Bank of Japan Gov. Kazuo Ueda arrives at the bank's headquarters in Tokyo on July 31.The Associated Press
John Rapley is an author and academic who divides his time among London, Johannesburg and Ottawa. His books include Why Empires Fall (Yale University Press, 2023) and Twilight of the Money Gods (Simon and Schuster, 2017).
For a while now, it’s been widely expected the U.S. Federal Reserve will start lowering interest rates when it next meets in September, starting with a cut of 0.25 per cent from its current target in the 5.25-per-cent to 5.5-per-cent range. After Monday’s drama on Wall Street, many economists now want it to start cutting quicker and deeper than that.
But precisely because of this week’s gyrations, the Fed, like all central banks, will need to do the opposite and proceed cautiously.
Earlier this year, I wrote that events in Japan were going to make life difficult for Western central banks this year and last week it came to pass. All it took to start a chain reaction was the Bank of Japan’s decision to raise its own interest rate by 0.25 per cent last Wednesday.
Back in 2022, when inflation shot up across most developed economies, it barely budged in Japan, given the country’s chronic economic funk. So while central banks in Europe and North America were raising interest rates to fight inflation, the BOJ stood by, keeping them below zero. That created an opportunity for what’s called a carry trade. Investors could borrow yen for next to nothing, then invest the money where returns were higher. More than US$2-trillion moved offshore this way, going into everything from American stocks to Mexican bonds.
So when the BOJ raised its target rate, it triggered the start of an unwinding of the yen carry trade. With Western stock markets already slowing and interest rates trending downward, it became clear the gap between Japanese rates and those in the rest of the developed economies would start narrowing.
Last Friday’s U.S. jobs report, which suggested a weakening American economy would prompt the Fed to cut interest rates, reinforced that conclusion. Investors started selling overseas to bring money back to Japan. The sudden increase in sales overwhelmed markets, driving them sharply downward.
Calm was quickly restored, though, since the fundamentals in the U.S. economy didn’t warrant a crash. And when the deputy governor of the Bank of Japan gave a speech on Wednesday in which he hinted the BOJ would go slow with further rate rises, it reassured Japanese investors that the sky wouldn’t soon be falling after all. Nevertheless, we’re likely to see more of this.
The virtuous cycle that had previously fuelled rallies in Western asset markets, in everything from real estate and stocks to cryptocurrencies and meme stocks, has gone into reverse. That won’t change soon. As Western banks cut interest rates, the gap between Japanese and overseas credit costs will keep contracting. As foreign investments are liquidated and the money is brought back to Japan, demand for the yen will strengthen. That will raise its value, which will further reduce the value of investments held overseas. That, in turn, will further intensify the unwinding of the carry trade.
A key takeaway is that in the era of globalized finance, central banks can’t act in isolation. They must always keep an eye on what’s happening in other economies, and what their peers are doing. And if that goes even for the mighty Fed, it’s doubly true of the Bank of Canada.
One gets a sense of this from a glance at Canada’s interest rates. Despite the BOC having started its easing program ahead of the Fed, with two cuts so far, bond yields, which affect borrowing costs, are still pretty much where they were at the start of this year. That’s because south of the border, the stronger economy and high fiscal deficit is keeping upward pressure on U.S. interest rates, affecting the bond yields here.
Much of that upward pressure, moreover, lies largely beyond the control of any central bank. Around 2016, the long bull market in bonds came to an end, as investors soured on Western debt, and since then the average rate on bonds has been rising, upping borrowing costs. Central banks have been able to interrupt this in times of crisis through lowering the policy rate, as during the pandemic, but they have not been able to reverse the steady upward march.
And given the scale of debt accumulated in the global economy, demand for loans will continue to keep the pressure going upward. Central banks are managing this transition to an era of more expensive credit. But there’s no going back.
The end of the era of cheap money was always going to involve some painful adjustments. So far, central banks have shown themselves up to the task of managing the transition, but with falls followed by rallies, which often leave the new peaks below the old ones. The overall trend in the market will thus likely remain downward.
Provided none of these down days turns into outright panics, central banks will probably continue moving at a measured pace. That won’t displease central banks, given the overvaluation of many assets.
But investors may not like seeing the value of their portfolios diminish. Investors enjoyed some great years, and now we’re in a new era.