Japan Has Fallen: Here’s What It Means for the World

Japan Has Fallen: Here’s What It Means for the World

The Bank of Japan called off its rate hikes this past week as it slashes the economic forecast for 2025. Private forecasters are now saying that first quarter GDP was likely negative and the second quarter is probably going to follow suit. Now, officials are predictably blaming trade wars, but Japan’s abrupt downfall isn’t actually abrupt. It is merely the latest global domino to fall. Japan was doomed to globally synchronize. And it was oil and swaps that said so all along. Since Japan’s reopening from the pandemic restrictions was later than almost everywhere else, the supply shock and its price impact were lagged. Despite the crash in the yen, which amplified price pressures, the fact Japan already experienced a recession has kept the Bank of Japan from following other central banks more closely. Whereas almost everyone else has long since pivoted, BOJ has been hiking rates, however slowly, while forecasting a strong recovery and more inflationary pressures up ahead. This had made Japan unique among major world economies. BOJ’s peers elsewhere have had to contend with weakening economies and sliding price pressures. They’ve been racing back toward the bottom, which meant Japan was the odd one out, which stood out from the globally synchronized. That was already in the process of changing earlier this year. And then this past week, the Bank of Japan took a first step toward reconverging with the rest of the world, putting a pivot there back on the table. Japan had represented maybe one last hope for the world’s soft landing after the lockdowns and the supply shock. And while the idea hasn’t been completely erased by recent events in other parts of the globe, it does take a significant blow from Japan finally falling back into the orbit of forgot how to grow. And that orbit and its inescapable gravity has been described this entire time by the swap market and then emphasized by what’s happening in crude oil. the interest rate swap market, US dollar interest rate swaps, it isn’t immediately clear how they would pertain to Japan, but the swap market and really swap spreads, they encompass pretty much everything worldwide. We’re talking about massive hundreds of trillions of dollars all over the world and not not all dollar denominated but primarily dollar denominated. And the marketplace includes banks, non-bank financials, the biggest companies, governments, basically everyone. Why? Because swaps are a powerful transformation that just isn’t appreciated by textbook economics. And money dealers are in the middle of almost every interest rate swap transaction. And I went over the basics behind interest rate swaps and interest rate swap spreads in our basics video series over at Urella University’s membership site. But money dealers are in the middle of almost every interest rate swap. And so they get information about the state of every possible variable on money, finance, and the economy, as well as policies and government interference, too. But that just makes the swap market the deepest and most sophisticated marketplace. Therefore, an unparalleled source of information that central bankers and economists refuse to take advantage of because for the last 18 years, this market has disagreed with basically everything central bankers have done and economists have claimed. We look at interest rate swaps and we analyze them from the perspective of the relationship with nominal US treasury yields. An interest rate swap spread is the fixed rate part of the interest rate swap. The quote there the return that you get from receiving fixed compared to the same maturity nominal US treasury. And while earlier swaps were based on Liber authorities have seen to it that Liber no longer exists. And so now later incarnations of swaps since 2022 have been based on sulfur for the floating rate side. But for our purposes here, it doesn’t really matter. Swap spreads immediately, you think that should they should never be negative. And it was once thought to be impossible. In fact, when swap spreads first turned negative back in October 2008, there were stories that filtered up from the marketplace of trading software that wouldn’t even accept the negative swap spread input because everyone thought it was impossible. Therefore, coders never coded into the trading platforms. Why? Because the swap rate is the fixed payment on one side of the transaction. And so what somebody receives for that fixed payment should never be below the same maturity US Treasury yield. Why would anyone accept, say, 4% from a swap payment from a big financial company when they could get 4.25% or maybe 4 and a.5% from a straightup Treasury note or bond? Why would you take less of a return from a financial counterparty when you can get a better return from the US government that is practically credit risk-f free? And while that sounds like the market is saying treasuries are considered riskier than their financial counterparties by this massive marketplace, the fact that this showed up when it did October of 2008 during that monstrous global monetary meltdown, there’s your first clue. Negative swap spread and especially persistently negative swap spreads, there are signs that things are messed up in very deep fundamental ways. big things messed up big time in very deep fundamental ways is not going to be good for the financial system and therefore the real economy. So when swap spreads go down even more get even more negative. That’s a clear indication of exactly what I just said. Not good things in finance and the real economy because of not good things in the monetary world we otherwise can’t see and observe. But in the most technical interpretation, all a negative swap spread means, what it really tells us is that this huge, sophisticated market is taking a look at where things are today, how things got to be this way, and then hedging and betting that interest rates over the long run are going to go down. And in the case of longer maturity swap contracts, which is those that we focus on, rates are going to stay down for a prolonged period of time. That’s really all interest rate swap spread tell us. It’s about the interest rate market and then we have to interpret the interest rate market and those signals in the context of wider economic circumstances which is where all these correlations come including oil prices as we’ll see. If nothing else, swap spreads and a correct interpretation of them are internally consistent because you think about it from this perspective. If the market is saying interest rates are going to go down and stay there historically speaking, what are the economic circumstances when rates are low and stay low like we saw in the 2008 crisis and its aftermath? It’s crisis and its aftermath that are consistent with depression economics. So negative and compressing swap spreads that say rates are going to go lower and stay there. It makes sense why people would hedge in this direction for some of the worst possible outcomes. Not always the worst possible outcomes or worst case. We’re not talking about a crash, but long run conditions where rates are low. Therefore, low growth, low inflation expectations, not good in the real economy, nor for the financial system because in that environment, the financial system is tends to be more volatile, too. Like I said, it’s internally consistent once you get your head around what it is that interest rate swaps are doing, what they’re for, and what swap spreads are really telling us. It’s not like swap spreads are showing up and doing things in isolation. they are corroborated and they correlate with a lot of economic and financial variables all throughout the global system. So when you see swap spread do something it’s very likely it’s something else looking at the system from a completely different angle is doing is coming to the same conclusions for the same reasons. Now remember these are not timing signals they don’t tell us when something might happen just that the probabilities are moving in one direction or another. Swap spreads really describe the backdrop against which shortrun events of the world tend to unfold. And over time, as the probabilities of that background move more and more concretely in one direction, then the shortrun events are more and more likely to happen in a way that’s consistent with the direction that swaps are pricing. For example, more negative swap spreads describe a world that is experiencing monetary and financial difficulties. As I said, the marketplace under those conditions sees more and more fragility that increasingly will lead to bad economic consequences. So, under those conditions, you’d quite naturally expect oil prices to go lower, like interest rates, more economic fallout from difficult monetary financial conditions priced into more negative spreads. There’s going to be less demand for oil at the very least, plus some money supplied for its financing. So, oil prices are going to go down very likely. At the same time, swap spreads are compressing more and more. There’s not a mechanical relationship between the swap market and oil market. They’re looking at the world from very different perspectives, but coming to the same conclusions, which is why there’s a strong historic long run correlation between swap spreads and oil prices. Real economy check and corroboration on what these deep fundamentals, financial and monetary fundamentals are are saying and doing. And this is exactly what we’ve seen especially since the middle of 2008 when monetary conditions became paramount as economic considerations especially since QE was always an illusion. Swap spreads tell us something about what’s going on in the monetary black hole and oil tends to tell us about the economic fallout from what happened in the black hole that we can’t see. So we got a pretty strong correlation and a long run correlation between swap spreads and oil prices. You can see the clear back and forth between the downturns and reflationary periods. Only ever reflationary periods since the first Euro dollar shortage back in 2008. What everybody calls the global financial crisis. It wasn’t financial. It was really a dollar shortage in the euro dollar system. The correlations retightened again in 2014 as oil prices came crashing down as the supply situation was normalized by the shale revolution in what was what we call euro dollar number three. be a pretty nasty euro dollar number three where the economic fundamentals of the silent depression of the 2010s really got fleshed out especially for the rest of the global economy starting with China and emerging markets and the correlation kept up pretty strong through 2017’s globally synchronized growth reflationary period and then the downturn the transition in 2018 and the downturn into 2019 or euro dollar number four oil prices and swaps were pretty much in lock step but then the correlation breaks down again during the big supply shock stock in the aftermath of the pandemic and lockdowns into the 2020s, the early 2020s. Both swap spreads and oil prices here, we’re just using WTI as a benchmark. While they’re moving in the same direction, oil prices, for pretty obvious reasons, the supply shock, were moving far more intensely higher. And that was supply restrictions all over again, culminating in the Russian invasion of Ukraine, which sent oil into the stratosphere, even as swap rates were saying, “Yeah, the economy isn’t that red-hot. It isn’t that inflationary. In fact, it isn’t either of those things. It’s it’s basically another reflationary period. And because swaps were not subject to the price illusion, and those participating in the marketplace could see the price illusion, swap spreads didn’t go where oil did or interest rates because interest rates were were interfered with by the Federal Reserve and other central banks in 2022 as well. But from May of 2022, swaps have been compressing all over again, becoming more negative, while everyone was on the great inflation 2.0, you know, saying that oil prices were going to stay high forever, just like they said about interest rates. The swap market has been compressing since then, saying, “Nope, we’re more and more seeing the opposite.” Swaps are pricing a very different background, one that was increasingly fragile and even deflationary. Therefore, one which should mean at the very least lower oil prices if over time. And OPEC came along, as I talked about in Thursday’s video, OPEC comes along and tries desperately to reverse the slide in oil prices. the convergence in oil prices with the background described by the swap market by interfering in the oil market on the supply side and they were partially successful in holding oil prices higher than they fundamentally should have been at least from the perspective of the swap market. Swaps all along said it was feudal and destined to fail. The economic background didn’t support those higher oil prices. But OPEC listened to mainstream economists and central bankers and thought soft landing was assured China’s going to come back and Europe’s going to get its stuff together and the economy globally was going to soar 2023 into 2024. But over time, given enough time, either OPEC would have to go bigger on supply or give up because economic demand like the swap market kept pricing wasn’t ever going to recover like the cartel had hoped and had been promised. And that’s right where we are today. That was the point of the video I made on Thursday. OPEC finally gave up on that fantasy and finally got with the program that was priced out by the swap market by ditching their supply restrictions and Saudi Arabia quietly saying we’ll accept lower oil prices. We accept the reality of the economic background that we have, the one that’s the one that’s priced out by the swap market. OPEC becomes another global domino to fall in globally synchronized at the very least forgot how to grow and we’ll see where it goes from here because swap pricing more recently isn’t very sanguin at all. So as OPEC has finally relented it is tacidly admitting the world is indeed like swaps have been pricing this entire time and where oil prices outside of its interference have been behaving more and more accordingly. Now, you think that because these are US dollar interest rate swaps and oil prices are priced in dollars, too, that this is all about the United States or just the US dollar terms. But the US dollar, it’s not really the US dollar. It’s the Euro dollar and the Euro dollar system, which means global reserve currency. In fact, interest rate swaps are an incredibly important part of that currency systems function and operation because they give that system a much farther reach and make it more elastic, flexible, dynamic, and useful. Since we’re talking about the Euro dollar world participating in the swap market, the participants are all thinking globally too and using the dollar cash flows that get swapped as the intermediate global currency, which is what a reserve currency really supposed to be. In other words, swaps are telling us about the global background is seen from inside the Euro dollar black hole with this incredible wealth of information distilled into these helpful financial spreads. That’s the background for globally synchronized coming from the swap market from all these different perspectives corresponding and correlating and coalescing into these swap spreads. But the absolute record low swap spreads that we’ve seen since then again higher prices higher chances higher probabilities about the background behind everything that’s unfolding including oil prices and financial volatility. Even if the short run doesn’t necessarily look like what the swap market is saying about the intermediate and longer terms, eventually over time, as we’ve seen, and we’ll see here in Japan, the world moves in that direction, even if we lose focus and focus in on the short run, the swap the swap market is saying over time, you give it enough time, this is where things are going. And that’s what we’re seeing in everything up to including central bank policy rates. Now, Japan’s economy was instead said to be accelerating into a recovery after its unexpected 2023 recession. Not only was it recovering or maybe even better, it was potentially inflationary. That was at least a position of the Bank of Japan. Therefore, Japan stuck out from the rest of the world over the last year, which was slowing down like the swap market had predicted as the background behind all of this stuff. And the Bank of Japan therefore was behaving contrary to all the rest of the world’s central banks as it raised rates twice last year and one more time this year because Japan was holding out the world’s one last hope for a soft landing. Maybe recovery, maybe even inflationary, at least amidst the world that was sliding more and more into the abyss that was priced by swaps and increasingly recognized by global oil prices. Japan was maybe the one last chance to say, “Here’s something that can defy the swap market and therefore the global predictions that the gravity was pulling everything to globally synchronized, forgot how to grow at the very best. But reality has started to intrude. This past week, as the Bank of Japan met, it halted its hikes as they slashed their growth projections. And private analysts have put more details on why that is. For the Bank of Japan specifically, it lowered its 2025 real GDP forecast to just half of a percent, which is nothing entirely recessionary already from 1.1% that had been borderline recessionary only 3 months ago. So, in the space of 3 months, they went from we’re accelerating to lackluster 1.1% to okay, we’re not even going to get that. We’re gonna hope for maybe just more of the same half a percent for the entire year of 2025. And one reason they slashed it is because private analysts are right now predicting first quarter GDP in Japan will be like the US turning slightly negative. Worse though, they’re also writing down the second quarter to the point that there’s a very high chance the second quarter of GDP in Japan follows the first quarter into the minus signs, meaning a very high chance of a technical recession for Japan in the first half of this year, which would certainly spoil the soft landing and inflation contrast to the rest of the globally synchronized. But here’s the final twist. Japan was never really on a course for a soft landing. It was entirely forgot how to grow the entire time. In fact, I already mentioned the recession in 2023. According to current estimates from the Japanese government, GDP contracted three times in that recession in 2023 and then only rebounded modestly over the three subsequent quarters. Since then, it has been the Bank of Japan trying to make that into a soft landing, something even more talking about inflation by its hiking of interest rates. That was really the only difference between Japan or anywhere else like Germany or Europe. The Bank of Japan’s reaction to that small upturn last year made it seem as though Japan was heading in a completely different direction when it was consistent with the swap market oil prices and forgot how to grow. So, while Europe experienced a similar upturn at basically the same time as Japan did, the ECB has been doing something very different, lowering rates and maybe even accelerating lower, heading into ultra low territory, realizing that it was never recovery in Europe and that the risks are all on the downside. Basically, exactly what the swap market has said this entire time and what oil without OPEC interference has been pricing more and more. That the Bank of Japan was doing something odd. not the Japanese economy and that over time the background said Japan was going to globally synchronize again too and the Bank of Japan wouldn’t be able to hold out its rate hiking as the one outlier among global central banks. Now that the Bank of Japan is realizing the downside case in the Japanese economy being forced to confront it. What has happened? The Bank of Japan took its first step toward globally synchronizing itself. So J Japan falling therefore completes and confirms globally synchronized at the very least forgot how to grow and forgot more how to grow. We still have to see if forgot how to grow and forgot more how to grow is becoming remember how to worse as the swap market as well as oil prices more recently they’re currently pricing but the fact that Bank of Japan is turning quote unquote dovish means less interference from them in both short-term rates on top of less interference in their narrative building. Japan has now fallen too right where swaps and oil prices increasingly have said it would. But this isn’t just so much global spillover as it is globally synchronized confirmation. And you know who would agree with that? Ronald McDonald. Not just Ronald McDonald oil prices and a whole bunch of more financial indications. What did McDonald say? Well, that’s in the video link below. As always, thank you very much for joining me. Huge thank you University members and your Reddell University subscribers. And until next time, take care.

Japan was, they said, on the cusp of generational shift. The real outlier in a growing tide of reversals, BoJ was still hiking still anticipating an inflationary recovery. It has all come crashing down, globally synchronized. But not before one final plot twist.

Eurodollar University’s Money & Macro Analysis

https://www.eurodollar.university
Twitter: https://twitter.com/JeffSnider_EDU