Following a decision by the Bank of Japan (BOJ), the yen's value has been on a downward trend.
Even as Japan's long-term interest rates reached a nine-year high, the yen's value continued to plummet.
Typically, when bond yields rise, it should lead to increased demand for that country's currency, but the opposite has been happening.
The market's perception is that the Bank of Japan intends to persist with its accommodative monetary policy.
In a press interview following the monetary policy announcement on July 28th, BOJ Governor Kuroda clearly stated that there were no plans to deviate from the existing policy direction.
The market interpreted this statement as a signal that the yen's depreciation was unlikely to reverse course.
Additionally, shortly after the BOJ meeting on July 28th, the central bank conducted an unusual temporary market intervention on July 31st.
To curb the rapid rise in interest rates, the BOJ purchased Japanese government bonds worth 300 billion yen.
This "temporary operation" marked the first intervention of its kind since February 22nd.
The market perceived this move as a clear indication of the BOJ's commitment to maintaining its accommodative stance.
The critical point to note is that following the BOJ's declaration to allow greater flexibility in the yield curve control (YCC) policy, they swiftly took action to lower rates when they spiked.
This demonstrated a strong commitment to suppressing a sharp rise in interest rates.
Furthermore, some suggest that the exchange rate is moving in line with real interest rate dynamics.
Real interest rates are calculated by subtracting the expected inflation rate from the nominal interest rate.
Governor Kuroda has consistently mentioned that as inflation rises, real interest rates tend to fall. The YCC policy suppresses nominal interest rates, and when market expectations for inflation increase, it is believed that this further enhances the policy's effectiveness by lowering real interest rates. Thus, if market expectations for inflation rise beyond the BOJ's tolerance, real interest rates could decrease further, resulting in further yen depreciation.
This issue of falling real interest rates in Japan has far-reaching implications beyond its borders and has become a significant factor affecting global financial markets.
In the United States, we are witnessing an era where risk-free interest rates are exceeding 5%.
By merely holding dollars without any active investments, a 5% risk-free return can be achieved. If the stock market fails to deliver higher returns than this, people may withdraw their money from the risky stock market and opt for the safety of cash. "Cash is the King!"
Massive cash hoards are accumulating, causing concern for top stock funds in the industry. With the U.S. Money Market offering interest rates exceeding 5%, market funds are experiencing outflows as investors opt for cash instead.
Even among active stock funds striving for above-average returns, even top-performing funds are struggling to attract capital from large investors. These large institutional investors are holding tens of billions of dollars in cash rather than investing them.
The volume of idle cash in money market accounts used by U.S. institutions currently exceeds $3.5 trillion. This cash has been accumulating steadily throughout the year, even when the stock market was booming.
The 3-month U.S. Treasury rate is approaching 5.5%, with U.S. Money Market Fund rates also in the 5% range.
The combination of the Federal Reserve's aggressive tightening of monetary policy and the anticipation of further interest rate hikes has created an environment where risk-free returns in the market exceed 5%.
As data from the Investment Company Institute (ICI) suggests, the total assets in U.S. money market funds have already surpassed $5.5 trillion. With the possibility of further rate hikes after the July Federal Open Market Committee (FOMC) meeting, cash inflows into money markets have accelerated.
As the market demand for returns surpassing the risk-free rate intensifies, and companies face rising capital costs, the currently elevated U.S. stock market may experience a significant downturn. The Financial Times article seems to have impeccably timed this revelation.
Institutional investors have been pulling substantial amounts of money from active funds in the second quarter. After the Federal Reserve signaled its intention to continue raising short-term interest rates and the money market began offering more attractive returns, investors are now opting to park their money in cash.
Now, holding cash seems to be a surefire way to earn returns.
-Seth Bernstein, CEO of Alliance Bernstein.
Jenny Johnson, CEO of Franklin Templeton, also managing trillions of dollars, is feeling the pinch of institutional investors pulling cash out of their funds.
She notes that simply parking money in ultra-short-term money market accounts is already quite rewarding.
While Franklin Templeton specializes in bond investments, it recognizes that the shift in client interest from cash to high-yield bond products could be short-lived if the Federal Reserve continues to raise rates.
The massive piles of sidelined cash are significant.
It's what T. Rowe Price's CEO referred to when he mentioned that there's an enormous pile of cash sitting on the sidelines. T. Rowe Price experienced a $20 billion net outflow due to redemptions in the second quarter. They expect their inflows won't turn positive until 2025.
The Federal Reserve's aggressive rate hikes, if they come to pass, could trigger a correction in the overvalued U.S. stock market.
Currently, the S&P 500 index is trading at 22 times earnings, which is equivalent to a 4.5% earnings yield.
However, if we add an expected earnings growth rate of 4%, we arrive at an expected return of just 8.5% - significantly below the current risk-free rate of more than 5%. So, it's not surprising that institutional investors are pulling money from the stock market.
Considering this landscape, the critical factor to watch in the coming months will be the actions and statements of Jerome Powell, Chairman of the U.S. Federal Reserve.
As markets evaluate his ability to manage the challenges posed by rising real interest rates, the decisions of the Fed will significantly influence the trajectory of global financial markets.
While Brazilian Central Bank Chief, Roberto Campos Neto, took proactive measures to raise interest rates ahead of other central banks during the COVID-19 pandemic, it appears that the true test of central banks worldwide lies ahead in how they navigate the era of rising real interest rates. Expectations for returns and corporate capital costs are artificially inflated due to factors like the risk-free interest rate, affecting asset pricing according to the Capital Asset Pricing Model (CAPM). Jerome Powell's words and actions will undoubtedly be scrutinized closely in the coming months.
Source: Ed Montague