The Germans celebrate Christmas Eve instead of Christmas Day. So Frohe Weihnachten from me for today! But it’s not all pleasantries because there’s a particular indicator I’m going to be watching, even over the Christmas break, just to remain vigilant. And I suggest you do too. Because this year, there’s a genuine threat of a Monetary Pearl Harbor.
Which reminds me of my favourite Christmas story…
In 2018, my family got snowed in for Christmas. My German mother and her Scottish partner had invited my Japanese in-laws to her home in the Austrian Alps.
Now, you might be thinking, ‘with that mix, what could possibly go wrong?’. And everything was going surprisingly well. Until disaster struck.
It happened after a particularly bad bout of Uno losses.
‘Why did you attack Pearl Harbor?’, my German mum asked her Japanese guests out of the blue.
The room went cold. I outright froze. Even my mum’s partner went quiet for once.
I can’t really tell you what anyone else’s reaction was because I was staring fixatedly at the table decorations. Pinecones and candles combined into a Christmassy garland running the length of the table. Very tasteful.
At some point, my Japanese father-in-law cleared his throat and said, ‘because America cut off Japan’s oil supply’, or something to that effect.
I don’t really recall what happened next. Perhaps I explained something about the oil embargo the Americans had imposed on Japan for its invasion of China. Perhaps we turned back to the Uno game. Either way, things only got less bad from there on in. And nobody made any comment about what the Germans had been up to at the time the Japanese were dropping bombs. Thank God.
A few months later, my mum complained that her guests had never called her or got in touch since their visit. She felt this was ‘strange’. I can’t say I’m surprised, though.
What does this have to do with the Japanese plan to blow up the global financial system? Well, there isn’t one. What we do have is kind of the opposite.
Japan’s misguided plan is actually all that’s holding the financial world together at the moment. But it might be about to fail, thanks to inflation.
Here’s the back story…
Ever since 2016, the Japanese central bank, the Bank of Japan, has been using its limitless budget to cap Japanese Government bond yields near zero. This means that it’s willing to buy as many government bonds as it takes to keep the government’s interest bill close to zero. And it’s been buying a lot of bonds to do this. It now owns more than half of all Japanese government bonds.
Now, usually, this sort of policy would cause the value of the currency to nosedive. Printing money devalues it, after all. But the Japanese yen is different…so far. Because the Bank of Japan is also intervening in the currency markets to support the value of the yen too.
But this merely causes a third mole to pop up in the game of whack-a-mole (which was invented in Japan). The third mole is inflation. And the central bank is actually supposed to whack this particular mole. That’s its primary job, not propping up the yen or the government.
Until recently, inflation really had stayed subdued in the land of deflation. But lately, prices have finally begun rising. And, in a culture where executives apologise publicly for raising prices, people don’t like inflation.
The challenge for the Bank of Japan is simple. It can’t whack the inflation mole without a new problem popping up to replace it. In this case, it can’t stop buying government bonds without requiring the Japanese Government to find investors to finance its deficits.
We’re talking about a sovereign debt crisis for one of the most important economies in the world…
A bit like the one that, very briefly, occurred in the UK bond market recently, when the price of gilts crashed so fast that the UK pension system almost went bust.
The Bank of England quickly reversed its tight monetary policy and went back to QE to bid up bonds and bail out the government. Perhaps the Bank of Japan would too. But for how long can either central bank ignore inflation?
If it’s not the Japanese bond market that breaks as the Bank of Japan turns to whacking inflation, it could be a falling yen that triggers chaos. That was the story of 2022, when the yen plunged.
Central banks basically face a choice between whacking inflation, whacking bond yields (keeping their government funded), or bidding up the currency. They can do two of the three, but not all three. So, which one will be sacrificed?
Either way, I’m on edge right now. Having bought a house in Australia with our money here, the bulk of our savings are now denominated in yen. This made sense during deflation in Japan, regardless of the exchange rate, because we’ll travel there a lot. But things are looking dicey.
If you’re worried like me, what should you do? Keep one eye on Japan’s financial markets. Spiking bond yields or a falling yen are a sign that the Bank of Japan’s policy is looking shaky.
At this point, the Japanese must choose their crisis: a crashing yen, soaring inflation, or a government that goes bust.
The question is when they make their choice…
[Aaaand, since writing those words, Japan’s central bank has shocked the market with an update to its bond purchasing program. It will now allow the Japanese Government’s borrowing costs to double to 0.5%. This is similar to an interest rate increase. Japanese stocks tumbled more than 3% on the news and Aussie stocks dived too.
If there’s a Monetary Pearl Harbor this Christmas, you won’t be able to tell me it came as a surprise…]
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
PS: Due to the festive season, The Daily Reckoning Australia will have a modified publishing schedule next week. Expect to see special editions of The Daily Reckoning Australia on Monday, Wednesday, and Friday next week — where you will get a glimpse at what our editors have been telling their paying subscribers recently on how to best navigate these sensitive market conditions. We will return to our usual daily publishing schedule on Tuesday, 3 January.
