04/29/2024
World Central Banks are facing a Kobayashi Maru. What's that, you might ask?
To keep inflation in the U.S. at bay, the Federal Reserve needs to hold interest rates higher for longer. Meanwhile, the rest of the world (RoW) needs the U.S. to lower interest rates.
Hugh Hendry, self-proclaimed Founder Ecletica Macro and St. Barts luxury hotelier, likens the current situation to the Kobayashi Maru.
The Kobayashi Maru is a training exercise in the Star Trek franchise designed to test the character of Starfleet Academy cadets by placing them in a no-win scenario. The test was introduced in the opening of Star Trek II: The Wrath of Khan but also in the 2009 film Star Trek and the animated Star Trek: Prodigy.
The point being, the Federal Reserve (and other Central Banks around the world), are in a no-win scenario based on historical similarities.
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The Federal Reserve (aka The Fed) has two mandates. The first is to moderate inflation (achieve stable prices) and the other is to maximize sustainable employment levels. Their stated goals are 2% inflation and 4.1% unemployment.
“Core” Personal Consumption Expenditures (PCE) has risen at a rate of 3.7% year-over year. Core PCE is the Fed's preferred measure of inflation because it excludes food and energy, which tend to swing up and down dramatically and more often than other prices primarily due to weather and geopolitical events.
Unemployment is a comfortable 3.8%. But behind the scenes, we know that a lot of people are working multiple jobs to make ends meet and many new jobs in the last year are due to Congressional and Presidential Administrative spending (aka fiscal spending).
To keep inflation in the U.S. at bay, the Fed needs to hold interest rates higher for longer. If they lower interest rates (making it "easier' to borrow money), inflation could take off again.
Meanwhile, the rest of the world (RoW) needs the Fed to lower interest rates.
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Let's use Japan as an example. Compared to the U.S. Dollar, the Japanese Yen has been devalued 40% over the last 18 months (see attached chart) - meaning, for the same quantity of Yen, Japan can purchase 40% less of anything bought in dollars (e.g., oil and U.S. imports).
Notably, during this devaluation period, one could borrow money in Yen at super lower interest rates, invest the money in U.S. Treasuries, and use the U.S. Treasuries as collateral to invest in U.S. stocks. Under these conditions, an investor could have made 20% or more in recent months.
If the Fed holds rates higher for longer, it won't be just the Japanese citizens doing this speculative trade. It's going to happen in Europe, China, the UK, etc. which will devalue their local currency, drive up the U.S. Dollar and drive up the U.S. stock market.
The problem with higher and higher stock prices is that it comes with fragility. The market is already vulnerable due to the inverted yield curve (that's a topic all on its own).
When the inevitable correction occurs to return markets to fair-market value, it could result in the collapse of the global currency system (after all, a fall from super overvaluation is a much harder landing with more severe consequences).
So if the Fed doesn't lower rates, it risks this eventual possibility.
But what if they do lower interest rates?
The Fed was in a similar position in 1927. Benjamin Strong was Governor of the Federal Reserve Bank of NY. With virtually no inflation in the U.S. and when interest rates already relatively low, he argued to lower interest rates to help stabilize European currencies and economies.
Corporate profits surged. This fueled the market bubble of 1928 and eventually led to the market collapse of 1929 and the Great Depression in the 1930's. The market fell 89.2% from October 28, 1929 through July 8, 1932. Consumer prices dropped (deflation) and unemployment soared. The market did not recover to its 1929 peak until 15 years later in November 1954.
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In response to the Yen reaching 34-year low, Japanese authorities have recently warned against the type of speculative trading described here (known as Yen Carry Trade), which is code for saying they are willing to purchase trillions of Yen to prop up the currency if it continues.
A rapid rise in the Yen would unravel carry trades, causing widespread market volatility and that could be catastrophic. Even more so with the ongoing inverted U.S. yield curve (see second attached chart).
Ditto for the other Central Banks and their respective currencies (some of which are not our allies and may actually be incentivized to cause chaos). The vulnerability here is real and should be taken seriously.
The easiest way for the Bank of Japan to save their currency is to start closing the gap in interest rates (Japanese bonds pay about 1% while U.S. Treasuries pay about 4.25%).
However, raising rates will slow economic growth in Japan which is already experiencing negative growth in 4 out of the last 10 quarters. They would be hiking themselves right into a recession.
The other Central Banks are facing the same question, but it's not as extreme, yet.
Will they individually choose to save their currency or their economy? Or will we arrive at another Bretton Woods agreement (signed in 1944 and ended in 1971 when Nixon took the U.S. Dollar off the gold standard)? What impact will that have on markets?
More importantly, is your portfolio able to ride with the waves of market volatility and achieve your financial goals?
If you are looking to put together a robust plan to sustain your lifestyle throughout retirement and strategically manage your investments, taxes, and income sources, let’s talk.
Fran McKay, CFP®, AAMS®, CRPC®
Serving clients across the United States since 2014
https://catalystwealthplanning.com/
Specializing in tax-efficient retirement, philanthropy, and estate planning for retirees and pre-retirees.
