1987 Redux, but with a Different Ending?

A couple of months ago, I wrote an article about markets suggesting that in the short-term equity bulls were more likely to be right than bond bears.  My reasoning was that central banks, led by the Federal Reserve and with the important exception of China, have reverted to Quantitative Easing.  Bond yields have not reacted to the threat of inflation because the Federal Reserve is using short-term financing to suppress them. 

Two months later bond yields have continued to rise, most notably in Japan.  As others have noted, the major driver behind this has been a rise in term premia i.e., the extra return required by investors to take duration risk.  The starkest and most worrying data comes from the U.S. and Japan. 

Over the past 18 months, the 10-year U.S. bond yield has broadly traded sideways, while the term premium has risen by 150bps.  In Japan the term premium is likewise up by 110bps this year alone, but bond yields have risen alongside them, in fact by rather more.  Investors need to extract different messages from these different behaviours.

In Japan, there has been a political tussle since Abe’s assassination three years ago.  The current LDP coalition regime under Ishiba is more left-leaning and favours tighter fiscal policy.  It is unpopular for many reasons and a change of an LDP leader is quite likely, but not a certainty.  The successors to Abe on the right, primarily Takaichi Sanae, favour spending more and taxing less.  In particular they would like to reduce the 10% sales tax. 

Which side eventually prevails will have an impact on bond yields, of course.  But the fact that bond yields have risen by more than term premia offers an alternative and more positive explanation viz that after many decades Japanese domestic investors are gradually moving away from safe assets towards riskier ones i.e., from risk-off to risk-on.

The U.S. is a different story.  It is clearly driven by expectations that interest rates are going to fall even while inflation is rising.  Term premia quantify investors’ preference for duration, and right now investors are demanding a higher return for taking the risk which long-term inflation poses to duration.

My friends at CrossBorder Capital point out that the nearest parallel to today’s rising term premia and inflation (and incidentally a weaker dollar) is 1987.  Rising markets then were punctured by the Bundesbank threatening to raise interest rates (and suggesting the U.S. do the same – would they dare do that today?)  Black Monday was the result.  Today the catalyst for an equity valuation reset is more likely to be Japan choosing to normalise interest rates, as Scott Bessent has publicly suggested.

Of course, 1987 was not a cataclysm for investors, though at the time it felt like it.  Black Monday’s 22.6% fall is still the U.S. equity market’s largest in a single day, but more than half was recovered within two trading days.  One reason for that was Alan Greenspan’s affirmation that the Federal Reserve was ready to ‘serve as a source of liquidity to support the economic and financial system.’  Hence the Greenspan put, followed by QE, was born.

How would the Federal Reserve react today?  They have far less ammunition, as the balance sheet is already stretched.  In all likelihood their response, as in April 2020, would be to slash interest rates.  In 1987 they only fell from 7.5% to 7%,* because the Federal Reserve lent on banks to lend generously to the affected security companies.  Today banks’ ability and desire to lend is restricted by capital adequacy requirements, and I doubt they would accede to Fed pressure in the same way.  Jumbo rate cuts are pretty well the only signal the Fed could give markets.

One probable casualty in this scenario would be the U.S. dollar, especially if Japan were to go down the route of raising interest rates.  This might not be of concern to the Trump administration, but the translation impact would wreak further havoc in investors’ equity returns.  72% of the listed Developed Market index is in U.S. equities and private equity is likewise dominated by American assets. 

A weaker dollar also raises the risk that the vast carry trade of funding U.S. assets in yen unwinds.  That could act as a significant destabilising force for markets globally.  Currency volatility is one aspect I thought would be prevalent in the post 2022 era, but which we have not really seen yet.

Would equity markets recover as quickly as in 1987?  The Federal Reserve will be more beholden to the Trump administration and therefore less credible, its restorative medicine looks less effective, and the financial system is undoubtedly more stressed.  As always, a key point will be borrowers’ ability to finance or refinance debt through the reverse repo markets.  I shall also be watching out for signs warning of a repeat of Silicon Valley Bank’s collapse, with other second line U.S. banks unable to meet capital adequacy requirements.  

The strongest argument I can find for optimism is that this time it’s not different, and 38 years after the Greenspan put came into this world, markets will again react positively to decisive easing by the Fed.  But my hunch is that the ending will indeed be different from 1987, which from a historical perspective looks like a minor blip in markets – albeit a nasty recession followed less than two years later.

*Note to all readers under the age of 55 today, this is not a mistake and 7.5% was indeed the cost of money in those days.