Why Japan's $20 Trillion Yen Carry Trade Unwind Could End Bull Market | Jim Welsh

Key Concepts

• Secular Bear Market: A prolonged period of declining asset prices, typically lasting several years.
• Liquidity Squeeze: A situation where there is a shortage of cash or easily convertible assets in the financial system, leading to forced selling.
• Advanced Decline Line (AD Line): A technical indicator that measures the cumulative number of advancing stocks minus the number of declining stocks, used to gauge market breadth and health.
• High-Low Indicator: A technical indicator that measures the number of stocks making new highs versus new lows, also used to assess market breadth.
• Yen Carry Trade: A strategy where investors borrow in low-interest-rate currencies (like the Japanese Yen) and invest in higher-yielding assets elsewhere.
• De-dollarization: The process by which countries reduce their reliance on the US dollar for international trade and finance.
• Rule of 72: A simplified way to estimate the number of years it takes for an investment to double at a fixed annual rate of interest.

Macroeconomic Outlook and Market Analysis with Jim Welsh

This discussion with macroeconomics writer Jim Welsh, founder of Macro Tides, delves into current economic conditions, market trends, and future outlooks, drawing parallels to past financial events, particularly the 2008 financial crisis.

Historical Parallels and Early Warnings

Jim Welsh recounts his cautionary stance in 2007, preceding the 2008 financial crisis. His concerns were triggered by:

• Liquidity Tightening: A significant jump in T-bill rates from 2.25% to nearly 4% within a week in August 2007 signaled underlying issues in the financial plumbing.
• Housing Market Bubble: The median home price to median income ratio had ballooned from a historical 3:1 to 4.5:1 by 2006-2007 due to relaxed lending standards, indicating an unsustainable housing market poised for a decline.
• Technical Divergence: A divergence between the S&P 500 making a higher high in October 2007 and the Advanced Decline (AD) line peaking earlier in June 2007 suggested underlying weakness.

Welsh believed a recession had begun in December 2007 and liquidity problems were evident by the summer of 2008.

The 2022 "Recession That Wasn't"

Welsh explains why he did not consider 2022 to be a recession, despite two quarters of negative real GDP. He points to:

• Inventory Adjustments and Trade: These factors were distorting the GDP report.
• Strong Job Growth: Underlying job creation remained robust throughout the first half of 2022, contradicting recessionary fears.
• Overblown Fears: The common definition of recession (two consecutive quarters of negative GDP) was misleading, as underlying economic factors did not support a true recession.

Current Economic Landscape: Bifurcation and Secular Bear Market Potential

Currently, Welsh observes a stark bifurcation in the economy:

• Bottom 50% Under Pressure: This segment has faced rising costs of living for about four years, with incomes not keeping pace.
• Top 10% Driving Spending: This group, representing nearly 50% of spending, derives confidence from financial markets, particularly the stock market.

Welsh anticipates a secular bear market in the coming period. He argues that a protracted downturn in the stock market will negatively impact the spending of the top 10%, thereby affecting the broader economy. While he doesn't foresee an immediate recession in the next six months, he believes the conditions for a secular bear market are developing.

Inflation and Federal Reserve Policy

Welsh expresses concern about upside pressure on inflation in the near term, citing the ISM Services Prices Paid index hitting 70, a three-year high, which historically leads CPI inflation by about three months. He highlights:

• Sticky Service Inflation: Services, comprising 80% of GDP, are experiencing more persistent inflation than goods.
• Fed's Dilemma: The Federal Reserve faces a difficult balancing act between rising inflation and a ticking-up unemployment rate, making decisions on interest rate policy complex.

Consumer Spending Trends and Vulnerabilities

Recent reports indicate a pullback in consumer spending, affecting both middle-class and affluent shoppers:

• Middle-Class Distress: Shoppers are shifting to discount retailers like Walmart, indicating a need to stretch their budgets. Home Depot has lowered its full-year outlook due to weakening sales and consumer uncertainty impacting home improvement demand.
• Wealthy Adjustments: While not explicitly detailed, the implication is that even the wealthy are re-evaluating spending, potentially on luxury items.

Welsh notes that while statistical recession indicators may not be flashing red, Moody's reported 22 states already in recession, with 11 treading water. He reiterates the economy's overdependence on the top 10% of wage earners.

Housing Market Outlook

Welsh predicts a decline in home prices over the next few years, with some markets already showing signs of this trend. He believes a significant downturn in the equity market will lead the top 10% to curtail discretionary spending, which currently supports economic growth.

Technical Analysis and Market Signals

Welsh emphasizes the importance of technical analysis, likening it to driving a car and looking through the windshield to anticipate road bends.

• S&P 500 and Long-Term Trend: A chart showing the S&P 500 significantly above its long-term regression line (dating back to the 1930s) indicates an extreme, often seen during periods of high optimism and excessive household allocation to stocks. This pattern has historically preceded secular bear markets.
• Advanced Decline Line (AD Line): The AD line peaking before the S&P 500 is a warning sign of weakening market breadth. While the AD line has made new highs, Welsh notes that the number of stocks making new highs has been weakening as the S&P 500 makes higher highs, signaling vulnerability to corrections.
• High-Low Indicator: This indicator also shows divergence, with the S&P 500 making higher highs while the number of stocks making new highs weakens, suggesting underlying weakness.
• Recent S&P 500 Action: The S&P 500 recently broke below a prior low after making a higher high and higher low, indicating a shift in trend and increased vulnerability.

Welsh advises that while being invested is acceptable, investors must be prepared to cut back when the "wheels start to come off." He anticipates a potential rebound rally towards the end of the year or early next year, but expects the AD line to fail to confirm any new highs, signaling a time to become more aggressive in selling and shorting.

Small Caps vs. Large Caps

Welsh observes that large-cap stocks, particularly the "Magnificent Seven" and AI-related stocks, have significantly outperformed small and mid-cap indices (like the Russell 2000) over the past 13 years. He attributes this to:

• Concentration in AI Stocks: A significant portion of the S&P 500's weight is now in AI-related companies.
• Loss-Making Small Caps: A substantial percentage of companies in the Russell 2000 are unprofitable, making the index less attractive.

Commodities: Gold and Silver

Gold and silver have reached new all-time highs, but Welsh believes they are entering an extended wave four correction.

• Gold's Wave Structure: He identifies the recent rally as the end of wave three, with an anticipated correction that could take gold below $3,500.
• Sentiment Extremes: Sentiment surveys showed 95% bullishness in October, indicating an overextended market.
• Liquidity Risk for Gold: During liquidity crises, like in 2008, even gold can be sold to raise cash, undermining its safe-haven status when needed most.

Treasury Bonds and Yields

Welsh argues that Treasury bonds have entered a new secular bear market, breaking a trend line that governed a 39-year bull market.

• Historical Context: He compares the current situation to the secular bear market in bonds from 1945 to 1981.
• Global Yield Increases: Rising yields are not confined to the US, with significant increases observed in Japan, Germany, and France, driven by increased government spending and deficits.
• Supply Pressure: Global supply of debt is increasing, leading to competition for capital and upward pressure on yields.
• Potential for Higher Yields: He believes the 10-year Treasury yield could move above 4.2% and potentially reach 5% or higher in the longer term, referencing historical 50% retracements.
• US Deficit Challenge: The US faces a significant challenge in reducing its deficit without damaging economic growth.

The US Dollar

Contrary to popular opinion, Welsh anticipates a significant rally in the US dollar index over the next 12 months, potentially driven by a liquidity squeeze and the unwinding of the yen carry trade.

• Dollar's Bottoming Process: He believes the dollar has been in a multi-year correction and is now in a bottoming process. A close above 100.25 on the DXY could signal a move towards 104-106 and potentially the previous high of 110.
• Reserve Currency Status: While acknowledging de-dollarization efforts by countries like China, Welsh believes the US dollar's dominance in financial market depth and liquidity is unmatched. The use of the dollar as a geopolitical weapon has motivated alternatives, but their development will take time.
• Historical Dollar Strength: The dollar has historically rallied during tough times, and current negative sentiment may be a precursor to a rally.
• Geopolitical Influence: Presidential administrations and their policies have historically had a greater impact on the dollar than interest rates or trade.

Conclusion and Actionable Insights

Jim Welsh's analysis suggests a complex economic environment characterized by underlying vulnerabilities despite current market strength.

• Near-Term Caution: While not calling for an immediate recession, Welsh advises caution and preparedness for a secular bear market.
• Technical Signals: Investors should monitor technical indicators like the AD line and high-low indicator for signs of weakening market breadth.
• Dollar Strength Potential: The dollar may see a significant rally, driven by liquidity concerns and the unwinding of carry trades.
• Bond Yields Rising: Expect continued upward pressure on bond yields globally.
• Gold Correction: Gold is likely to undergo an extended correction.

Welsh recommends being invested but ready to cut back when warning signs intensify. He suggests that the current environment is not conducive to a "buy and hold anything" strategy as seen in 2009, but rather requires active management and vigilance.

For further information, individuals can visit Macrotides.com or contact Jim Welsh directly at jim.welsh.macro@gmail.com.