnings growth in the second half of 2013. It’s hard for me to be optimistic about earnings growth for U.S. companies when economies in Europe and China are showing disappointing growth.
And I do think that the tapering off of Federal Reserve asset purchases—let alone any reduction, however unlikely, in the total size of the central bank’s balance sheet—will put downward pressure on stock prices.
Does all this add up to an easy continuation of the rally in U.S. stocks? I don’t think so.
But it doesn’t add up to a crash either.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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