NEVER do an after action report

 

How on Earth did we end up with negative rates? Simple, by avoiding as much as possible any “wargaming” of economic predicaments.

 Thanks to a friend, Marc Udeschini,  for starting my down this rabbit hole. He asked: "Is a period of hot inflation the likely path forward?".

That got me thinking, not so much about the future as about  the past.

 After all, one of the high point in my life was meeting a person who was a "high priest" in insurance since the 60ies. I won't name him because he passed away and he was quite prominent, but after the meeting we talked a little, liked each other's way of thinking, and started REALLY talking. at some point, I asked him "Why do life policies carry a 4% minimum guaranteed return?".

He told me that prior to the Yom Kippur oil crisis and the resulting inflation explosion, Insurance companies merely gathered assets by offering a fixed 4% return  against their name. Fast forward to 1974, and one year rates in Italy reach 18% (!). So, in order not to be wiped out by mobs of clients demanding their money back, they promise to give back 80% of the yield on their financial portfolio, with the OLD guaranteed rate becoming a never to be breached minimum guarantee. And when I asked to this old sage I was in awe of, "did you have any hint of what was about to happen, earlier in the 70ies?", his answer was "Not a clue".

So, as in my old age I decided that being prepared beats being a clairvoyant, let's roll onto the past.

 How the heck did we get here??

That's where Marc had me click. After all, there IS a country which is further along everyone else down the rabbit hole: Japan. And I seem to recollect that when the ECB was starting its "Drang nach Osten" towards negative rates, she anwered the meager band of skeptics with words like "We are not Japan".

Well, a decade on, here we are, and the first casualty of that drive was that phrase.

What did we miss? A thorough AND PUBLIC discussion about the Japanese financial history, or for the Militarily inclined, an AAR (After Action Report).

Just to make it clear, this is the Topix index including dividends, as per Bloomberg LP:

 Bear in mind that this total return index is still BELOW the 1989 peak. But over long periods, and before this abnormal interest rates environment, "time value of money" still meant something. You invested in Japanese shares only if you thought you could beat the Japanese Government Bond rate of over 5%, or not at all. 

Now, think what would have happened to a shy but young "Sarariman" who wanted to have some retirement money stashed away, who perchance knew someone at the Finance Ministry who could arrange this mutually beneficial deal: the young pup would pay 50 million Yen now, in order to buy a 30 year zero coupon at slightly lower rates than those prevailing on 10 year bonds, seen below.

 

 

They agree on 5% instead of the 5,6% of the ten year, delivery against payment.

So, since over 30 years have elapsed, where is our VERY shy employee now?

 Be advised if you are younger than my 58 years, that at the time Japan inc. was on a roll and represented 40% of the world equity markets. Books were published saying things like "Japan will conquer the world" or "The Imperial palace in Japan is worth like the whole of California", so practically EVERY international long investor had a sizable chunk there... and now?

Yyyep, that guy was lucky. Here are the numbers, for those who want a quick recap:

start date	31/12/1989
end date	18/11/2020
Years elapsed	30,9
Rate	5%
capitalization factor	4,52
(1+ 5%) ^ 30,9
amount	50.000.000
Final amount	225.842.891
Topix at start	2.888

So, at what level of the Topix, including reinvested dividends, consummate pros who held fast will reach that (formerly) young buck? + 2.888 * 4,52 = 13.045 or thereabouts. So, if and when someone tells you "THE JAPANESE MARKET MAKES NEW HISTORIC HIGHS", hold the Champagne. Root beer is nearer the mark.

So what's the gist of my writing? it's that BEFORE embarking in policies remotely likely to land us there, Western Central Banks should have started a frank discussion of the pros and cons, and make no bones that for once, they did not crave "compliance": they wanted the best professionals to ruthlessly shoot at that plan to see if it still floated afterwards.

That unfortunately did not happen. So, from then on, we've skipped from crisis to crisis like a stone across a pond.