Here's How ​Japan's NIRP Increases the Probability of Global Market Crash

Michael Markowski  |

The assassination of Austria’s Archduke Ferdinand in Serbia was the catalyst that started World War I in 1914. Japan’s instituting a Negative Interest Rate Policy (NIRP) on January 29, 2016 is the catalyst that has significantly increased the probability of a global market crash of the magnitude of 2008.

As recently as August 2015, I had stated that it was “unlikely that there will be another crash that rivals 1929’s and 2008’s any time soon”.

During the first two months of 2016, I observed a degree of volatility that I had only seen once throughout my 40-year career in the markets, and that was in 2008. Given my experience and track record for developing algorithms that successfully warn investors about potential catastrophes — including Lehman, Bear Stearns and Merrill Lynch documented in my 2007 Equities Magazine column — I conducted extensive research on the crash of 2008. Through this research I discovered metrics that could have been used to predict the 2008 crash, and the V-shaped reversal. The metrics are now powering an indicator or warning system that I developed and named the “NIRP Crash Indicator” which I am utilizing to monitor the markets for indications of any impending crash. The NIRP Crash Indicator is freely available at www.dynastywealth.com.

The four-signal (green, yellow, orange and red) NIRP Crash Indicator only monitors for potential crashes during periods of heightened volatility and is not to be relied upon for gradual corrections. Additionally, the market could potentially reach new all-time highs before the reading turns red. Finally, the probability of a crash would diminish should an extremely positive U.S. or global economic event occur. For the month of February the indicator fluctuated between yellow and orange.

Volatility and NIRPs

The Bank of Japan (BoJ) announcing in late January 2016 that it was instituting a Negative Interest Rate Policy (NIRP) has increased the volatility of the global markets, which in turn has increased the probability of a global stock-market crash. To reach this conclusion, I thoroughly analyzed the implications for the BoJ’s decision to implement a NIRP, a central bank’s stimulus weapon of last resort. I have also analyzed the ensuing extreme increase in volatility for global markets in the days following the BoJ’s announcement. Usage of NIRPs by central banks to stimulate their economies has become mainstream. With the BoJ’s instituting of a NIRP, the volatility of the global capital markets will continue to heighten. NIRPs significantly increase the risk of global deflation to the point that markets could inevitably crash or correct significantly.

During the first two weeks of February 2016 the following newsworthy events had an impact on the volatility of world markets:

  • Exchange rates of the euro and the Japanese yen versus the U.S. dollar spiked by 4% and 8%, respectively. This occurred in February even though the U.S. Federal Reserve Bank raised interest rates in December 2015, and the European Central Bank (ECB) and the BoJ lowered interest rates in December of 2015 and in January of 2016 respectively. Normally, the currency (U.S. Dollar) of the country raising rates would have increased versus the countries that had lowered their rates.
  • The S&P 500 declined to new weekly lows — a 3.8% decline in just two weeks. The Nikkei also closed at new lows and at the month’s halfway mark was down by 14%. February’s declines for these two global indices came on the heels of (i) the S&P’s decline of 5%, and (ii) the Nikkei’s decline of 8% for the month of January 2016.
  • The KBW NASDAQ Bank Index (BKX) closed at two new weekly lows. Since the beginning of 2016 the index consisting of the money-center banks closed lower for six straight weeks and had declined by as much as 23%. On February 11, 2016, the share prices of all money-center banks (other than J.P. Morgan) were trading at under their tangible book values.
  • During the U.S. Treasury auction held the week ending February 13, 2016, the yield on the U.S. 10-year notes fell to its lowest level since 2012. The difference or the spread between yields for the two-year notes and the 10-year treasury bonds fell to their lowest level since 2007. Decreasing yields for the treasury bonds and notes depict a flight to safety.

From the beginning of 2016 through February 15, 2016, the S&P 500 index experienced 15 days of 1% or greater fluctuations. The volatility rivaled the 45-day period prior to the crash of 2008. From the end of July 2008, to Lehman’s bankruptcy on September 15, 2008, the S&P 500 experienced 15 daily closing fluctuations of 1% as compared to the prior day.

The volatility of the global markets will continue to escalate. The Bank of Japan has elevated the NIRPs and deflation fears onto the world’s center-stage. Economists and corporations loathe deflation — and for good reason. The last time that deflation was a global issue (1929-1937) it resulted in:

  • The U.S. consumer price index declining by 18% between 1929 and 1936.
  • Corporate profits declining 55% between 1931 and 1937.

NIRPs and Deflation

The January 29, 2016 announcement by the BoJ stating that it was instituting a NIRP was a shock to the media and global investors. Eight days prior to the announcement BoJ’s Governor Kuroda had stated to the media that Japan’s central bank had no intention of utilizing a NIRP. Now that Japan has instituted a NIRP a quarter of the world’s GDP will be produced by countries utilizing NIRPs. Because Japan is considered the most fiscally conservative country in the world, it is now only a matter of time before the yields on some or all of the sovereign debt of all developed countries is negative.

An argument that has been raised by U.S. Congressional leaders is the legality of the U.S. Federal Reserve to institute a NIRP? The legality of a NIRP is irrelevant. The market ultimately determines the yield for debt securities based on the price that a purchaser pays for the securities in the secondary market or the bid submitted to participate in a government securities new issue auction. Japan is a good example. Three weeks after the BoJ instituted its NIRP the yield on Japan’s 10 year bonds went negative and have since remained below zero.

In late 2008 and early 2009 I performed extensive post-crash research on deflation for my articles published by Equities Magazine entitled “The Boogeyman is Deflation” and my deflation white paper from which the article was excerpted. Thus, I have a reservoir of knowledge on deflation to draw upon. Because I had recognized that the onset of deflation was probable after the 2008 crash, I had remained very negative on stocks until May of 2013 when I produced my article “Put a Fork in the Bear”. What triggered my turning bullish was the Cyprus banking crisis in March of 2013. It was a watershed event signaling that liquid assets held by wealthy Europeans would begin to flow from Europe into the US. At the time, I had also concluded that because five years had passed since the crash of 2008, Ben Bernanke, then Chairman of the U.S. Federal Reserve Board, had performed a miracle. It had seemed that the Fed’s massive doses of fiscal and monetary stimulus were successful at preventing the onset of deflation.

The NIRP significantly increases the probability that an economy will eventually experience deflation. The ultimate purpose of the negative interest rate is to motivate a depositor to remove their funds from their bank and spend or invest it, because by leaving money in a bank the depositor would be charged a fee. There is no guarantee that negative interest rates would encourage depositors, and could backfire, especially considering a bank would be prone to continually raise the negative interest rate to motivate the depositor to spend or invest more and more of the money. At some point the depositor might do one or more of the following:

  • Remove cash from the bank and hoard it.
  • Prepay utility bills a year in advance.
  • Pay credit card balances.
  • Prepay mortgages and other bills.

Any or all of the above happenings would result in the following:

  • Consumers not having the discretionary cash to buy goods and services.
  • Merchants and manufacturers having to continually lower the prices of their products and services to get consumers to open their wallets.
  • Steady price declines of goods over an extended period could encourage consumers to wait for prices to go down before they buy.

The probability is thus very high that via the utilization of NIRPs central banks will accelerate the onset of deflation. This is especially true for Japan. The country’s population is the world’s oldest and most conservative with a correspondingly high percentage of its citizens being dependent upon pensions. Elderly and retired individuals are hyper aware of interest rates and thus are the most likely age group to reject a NIRP. Fortune recently reported that the sales of safes in Japan had increased 100% since the BoJ instituted its NIRP. The odds are very high that Japan’s NIRP will fail immediately and miserably with the result of deflation going viral. Because of Japan’s central bank instituting a NIRP the catalysts are now in place that will inevitably lead to a market crash or a steady decline.

Impact of NIRPS on Capital Markets

The global markets have not yet discounted the devastating impact that deflation could have on corporate profits. Based on my 40 years of experience I believe that the prices of all shares trading on global markets will decline to at least 50% below their all-time highs. I predict that the reset of the markets to much lower levels could occur by the end of 2016 because of the following:

  1. NIRPs are controversial. The concept of a central bank instituting a NIRP is relatively new. Thus, NIRPs invite controversy, criticism and the front-page coverage enabling its issues to spread virally. Some prime examples:
  2. Economics 101. The first thing every undergraduate of any of the world’s business schools learns in Economics 101 concerns the devastating effects that deflation can have on an economy. As the visibility of deflation increases there will be an abundance of armchair quarterbacks providing the public with frightening details about the devastating impact that deflation can have on an economy. Thus, the risks of deflation will become viral.
  3. 50-year investors. Investors with 50-year-or-longer time horizons, such as endowments and large pension plans, have full-time economists on their payroll who will be sure to inform them about the dangers of deflation. The result will be that such investors will reduce their exposure to equities or stocks until the share prices have declined significantly.
  4. Market veterans. The wise, experienced and highly credible market veterans who understand deflation and do not have a vested interest in keeping their clients or the masses in the market will publicly advise investors to sell. Prime examples are Byron Wien, renowned Wall Street veteran, and Martin Feldstein former presidential economic advisor (who, combined, have more than 80 years in the market). Both publicly stated on CNBC on February 16, 2016, when the market was near its 52-week lows, that it would decline much further.
  5. 5.Deflation’s prescription. There is only one fail-safe solution available that can be used by an investor to fully eliminate the deflation risk. It is to invest in bonds that are backed by a government of a developed country such as the U.S., Japan or Germany. In a deflationary environment the value of hard assets such as real estate and equipment declines significantly. Banks and corporate bonds are very risky during a deflationary period. There were 9,000 bank failures during the 1930s. Savvy investors reacting to the heightened deflationary risk are the cause of plummeting yields on U.S., Japanese, and German 10-year bonds since the end of 2015. Speculative capital that was available when the Fed was using massive doses of monetary stimulus has been drained from the markets. This capital will not return until the markets have corrected significantly. To gain a better understanding of why government bonds are the only “fail-safe” solutions please see my May 2009 “Safe Haven” white paper.
  6. Negative interest rates in the U.S. As the fear of negative interest rates and deflation spreads the demand for U.S. Treasury securities at the auctions and secondary market has increased and will continue to accelerate. From the beginning of 2016 through February 22, 2016, the yields on 10-year U.S. Treasury notes fell from 2.3% to 1.7%. As more and more U.S. and global investors seek a safe haven, the interest rates on U.S. treasuries will further decline. Eventually they could become negative regardless of whether the U.S. Federal Reserve Board institutes a NIRP. Should this happen the fear of deflation will hyper-accelerate.
  • Barron’s, “Up and Down Wall Street: Less Than Zero” (February 29, 2016). Author Randall Forsyth pointed out that the movement that has been underway to remove the $100 USD note and €500 note from circulation is to prevent hoarding of cash by depositors in an effort to avoid the negative interest rates charged by banks on funds remaining on deposit. (Please see excerpt from article.)
  • CNBC’s “Thumbs Down…on Main Street” video February 19, 2016. CNBC regular, Rick Santelli, has frequently ranted on air about negative interest rates since Japan instituted its NIRP>
  • The Wall Street Journal front page of Section C “Negative Rates New Foe: Main Street” (February 19, 2015). Article is about “BoJ Governor Haruhiko Kuroda’s “dodging a concerted attack in Japanese parliament from lawmakers who charged the policy was victimizing consumers and sending a message of despair.”

Eventually, all market veterans and individual investors who are aware, or become aware that (i) the utilization of a NIRP significantly increases the risk of deflation, and (ii) who make their own investment decisions, will exit or reduce their allocations in the stock market. Only the uninformed, mutual fund managers and short-term traders will remain in the markets. Mutual funds have mandates that require them to remain fully invested. Most of the more experienced and long-term investors have exited the market with no intention of re-entering until the risk of deflation has abated or has been fully discounted. The foundation supporting the markets at their present or at discounted levels will have been diminished.

Bullish prognosticators argue that the U.S. stock market is fairly valued or undervalued in as much as there are no imminent signs of a recession. However, the risk is that if the market continues to new lows by either a crash or a steady decline it would likely cause a recession. Consumers, especially those with 401Ks would reduce their spending as they watch their retirement plans erode. The January 2016’s Consumer Confidence Survey fell to a 7-month low for several reasons, including the recent instability of the financial markets. Another bullish argument is that the U.S. economy and corporations are immune from the external negative developments of other countries. This, too, is a weak argument because 33% of the revenue by the members of the S&P 500 for 2014 was generated from outside the U.S.

Now that we've covered why NIRPs can be catastrophic for the financial markets, my next article will take a look at the NIRP Crash Indicator to see how it can may investors to protect portfolios and even potentially position themselves to benefit from a market crash and subsequent recovery. Be sure to check back Monday for more!

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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