Japan jumps the shark!
“Jump the Shark!” is an idiom that typically describes a moment in the evolution of a television show when the quality declines and some type of gimmick is used in a desperate attempt to keep viewers interested. The term comes from a scene in Happy Days when the character Fonzie jumps over a shark on water-skis. The usage of the term has broadened beyond television to indicate a desperate attempt to the level of absurdity in the evolution of decline.
Japan going to negative interest has certainly jumped the shark!
Japan Jumps the Shark!
Function of Interest Rates
The function of interest rates is really (or should be) a direct value representation of the risk of capital. Lending money to an individual or business with higher risk, means a higher rate of interest to off-set the possible loss of a default. Lower interest rates are associated with lower risk lending.
In a free-market interest rate environment, rates move based on the perceived value of risk which drives lending and borrowing. Rates for different borrowers and different lenders vary, based on a variety of terms; the collateral, the credit worthiness, the length of time, the payment schedule, etc. In the free market it works very well. We have even seen a boom in peer-to-peer lending, which uses the basic principal of interest equates to the risk of the loan. It has worked for centuries and continues to do so in the private sector. It is certainly not without risk, but that risk is directly reflected in the interest rate of the loan.
But what happens if someone steps in and artificially sets the interest rate, regardless of the credit worthiness of the borrower? How are we to tell if the interest rate actually reflects the risk? There are credit rating agencies; S&P, Moody’s, and others that supposedly does exhaustive analysis on the risk and rates the credit worthiness of the borrower. In fact the public and corporate private sector rely heavily on this supposed “credit rating” to further determine the rates of interest. Yet we have seen that these credit ratings for the most part are really worth nothing. GM, Freddie, Fannie, and a host of companies that went bankrupt and failed had stellar credit ratings – some all the way up to just before they failed. Governments, many that are in debt and even municipals have stellar ratings and many of them had stellar credit ratings until they failed. It is only 20/20 hindsight that these ratings companies lower the rating after problems occur. That should tell you their exhaustive analysis of risk pretty much sucks.
I am currently in Puerto Rico and if you have been following the news Puerto Rico has a serious public debt problem, however their bonds were also rated between A – B (low to medium risk – low risk of default) until February 2015 when they dropped them to C, which was AFTER the problems. Thanks Moody’s, but that has been the story with corporate and public bonds. The problem is the rating agencies have a VESTED INTEREST, because they are PAID by the people that are issuing the bonds. So they have an incentive to rate it as high as they can, because that is what they are paid for.
Suffice to say a credit rating does not hold much water and when a bond fails that AAA credit rating it once had means nothing. You sure can’t cash a credit rating at the bank.
Central Banks Playing God!
Since we live in a fiat based Keynesian economic world, money supply and interest rates are SET by the central banks. It is a very delicate process, as the central banks want to make sure their rates are set relative to the free market. It is a balancing act between the free market supply and demand vs. setting an arbitrary rate that allows the free market to move without too much influence.
The central banks try to control the flow of money, lending, borrowing, and saving by slowly raising and lowering rates. The general Keynesian theory states the central banks and the control of interest rates is the primary tool for managing a free market system. The truth is we have not lived in a Free Market system since the 1930s. Sure we can transact business freely, but the BUYING power of our currency is manipulated by the central banks. That manipulation is done to help persuade us to borrow more or save more. You could say it is a way the government tries to control our decision process in the free market. It certainly skews are ability to make value oriented decisions.
In only three occasions in our recent Keynesian Fiat currency history has the Federal Reserve taken radical action to try to spur or slow down our spending. One could say fully trying to man-handle the free market economy.
The first is when the U.S. was forced off the gold standard as the world started dumping dollars. Inflation rocketed and the Fed took interest rates up fast and hard to over 20% before the deluge stopped. The Fed was still trying to figure out how to manage a fiat currency. Interest rates moved all over – a volatile and uncertain time.
Courtesy of Fredy
The second was after the Dot.com bubble bursting when the Fed took interest rates from 6% to 1% to try to spur borrowing and spending again (creating the cheap money that helped fuel the housing bubble).
The third and most radical of all has been after the 2008-2009 crisis and taking rates to ZERO for almost 8 years. Not only did they take rates to zero, they ramped up the money supply by trillions, bought bonds, bought mortgage backed securities, and proceeded to bailout the banking community. In all three of these occasions the interest rates were NOT a reflection of risk, but rather treated as a tool to try to control the free market.
Some may argue, and perhaps persuasively, that the central banks need to control interest rates when the free market fails. While I would rather not go into that debate, because it is more of an ideological one – those like me that believe that failure IS an option and those that believe that failure is NOT an option and governments need to intervene. Let’s say that we all agree that the government sometimes needs to intervene and adjust interest rates in a time of crisis. They, as pointed out above, have done it before to help relieve economic stress and it worked (certainly at a considerable expense to the government and ultimately the tax payer). What happens when that government interventionism of extreme interest rates becomes the norm? What happens when a nation, the people, and business become dependent on the interventionism? When the interventionism that has been pushed beyond the boundaries of anything even resembling the free market and the laws of supply and demand?
Japan in the 1980s went through a huge booming cycle. It was a boom based on huge revenue growth and the ability to access leverage capital. The expansion of growth was accelerated on debt financing. Eventually with all debt bubbles that accelerate beyond the growth potential (the inability to finance the debt), it comes crashing down. Japan’s government intervened and took their interest rates to an unprecedented level in an effort to try to keep the spending boom going. It didn’t work and Japan feels the stagnation. It became known as the lost decade and Japan is now in their lost decades.
The unprecedented move in Japanese interest rates to zero did create a new financing mechanism known as the “carry trade”. Investors from around the world figured out if they could borrow money from Japan at zero interest rates and invest in other bonds that paid higher interest rates they could make a profit (arbitrage).
There were only two risk factors; if interest rates changed and the currency risk. It became apparent that Japan was not going to raise interest rates for a long time, they were stuck. So the risk really became currency risk. Japan eventually became the source of cheap money. Japan was lending unprecedented amounts of money at next to nothing around the world. The “carry trade” sourced in Japan became massive.
Japan’s massive experiment in Keynesian Economic theory of interventionism with money printing and setting rates at zero seemed to work. Japan didn’t collapse, but they didn’t grow either. Government interventionism became permanent and the free markets received another death blow. No longer was credit risk a consideration, even the trusted-all-knowing credit rating agencies rated Japan with AAA credit.
Following their footsteps…
When the crisis in 2008-2009 hit a debate began to rage in economic wonky circles. Some turned to Japan’s massive Keynesian experiment (“Lost Decades”) and supported taking similar action, others were against it. Bernanke once responded we are not Japan, as if taking exactly the same monetary policy action that Japan did would generate a different result. At the time I wrote – we are just following in Japan’s footsteps.
The Western central banks quickly followed Japan’s lead. Everyone was printing money, running zero rates, and monetizing government deficit spending. It was not a solution, but it certainly bought time.
Concern started to surface in 2011, rates were zero and central banks were issuing more stimulus (QE and money printing). They were buying time, but if things continue to get worse, where to go from there? Rates were already floored at zero, you couldn’t take them negative – could you? Several economists argued that taking rates negative would reflect a full default and failure of the fiat currency system. One asked, who would be stupid enough to loan money and PAY to loan the money? The retort was that investors would pay for security. Absurd, are these not the same governments that are running massive deficits and mounting debt?
When Money Markets had gone negative – it was considered a default, a failure, the system was broken. Now to consider what was once absurd as an actual monetary policy, what kind of economic fantasyland do we live in.
As time progressed and this massive Western Keynesian experiment continued – the world just accepting the once absurd as now the new normal. Rates at zero, central banks buying government bonds (monetizing deficit spending), buying mortgages, some even buying the stock market. The government is NOT the biggest market participant. Free Markets be damn, it is a government market. Socialism has stepped firmly into the financial market system and the investors embraced it. It fueled one of the greatest equity and bond market rallies ever. The private sector would drive the equity market higher and the public sector (Fed) would drive the bond market higher. A win-win.
But what happens when we have another economic slow-down, what next? The central banks of the West are all in, there is nowhere to go. They are printing trillions and rates are at ZERO. Could a central bank actually take rates into the unknown territory of negative rates? Would the world accept it and could it even work?
I had started suggesting what was once absurd as a real possibility in some market previews in late 2014. My stomach turned as I even was willing to accept that we could venture into what even economics 101 tells us is impossible as it would be the open failure of a fiat currency economic system. However, there was a time before 2008 when if you told someone that the Fed would print money to buy government bonds and mortgages – I would be called crazy and an idiot. Yet here we are and it is now considered the norm.
The leader, the proverbial “Canary in the Coal Mine”, has been Japan. They have survived their lost decade and continue to head further down the Keynesian rabbit hole. The term in Japan for their radical economic policies is called “Abenomics” after their Prime Minister Shinzo Abe, who in 2012 expanded the Keynesian experiment further, with a three prong approach: print more money, take rates lower, and tax hikes. Japan had already been running in their “Lost Decades”, now Abenomics super-charged their already easy Keynesian policies.
After 4 years of Abenomics it is not really working. They are injecting more stimulus, rates are floored at zero, and taxes raised – but the economy will not grow.
This morning Japan took that step into the unknown. They took their interest rates negative. It has been called radical, even economic “kamikaze”. One asked, how much more negative can you take rates? Seriously – we have moved deeper into the hole that I don’t see possible to retreat from.
I believe it is only a matter of time before the other Western nations follow Japan’s footstep. The Fed may want to talk tough and give the impression of being Hawkish and raising rates, but one of our largest trading partners and allies just took rates negative.
Of course the pre-market futures rallied. A signal that more stimulus is coming, rates are around the world are going down (not up), and negative interest rates (once considered the unimaginable) is now a reality. This should certainly give the equity markets a boost and raise the expectations that rates are certainly not going up and may even go down. Could the U.S. see negative interest rates, I would have said no yesterday, now I think even the impossible is possible.
Japan has jumped the shark!
Support & Resistance
We are seeing a strong gapping rally higher on Japan’s radical negative rate move. We could see 16,400 before selling pressure ensues. I would give 16,600 the high range if we start getting above 16,400. 16,000 is going to be short-term support heading into next week.
We have seen some volatility in the tech heavy index and the overweights have whipped this index around. I think a visit to 4250 today is in the cards. A strong close above 4250 means a move to 4350 next week is possible. Look at 4200 as a neutral close with 4150 as short-term support.
The S&P is pushing up into a resistance band and selling pressure in the futures looks like it would start at 1920. If offers lift and we get some buy-side volume, a push to 1940 could be in the cards in today’s trading session. A close below 1900 will be a sign of weakness heading into next week.
All eyes are on the 1020 level and if the broad index is seeing enough order flow to start a rally out of this 1000 – 1020 consolidation zone. Could Japan’s negative rates be the catalyst? I am not sure, I think we need to get some reaction from the ECB, London, and the Fed – to tell whether this is a lone wolf or if we will see more easing from the West. For now watch the close, strong volume and a close above 1020 is a short-term bullish sign. Sure, it could be nothing more than a start of a “dead-cat bounce” into the 1080 area – but that’s something.
If the market assumes any Hawkish tone out of the Fed in reaction to Japan, this early market rally could begin to weaken and we could sell-off. For now – this is just another catalyst event and further step into the Keynesian rabbit hole.
The Federal Reserve earlier this week kept rates unchanged and continues their monetization of bonds and mortgage backed securities. Nothing has changed.