Inflation is desirable until it isn’t.
Governments all over the world have followed Japan’s lead in propping up their economies through monetary policy especially since the 2008 Great-financial-crisis (GFC). They have kept the interest rates artificially lower to allow the economy to grow and accept some inflation along the way. But what happens when inflation is not controllable ? E.g. from supply shocks as we are witnessing recently in 2022
BoJ head-scratching is not unique
The Bank of Japan (BoJ) is a very interesting case study. BoJ adopted an interesting policy called the yield curve control (YCC) –in 2016. Under this policy they wanted to maintain a cap on the 10 year sovereign yield to 25 bps. The Japanese thought they were one step ahead by not just managing the short term rates but also controlling the entire yield-curve. Typically, a central bank can set their reference rate which is, in most cases, an overnight lending rate. However, the yield of the government debt expiring 10-years out is typically up to the marketplace to determine (futures market). So how does this story end?
In 2016, the risks for Japanese inflation expectations were to the downside. The long term inflation target of the BoJ has been 2% and to achieve that, inflation might very well have to spend some time above this target, for it to be equal to the target on average over the long run. By adopting yield curve control (YCC), the BoJ meant to amplify any positive nominal growth leading to desirable levels of inflation.
But, what happened in June 2022, with the supply chain disruptions caused by the pandemic (where demand shot up too fast for the supply to catch-up) and the Russia-Ukraine tensions is that we have an inflation regime much higher than the 2% central bank expectation, driven largely from the supply side. The JGB (Japanese Government Bonds) futures market started trading higher than the 25bps, the BOJ cap for the 10 year yield2.
The long-term interest rate of BoJ recorded 0.255% on the 13th June,2022 the highest since January 2016. Yields on government bonds with seven years remaining, have risen to 0.30%, and interest rates with short maturities exceed interest rates with long maturities (recession fears).
The BoJ was intervening in the Cash market and essentially telling the market what the 10 year yield should be. But the futures market was having none of it. It is a fraught venture, as if BoJ wants to safeguard their credibility and maintain the YCC of 25 bps, they will have to commit to intervene endlessly. So, why was this policy adopted? Simple, it was adopted to boost the desirable impact of inflation.We know this story doesn’t have a happy ending – in the past whenever central banks have tried to maintain pegs against market expectations, things have usually not ended well for them. Remember the classic case of the Bank of England (BoE) in September 1992 when BoE was trying to maintain a peg against Germany’s Deutschmark? BoE was maintaining GBP higher than 2.7 DEM to GBP. The peg broke down because the inflation rate in the UK was many times higher than what it was in Germany. The market won again, giving investors like George Soros a huge windfall in profits1.
Impact of Inflation on Businesses
Businesses have many things to learn from the above stories. We know that today, inflation is rising due to covid supply shortages, energy price rises, food shocks emanating from the Russia/Ukraine war and many disruptions the world has witnessed over the past few years. The port of Odessa is still blockaded and grain is stuck in warehouses waiting to be exported.
This time inflation doesn’t look transitory but looks like it is here to stay. Headline inflation rise is causing a cost of living issue in many countries and has forced the government’s hand. Central banks which have inflation targets are forced to raise interest rates. Even the Swiss national bank (SNB) surprised the markets by increasing their rates by 50bps. The Fed has raised by 75bps, one of the highest in the last 40 years and the markets are pricing another 75bps raise in July.
It is important to remember that few months ago, a 50 bps increase alone would not have been considered likely. Didn’t the Fed see it coming?
The RBI has also hiked their reference rates twice in the last six months leading to a cumulative increase of 90 bps. These raises look rushed and knee-jerk and have a direct impact on businesses.
Money flows out of riskier assets leading to an asset price correction and liquidity tightness. Borrowing rates also rise creating cash flow or liquidity issues for many businesses tearing up their balance sheets significantly.
How can corporations manage to protect their balance sheets in volatile markets?
Rising rates mean higher volatility in the markets which means collapsing demands and incremental outflow due to higher interests. For a corporation with FX exposure, this will impact your balance sheet as well as your Profit and Loss (P&L).
My advice is to refine your firm’s hedging policy. For example, revisit the fixed caps in your policy e.g. USDJPY rate or EURUSD rate need to be revisited. It can also help to look at a wider set of tools and derivatives with less drag on carry profile (aka costs) of the hedging instruments, should there be a wider tolerance for mark to market moves before hedging risk on the street.
By doing so, corporations can manage their liquidity and cash flow situation protecting them against unprecedented black swan events like above.
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