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Interest rates
US Treasury yields are moving up sharply again. The move has been attributed, in the headlines, to rising oil prices and renewed hostilities in the Gulf. This is true so far as it goes, but that is not very far. The bigger issues are non-energy inflation and the Federal Reserve.
Here are Treasury yields of various maturities since the war in Iran began:
Rates are rising all along the yield curve. But notice the difference between the longer tenors (the dark blue and pink lines) and the short ones (light blue and green). The longer tenors rose sharply when the war began, and then stayed flat, other than a brief pop in May, until a month ago. Not so the shorter tenors, which have been grinding steadily higher since April. The shorter maturities are not reflecting inflation anxieties that ebb and flow with the winds of war and the price of oil. On the contrary, for all of May and June, short rates and oil prices were moving in opposite directions — rates up, oil down.
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Short rates are primarily sensitive to expectations for monetary policy. They are suggesting that the Fed is going to have to raise rates for reasons more fundamental than oil prices, but which the oil price could exacerbate. You can see this more vividly by looking at real interest rates (the yield on inflation-indexed Treasuries). Here is how two-year real rates have changed across maturities since the beginning of the war:
The big move has been at the short end. The market is anticipating a chunky tightening in real financial conditions, not just higher inflation. That is: they are betting that the Fed will have to tighten. It’s not hard to see why. PCE inflation excluding food and energy has risen from an annual rate of 2.8 per cent last October to 3.4 per cent in May. The unemployment rate has fallen from 4.5 per cent in November to 4.2 per cent today. Nominal wages are decelerating, but still rising at more than 3 per cent a year. There is an investment boom on. And on top of all that, oil is back at $100.
The argument for increasing rates now is not decisive, but the bond market finds it pretty compelling. The Fed may well move at next week’s meeting. If it doesn’t, watch inflation expectations for signs that the central bank, and its new chair Kevin Warsh, are leaking credibility.
Japan
Lately Unhedged has been venting our worries about big-cap US growth stocks: stretched valuations, heavy concentration in AI (where the economics are uncertain) and ugly trading for several months now.
Japanese equities offer a compelling alternative. Their tailwinds have little to do with what is happening in the US. Consider tech concentration: tech hardware accounts for roughly 21 per cent of the Topix index, with semiconductor toolmaker Tokyo Electron making up less than 12 per cent of the sector. So there is some AI exposure, but not to the whiplash-inducing levels of the US or Korea.
And despite excellent recent performance, the Topix still trades at a discount of more than 20 per cent to the S&P 500:
But the main tailwind remains corporate governance reform. There has been progress on inefficient balance sheets, cross-shareholdings and hostility to global investors or changes in corporate control, but there is still plenty of work to do. Here’s Dan Rasmussen of Verdad Advisers:
There are 1,000 companies that trade below book value, and the cheapest quintile of the Japanese market still owns about 40 per cent of their market cap in cross-shareholdings. So there’s still a huge amount to go in Japan, and I think that makes this trade very interesting — because again, it’s not about future profits; it’s about past profits. And whether those past profits get returned, the money’s already been earned . . . Things like the sale of cross-shareholdings are going to meaningfully positively impact profits because there’s a lot of embedded gains in cross-shareholdings
At the same time, domestic sentiment is turning. Japanese retail investors are showing renewed interest in local markets, and officials have stated a desire to see the massive Government Pension Investment Fund invest more in domestic assets. Roughly half of GPIF’s portfolio remains in foreign bonds and equities.
The biggest catch, for foreign investors, is the ever-falling yen and surging Japanese bond yields. The yen has moved inversely to equity gains for the past two years, eating away at global investors’ returns, as this chart from Capital Economics shows:
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If the GPIF does allocate more capital to domestic assets, this could be a “very elegant solution” to the country’s macro issues, according to Fredrik Repton of Neuberger Berman. But ultimately other domestic financial institutions would need to follow, and it “will take a long time to get there”.
There is also an open question about whether the weak currency has taken official attention from rising borrowing costs, and whether that could flip back in response to excessive fiscal stimulus. In a note this week, Mallika Sachdeva at Deutsche Bank wrote that “incentives may be shifting from FX management to yield management”, which would send the yen lower still.
The big question for investors in Japanese equity? Whether to hedge the currency, and what it will cost to do so.
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