I’m told that when you make a risotto, you’re supposed to add the stock a ladle at a time and let it evaporate/absorb. Have you ever just dumped the lot in and feared you’ve ruined the whole dish? How about building a fire. Have you ever smothered it in so much wood that the embers begin to fade and die out? If you haven’t, congratulations, you’re a better chef and pyromaniac than me. But if you have, you’re likely more in tune with something called ‘japanification’ than our masterchefs. We use this term to refer to the economic malaise that has plagued the Japanese economy for several decades. Despite the immense injection of monetary stimulus (stock/wood) they can’t get the rice to cook, the fire to catch or the economy to grow. The economy has been stuck in a low growth and disinflationary trap that has moved bond yields lower even as the level of debt continues to rise.
The developed world has largely entered at least a temporary phase of Japanification thanks to the de facto yield curve control taking place within most central banks. The UK’s £300bn asset purchase program has provided a lot of fuel to the UK economy and governments have produced debt pushing the UK’s debt to GDP ratio above 100% – the highest since records began in 1993. Despite that, yields continue to sit at record lows with little sign of abating. Implied volatility in these assets is also at all time lows. The figures are comparable in the Eurozone and the US with a Covid central bank spending tab of €1.35t and $6t respectively as government debt continues to drive higher. Most nations haven’t embarked upon a path of explicit yield curve control despite a lot of discussions about it. However, almost every developed central bank has committed to maintaining the stability of credit markets to ensure the smooth functioning of the economy. If that isn’t a guarantee of low borrowing costs, I don’t know what is.
Here’s why you should care. Interest rates are the main driver of fx forward/swap rates. The expectation of how respective interest and inflation rates will converge/diverge also plays a significant role in forward pricing. If a state of Japanification overcomes developed markets it has the impact of driving yield investors into riskier contracts. This could come in the form of underperforming corporate debt or lower quality bonds but it frequently drives investors to hold emerging market higher yield debt overseas. We have seen this come into play already in markets including South Africa, Mexico and Brazil. Each of these nations’ forward contracts over 6 months have become 38%, 28% and 36% relatively more expensive to buy into since the begging of the year.
If you never buy forward and keep your currency transactions limited to spot this will also spill over to impact you. Spot values will try to converge with forward rates. If a currency attracts a significant level of interest leaving it with a strong forward price more market participants (ceteris paribus) will want exposure to the pair encouraging the spot price to move in favour of the higher yielding currency. Typically referred to picking up pennies in front of a train, these conditions can lead to vulnerabilities in the form of rapid short coverings in emerging market currencies if fundamentals deteriorate.
Discussion and Analysis by Charles Porter