The dollar crashed last night against the Yen in a Flash Crash, dropping 3% (a very significant figure), before settling in to a 1% decline to 107.5 Yen to a dollar. This demonstrates a potential risk that the Yen could appreciate roughly 10% or even 20% to reach fair value. Its price is held down by Japan so that they can encourage exports through devaluation. If global investors get burned by a US stock crash they may decide to withdraw funds from the US, thus making the dollar go down and the Yen to go up. This would force Japan to have even deeper negative interest rates, thus pulling down global interest rates.
If Japan devalues that can cause China to feel it needs to have a competitive devaluation.
It seems clear that the US market has decided to join global markets by declining to match the weak performance of the rest of the world. A new bear market has started in the US. The 2 year Treasury’s yield dropped 60 bps since November, a steep decline; now the 2 year Treasury Note yields 2.39%.
Lower US rates could reduce the risk of a financial accident happening such as Japanese banks exporting funds to the US to earn higher yield and then experiencing a currency devaluation (assuming they waited to buy dollar bonds and then decided not to buy any.) On the other hand, if they already bought dollar-based bonds then if the dollar crashes this could trigger losses in Japanese banks that secretly bought dollar denominated securitized leveraged loans and bonds. The Horseman Capital Global newsletter of October, 2018 hinted that Japanese banks have bought a lot of these loans and with grim conditions in Japan some unwise investments with a global reach may have occurred.
Declining US rates will bring relief to EM countries that owe dollar-based debt.
Even though a steep decline in US stocks would encourage foreign investors to flee thus putting downward pressure on the dollar, it is possible that foreign investors will stay in the US and instead buy Treasuries simply because the rest of the Developed world has extremely low or negative interest rates. The US is the cleanest shirt in the dirty clothes hamper and there is no time to prepare a clean shirt.
I expect the SP to reach bottom in a year at roughly half off from its peak of 2,941. Tech stocks may follow the 1970’s NiftyFifty or 2000-2002 Nasdaq crashes and have a 78% or 80% crash. A deep stock crash has cut CPI inflation in previous crashes by 1.2% according to Leuthold. In my opinion that could actually increase the real yield of a bond and thus investors may desire to own Treasuries despite the recent drop in nominal rates. A 1.2% drop in inflation with no change in interest rates would make a 10 year Treasury’s real yield slightly above its long term average of 2.1%.
The tax cut of December, 2017 mainly cut business’s income taxes (while doing minimal changes for individuals). Businesses use logic rather than emotions to decide to expand and logic showed them that expansion was unsafe, thus the business tax cut was saved instead of spent, so no significant stimulus occurred. The stock market incorrectly leapt to the conclusion that this would expand the economy in 2018, but any expansion was unsustainable and has now reverted to the usual mid-2% GDP. With trade wars I expect a further slow down in GDP. Thus US stocks have now realized the hoped-for stimulus is gone and we are at the end of a long cycle and thus due for a cyclical recession.
Investors need independent financial advice about the risks of an FX crisis triggering a global stock crash.