No More Free Money in Japan; Turmoil Elsewhere
The Bank of Japan implemented its 1st rate hike, which is destroying the Japanese stock market and rippling into all other markets, including the U.S. Domestically, this was reinforced by Friday’s “soft” jobs report, which raised concerns that the economy is weakening so quickly that it is headed for recession. Japanese investors are unwinding their carry trade, where they borrow at zero rates and invest both domestically and overseas. Here, investors quickly priced in multiple rate reductions by the Fed, bond prices surged and the stock market swooned. This is something of an overreaction in both places. The Bank of Japan will surely move very, very slowly, especially given the reaction to its first move. Here, a recession isn’t likely, but given the above, the Fed may act more aggressively with a few rate cuts to restore confidence that economic conditions do not warrant on their own. All of this is fluid and subject to change. The most likely outcome is the Fed will get the soft landing it has hoped for, slower economic growth without a recession, even as inflation continues to moderate.
Rates have been negative or around zero in Japan for seemingly forever. Japanese investors adapted by borrowing heavily and investing in risk assets like stocks in Japan, but also overseas. This was known as the carry trade, borrow cheap in Japan and invest at much higher yields elsewhere. The rate hike in Japan was taken as a signal that strategy is approaching its end and investors are now reversing their positions. And this change in attitude happened quite suddenly. Something similar is happening here, but less acute.
Recessions are very hard to forecast and most are unanticipated. While there have been times when the Fed hiked interest rates dramatically, so a recession seemed likely, economic downturns rarely followed in any prescribed fashion. That’s just one reason why the National Bureau of Economic Research, NBER, often takes a year or more to render its judgment that a recession occurred. Most often, an economic recovery was already underway by the time NBER called the recession. It’s just easier with hindsight. So, the market jumping to the conclusion that a recession is imminent, even as growth is holding up quite well, is somewhat premature. Powell spoke just a few days before, after the Fed chose not to reduce policy rates at its meeting and only opened the door to a first rate cut at the September meeting. But after the jobs report, the market repriced for a 50-basis point reduction in September with more to follow. The plunge in Japanese stocks could affect the Fed’s thinking, contributing to the idea that more rate cuts are needed to support the domestic economy. Warren Buffett’s sale of 50% of his position in Apple and a sizable sale of Bank of America stock is another factor unnerving investors, which shows that forecasting isn’t easy, especially when one must forecast the future.
In truth, hiring remains well above the underlying growth rate of the domestic labor supply, which analysts peg between 50,000 and 100,000 monthly. So, the job increase of 114,000 reported Friday was still above this range. But domestic labor force growth is far exceeded by new labor supply from immigrants, which is why the overall labor force keeps rising so quickly.
In July, the labor force of native born is reported to have fallen 279,000 on a non-seasonally adjusted basis, while the labor force of foreign-born workers soared by 1,648,000, also on an NSA basis. Net, after seasonal adjustment, the workforce surged by 420,000 job seekers, far more than the 114,000 estimate of hiring from the establishment survey (or the 67,000 from the household survey, which is what is used to calculate the unemployment rate.) While it is tough to make precise comparisons, since we’re looking at both seasonally adjusted and non-seasonally adjusted data, it is clear that foreign born workers are the primary source of new labor supply. And they are entering in droves.
No doubt, it is because of the influx of immigrants that the economic expansion has been so solid. There are simply insufficient native-born entrants into the workforce to maintain the pace of expansion that we have experienced. Immigrants have filled that gap. And we continue to attract many immigrants, legal and illegal, even as the pace of hiring has moderated, so the unemployment rate has increased. But these are not the kind of conditions that precede a recession. Immigrants will add to growth, either because they work or receive financial benefits from the government. And they must spend money to put food on the table and other necessities. So, the expansion still enjoys significant tailwinds.
The decline in market rates, notably the 10-year Treasury, is likely to reinvigorate the housing market. Many potential buyers have been deterred by the rise in home prices and the rise in mortgage rates. But builders responded by constructing more smaller units with fewer amenities to keep prices down and they now commonly also paydown mortgage rates for the first five years. This, along with the shortage of homes and apartments across the country, has prevented the housing market from weakening substantially. With mortgage rates following Treasury yields lower, housing should get a nice positive flip in the coming months.
The same dynamic should also help outlays for durable goods, such as autos. And lower market rates will enable firms to invest in new factories, machinery, and technology and support the effort to bring manufacturing on shore. Policies to promote domestically based technology will also benefit from lower interest rates. So, an outright recession remains unlikely. All of this points to a Fed that may be able to achieve its ultimate ideal circumstance, one that has rarely been experienced in the past, a soft landing. It’s hardly a done deal, since there are many things going on that could derail this outcome. Ground zero for the market’s action is located in Japan and authorities there must quickly restore public confidence. I’m told there’s a major election coming up in November with major political developments most every week. Overseas, two wars are still ongoing and the one in the Middle East could worsen at any moment. We’ve experienced no disruptions to oil supplies, but that’s always a possibility. Nonetheless, it seems that the soft-landing scenario is the most likely outcome. And it is vastly more desirable than other possibilities, so we should be grateful for that.
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