Japan could hold the key to understanding why Charles Schwab Corp. is making headlines for all the wrong reasons
Schwab and its assets of over $7 trillion spanning various industries may be feeling vulnerable in the face of the financial world’s instability, which is being caused by the Federal Reserve’s most assertive tightening cycle since the mid-1990s.
Japan, which is experiencing a comparable level of resistance to financial transformation, may offer better insights into the root causes of the problem, making it a more likely source of clues.
The adverse impact that the Federal Reserve’s interest rate increases had on Silicon Valley Bank and Signature Bank in the United States has caused anxiety in Asia. Schwab, with assets exceeding Japan’s annual gross domestic product, facing potential challenges has only heightened concerns that the worldwide capitalist system is rapidly losing ground.
Similar to SVB, Schwab purchased longer-term bonds with low yields during 2020 and 2021. However, as the Federal Reserve increased interest rates significantly since last year, Schwab began to experience significant unrealized losses in a short amount of time. According to Bloomberg, by March 2022, these paper losses for Schwab had exceeded $5 billion, which had ballooned to over $13 billion by the end of 2022.
The relevance of the Japan connection becomes even more apparent here. Within the next 14 days, Kazuo Ueda will become the new head of the Bank of Japan. He will then be confronted with the daunting challenge of balancing the normalization of monetary policy with avoiding a damaging blow to the economy.
The anxiety that the BOJ may shift away from over two decades of quantitative easing is putting considerable pressure on Asia’s second-largest economy. Since the BOJ was the first to introduce quantitative easing back in 2000 and 2001, the abundance of yen liquidity has become an integral part of Japan’s financial fabric.
The suggestion of the BOJ tapering, let alone an actual interest rate hike, is likely to unsettle Japan’s political and corporate elites. A case in point is December 20, when outgoing BOJ governor Haruhiko Kuroda tested the world’s readiness for the BOJ to reduce its level of stimulus slightly.
However, Kuroda’s attempt to let 10-year yields rise to as high as 0.5% didn’t yield the desired outcome. Instead, it caused panic in the global markets, leading to a surge in the value of the yen and a spike in U.S. Treasury yields due to the failure of the so-called yen-carry trade.
Japan, having been the first to adopt quantitative easing, has become the world’s largest creditor nation. Borrowing yen at low rates and investing those funds in higher-yielding markets, from India to Poland to Brazil, has emerged as a favored funding strategy for investors globally.
Therefore, whenever the yen experiences sudden fluctuations, it tends to destabilize the global markets. This scenario played out yet again on December 20, leading Kuroda and his team to quickly reverse their decision. In the following weeks, the BOJ purchased more bonds to signal that its monetary policy hadn’t changed.
This sheds light on the precarious financial landscape that Ueda is about to inherit when he takes over as the new governor on April 8. It could also clarify why, during his appearances before parliament, Ueda made a concerted effort to indicate that the current policy of quantitative easing would remain unchanged.
Of course, the situation could change in the future. However, Ueda appears to be unwilling to test the markets again anytime soon. Moreover, the turbulence that SVB, Credit Suisse, and now Schwab have been experiencing is likely to prolong the current era of quantitative easing by the BOJ.
This is because Japan has developed a strong dependency on the BOJ’s free money. Any efforts policymakers have made to wind down the QE program, such as in 2006 or December 2022, have sent shockwaves across global markets.
The situation with Schwab indicates that the U.S. is experiencing a similar dynamic, where financial institutions are driving the market. However, due to its sheer size, the U.S. financial system’s risk is much greater. Only a small fraction of Schwab’s 34 million depositors, less than 20%, have accounts that exceed the FDIC’s $250,000 insurance cap, whereas at SVB, it was around 90%.
In either case, Schwab’s difficulties imply that the U.S. may have a Japan-like dependence on low-interest rates, which investors may not have fully realized.
Jerome Powell is now in the spotlight. Thus far, the Federal Reserve chairman seems to be prepared to continue raising rates. The Fed believes it has not completed its most aggressive tightening cycle since the mid-1990s, with inflation increasing at a 6% rate.
Whether the U.S. financial system can handle further moves by the Fed remains to be seen. Since the Fed adopted QE, banks appear to have forgotten that yields can rise, as well as how to hedge against markets turning against them.
As inflation continues to rise at a 6% pace, Jerome Powell appears willing to continue hiking rates, despite the growing risks of collateral damage to the financial system.
However, the Fed may need to reverse course or halt the rate cycle if the risks become too great. It’s also worth noting that the Fed may not be the best team to combat inflation, which is largely driven by high oil prices and supply-side disruptions. Instead, investing in productivity-enhancing technologies could be a better solution.
Furthermore, as Japan has demonstrated in the past, financial institutions heavily reliant on low yields may be ill-equipped to withstand the fallout from rate hikes.