315. Why we should all care about Japan’s rising rates

30:09Listen to what it sounds like to be a million miles away.

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31:09You know, on the one hand, you've said as and when Japanese interest rates rise significantly, the carry trade, which has freed up enormous amounts of money to invest in US government debt, will, it might not end completely, but the flow of funds into America will reduce very significantly, and that will mean other things being equal, as it were, that the price of US government debt will be lower and US interest rates will be higher. But equally, what you call a disorderly adjustment, whether it's, you know, actually a sharp rise up or a sharp rise down, in the kind of world in which you live, we are talking about the potential for really very significant losses, which equally could lead to, you know, wholesale dumping of US treasuries.

32:11And, you know, I guess how worried should we be by what feels like an incredibly unstable equilibrium with America so dependent on Japanese credit? The sort of US is kind of constantly trying to do two things that oppose each other. So for one thing, if they want the Japanese yen to be stronger, then it doesn't make sense for them to force Japan to invest money in the United States, which they've done. The tariffs also weaken. You know, historically, when a country initiates tariffs, it causes the other countries' currencies to depreciate against them, often by about the amount of the tariff. So they're implementing all of these policies like forcing Japan to move money into the United States, which involves selling yen and buying dollars, which weakens the yen.

33:08They've got the tariffs, which weaken the yen. And then they're kind of trying to support the yen. This is kind of incoherent and it's not going to work. But, yeah, the real worry with an unwind of carry trades, and it does happen from time to time. The carry trade is sort of on Wall Street, there's an expression for certain types of investments as picking up pennies in front of a bulldozer, you know, where there's sort of these things that will give you a small, steady return. And it's great for ages until one day you get absolutely flattened by it. And that's the nature of the carry trade. And from time to time, we've seen Kerry trades unwind and they tend to unwind in a reasonably chaotic manner because it's sort of one of those slowly, slowly and then all at once kind of things.

34:01Because what happens is that people feel a little bit squeezed. They unwind a bit more. They feel their unwind squeezes them more. They unwind a bit more and so on. And then suddenly they just need out. and that's really kind of the worry with a situation like that. And I've heard you describe investing in the carry trade as basically being paid to hold a grenade because it's not sustainable, is it? What seems to happen is that most of the time it works but then every once in a while it does a sharp reset and so you might kind of have two years worth of gains that get wiped out in a day. The question is sort of how levered are you as an investor?

34:47If you're just doing it on a small scale, it kind of doesn't matter to you. But if you borrowed a huge amount of Japanese yen and used it to fund, I don't know, like big – because it's not just borrowing yen and buying, you know, U.S. bonds. It's also the U.S. stock market or anything, you know, like people around the world. We've seen huge outperformance of the U.S. stock market really since the global financial crisis. If you look at global stock markets, they've kind of gone sideways since the GFC. The U.S. has gone up a lot and this has attracted money. And, you know, a year or two ago, you would listen to people and they'd say, well, is there even a reason to internationally diversify?

35:32Like this was always the idea that it made sense to diversify internationally. Suddenly, people started saying, well, shouldn't you just own the U.S. stock market? Shouldn't you just own the Magnificent Seven? And the risk is that people have done this over a long time. They've gotten really comfortable with the idea of owning dollars and owning U.S. investments. And they could get burned on this with a sudden unwind. And in particular, the levered investors. You know, for the kind of person who just has a bit more money invested in the U.S. than they normally would, this shouldn't be a big deal.

36:12But if you borrowed money to do this, it becomes quite a problem for you. Not long after his Japanese adventure, he also started talking up his interventions, which actually in some ways are not more conventional. He started talking about he was going to buy, you know, US Treasury bonds using money that, I mean, I felt a bit foolish. I didn't even know he had a pool of money that he could deploy in this kind of way. Because, you know, I'm an old fashioned sort of person. I thought only central banks had the ability to intervene in debt markets. So what is this pool of money that he has? And how unusual is it that he's been buying US government debt with it?

37:04The Treasury doesn't usually do this. It's not their role. But the money even that he is using to do this is sort of the general account, the Treasury's general account, which is basically when money comes in in the form of taxes, before it gets spent, it kind of piles up there. And they've built up more in that account than they normally would have. And then he's deploying that in this way. Now, there's a few things. Firstly, he's not meant to do this. And this is the taxpayer's money that's designated to be spent in other ways that he's spending this way. But on top of that, while it looks like a chunky amount of money, it's kind of not enough to do what he wants to do.

37:47So it's to a certain extent performative, but it's also kind of this renegade thing that he's doing. And once again, I wouldn't reasonably expect it to work. And in fact, I feel that the very fact that they look like they're trying to manipulate prices almost draws attention. And in a way, you know, if we go back to, you know, Scott Bessent used to work for Soros. He used to work for Stanley Druckenmiller. And they kind of famously had that trade that was, you know, referred to as breaking the Bank of England. But really what it was, was the British government were trying to keep the pound stronger than it should have been in markets.

38:26And so basically, you know, the Bank of England was trying to support the pound, Soros, but really kind of everyone who traded dollar pound didn't believe that Britain could hold that rate. And Britain had to devalue in a fairly chaotic manner. And George Soros made a billion dollars in a day. And that was really a bet on governments not being able to control things like this. So it's kind of wild seeing Scott Bessent on the other side of this bet right now. And there are other examples of where he's made big money from currencies, isn't there? Like 2013 was the yen. Tell us a bit more about his hedge fund background.

39:11Yeah, well, the yen trade, you know, was another one that he would have been involved with through Source and Druckenmiller. And in that case, he was actually betting with the Bank of Japan. So he wasn't betting against like he was with the pound. But, you know, he had a long, successful career working for Soros. He went out on his own, I'm trying to remember, maybe 10 or 12 years ago. And at the time, it was the biggest hedge fund launch, I think, in history. But to a certain extent, you know, he does get credit as sort of being involved in these big macro trades. But it's worth noting that the most successful ones were sort of under Soros and Druckenmiller.

39:55So one of the things that puzzles me about him, and it's a sort of trying to understand his psychology, right? Why does he now think he's different? Why is he now the one government that's going to humiliate the market? I struggle to understand that some might be just a belief that he's awful. You know, he thinks he's just smarter than other government employees in the past. The other argument might be that maybe he doesn't even believe this will work. You know, he hasn't necessarily deployed a ton of capital doing this. He's more, you know, he's kind of threatened more than he's done anything.

40:33And I wonder to a certain extent if he wanted Warsh to hike interest rates and sort of take the hit and he gets to look to Trump and say, you know, I did my best. It's that guy's fault. that that's a possible version of the world that he's thinking through. I quite like that. I mean, that is basically two hedges in the case of Walsh and Besant basically trying to outsmart their boss, Trump. And you mentioned Drucker Miller there because obviously he, as you say, you know, Besant's mentor. He describes him as the greatest money making machine in history. but Druckenmiller has been really vocal in saying Besant's wrong on this, which is interesting too, isn't it?

41:16It's very interesting because, you know, but also it's worth noting that Druckenmiller has been banging this drum for years. And basically, you know, one of Druckenmiller's key arguments is that the price of the 10-year treasury, you know, people refer to it as the most important number in the world and it's the rate of which people will lend to the US government. And it's sort of, the idea is that it disciplines the government Like that basically, if the bond market won't lend to you at the rates you want, it says that you either need to increase taxes or cut spending. You need to do something to be more fiscally responsible.

41:53It imposes discipline on the government. And Druckenmiller said for ages that, you know, governments need to be more fiscally responsible, that they should. We've seen national debts around the world really more than double over the last 25 years. And we've reached a point where the interest paid on national debts in the U.S., but also in many developed countries, is becoming quite a problem. It's greater than U.S. military spending at the moment. if interest rates stay at this level that will grow because like even without any further borrowing and the reason it has to grow is there's a load of money that was borrowed when interest rates were very low and as those loans roll off they have to re-borrow at these new higher interest rates which are you know 3.75 to 4 percent at the short end of the curve or five at the 10-year rate And essentially, just paying the interest on the debt is going to soon be greater than the amount spent on Medicare, on Social Security.

43:10It's a problem. And the solution to that problem isn't trying to meddle with the interest rate. It's trying to balance out the economy. And no one wants to cut services. No one wants to hike taxes. It depends on the country. Like in the UK, taxes are actually very high. In the US, they're not. And so the US actually has maybe more room to move in that they can either cut spending or increase taxes. In the UK, it's going to be difficult to hike taxes anymore. They're probably stuck with just having to reduce services or government spend. Basically, Scott Bessent is gambling with taxpayers' money that is supposed to pay essentially public officials, civil servants, public employees wages.

43:59Is there any, I mean, obviously, this is Trump. Trump never follows the rules. It turns out people who work for him don't follow the rules. I mean, is Congress up in arms? I mean, Congress ought to be up in arms about this. Yeah, well, you know, once again, like one of the issues that we've seen in the last year and a half or so is that, you know, under the U.S. Constitution, Congress has the power of the purse. Congress gets to decide on taxing and spending. So even on day one, when we saw the Doge thing with like sort of an attempt to sort of slash taxes without consulting Congress, that wasn't the right way to do it.

44:40the tariffs a way of bringing in tax money without consulting Congress. That's not really the way to do it. The way the U.S. government is supposed to work is the president is, you know, there's three branches of government and they're supposed to work together in order to find solutions. While under the Trump administration, we've seen this sort of consolidation of power within the executive branch. You know, Trump has had the time to sit down with Congress and sort of have this stuff put into law. But instead, it's always been this sort of, you know, executive action that's not permanent and that's not, you know, the way things are supposed to work.

45:26So once again, Bessent sort of stepping outside his mandate and doing his own thing. Another element to all of this drama as well was, I know this is something you've looked into, Patrick was this suggestion that there might be military intervention for higher interest rates which suddenly blows your mind and I mean what did you find when you looked at where did it come from what did you find when you looked into this? Trump was asked about percent and you know whether he approved of what was going on and so on and he gave this answer that at first he sort of said like no Scott did it himself I didn't tell him to do this but you know we can kind of do what we want.

46:07The ultimate intervention is a military intervention, you know, which seemed kind of, I mean, it made no sense. I kind of think it was just sort of rambling, like Trump says an awful lot of stuff. He means about 10 % of it. I kind of view that as humorous, humorous to me. I don't know, not saying that he meant it to be funny, but, you know, it kind of makes no sense. In the context of$40 trillion of, you know, US government debt. And if you include, you know, all the short term bills that have to be rolled over every few weeks, you know, the financing requirements of the US government, I think actually something like 30 trillion of debt has to be refinanced every single year.

47:04if you include all the bills that are rolling over all the time. You know, obviously against that, you know, the amount of taxpayers' money that Besant has deployed to buy U.S. debt is a drop in the, literally a drop in the ocean, and you sort of have to assume that he is going to end up losing money on all of that. But at what point, given the irresponsibility of Trump and Besant, At what point do the world's creditors simply say, you know, enough is enough? At what point does this become a genuine funding crisis for America? It's hard to say because there's sort of there's often been talk of this sort of de-dollarization.

47:51You know, there was a lot of talk back when the US sanctioned Russia at the start of the war in Ukraine, cut them off from SWIFT and that sort of thing. And there's always been this question, you know, the U.S. dollar, the exorbitant privilege argument. And at what point will the rest of the world stop lending to the U.S.? But the truth of it is that there's kind of no alternative. Like, we can talk a lot about this. But if you're, we'll say, China and have a huge amount of capital that needs to be stored somewhere, you basically kind of need to store it either in Europe or the United States. The United States issues a lot of debt, which means that you can put a lot of money there.

48:37So we'll say, for example, if China decided that they didn't want to buy dollar denominated bonds anymore and decided to pile into European bonds, you know, another reasonably large economy. Because Europe doesn't borrow that much, a huge amount of money coming in would push interest rates down and kind of cause the European economy to be overstimulated. How Europe would deal with that would probably be to issue bonds as the demand comes in. And what would they do with that money? You know, they're now borrowing money that they don't need to in order to keep their interest rates at a normal level.

49:15The answer is that they would use that money to buy U.S. Treasury bonds, right? There's even just this global sort of strategy like Germany, Japan, China have all been sort of pioneers or big believers in running an export oriented economy. Japan and Germany initially and now China, what they've done is that they've sold goods abroad by kind of suppressing wages in their own country or by, you know, by essentially manipulating their own economy so that they can export more than they import. And when that money comes in, they just hold on to it. They store it at the central bank. And of course, the central bank uses that to buy dollars or to buy U.S.

49:59bonds. And so the trade imbalance itself causes the U.S. to have huge debt. But it also means that these countries, they basically need to store the money in the country that is buying their goods, right? Because the country buying their goods is borrowing money to buy those goods. That means they're issuing bonds, and that means those are the bonds you can put money in. So you can't really walk away from the dollar like that. Even when we look at that announcement from the Norwegian Sovereign Wealth Fund, they said they were going to stop buying treasuries, but they said they would be buying U.S.

50:38agency securities, right? But you can walk away to a certain extent, but not if you're going to run an export-oriented economy, you don't really get to do that. So, and it is actually just a global problem. Like, we can point a lot of fingers at, you know, wackiness out of the Trump administration or whatever, but it is a global problem. When we have China right now exporting way more than they import, like they're not really buying anything anymore and they don't seem to even intend to buy foreign goods. It becomes a very weird thing, like where you're sort of selling, you know, the fruits of your country for IOUs that you essentially can't cash.

51:24Like if you destroy all the global economies, all of the foreign businesses, they can't earn the money to pay you back. Like it's there's a lot of weird economic strategies being deployed all at once and they're kind of clashing with each other. And that's sort of the chaos that we're seeing. Bringing it back then to, you know, the impact globally. Obviously, we talk a lot about what's happening in the UK with borrowing costs here. Does our Chancellor, our government need to be worried about what is going on with US Treasuries? To a certain extent, everyone does because the U.S. is almost, the U.S.

52:01Treasury is just the base rate. And when that goes up and down, it causes problems. Like even, you know, a couple of years ago when U.S. interest rates went up and emerging markets didn't, what you saw was a big flood of capital out of emerging markets into the U.S. where you could just earn a higher return with an investment in a more stable economy. So basically, the U.S. economy, when it moves, it just does affect everywhere else. Britain is maybe a little bit less exposed. So when we talked about this idea of sort of the short duration of U.S. bonds, like Scott Bessent has essentially been borrowing.

52:42He's only been issuing short term treasuries rather than long term ones in order to keep that down. And so what that means is I think around 25 percent of U.S. government debt has to be refinanced every two years, which is amongst the highest it's been. And it's almost at an emerging markets level of sort of reliance on short term interest rates. The British government has actually borrowed much longer. So the British government has all sorts of problems, but one of the good things is that they're less sensitive to sort of movements in interest rates than the United States is and than many other countries are.

53:25On the other hand, one of the things that is very striking, and I don't know if you have any sympathy with the British government over this, is that when you get a movement in the 10-year or the 30-year US Treasuries, the downward movement typically in gilts, in UK government bonds, is bigger. Pretty much every week, some member of the government sends me the IMF chart, which shows that consolidation of UK government debt is moving a little bit faster than anywhere else in the world on the official projections. And yet investors just don't care. Why, when there's an ugly contest, is the UK and you get these periods of nervousness about sovereign debt, why do investors always see the UK as the ugliest?

54:19The UK economy is just quite different to the US economy. And it's also worth noting that it's just a much smaller bond market. So when the big thing moves in price, you know, a small thing that people still have a lot of faith in. If you're an international investor, what countries are really on your radar? And there are things like the big European countries, the UK, Switzerland, Japan, a few others. And so with the UK being just a smaller market than many of the others, it just means that a move will probably hit the UK a little bit harder. There's all sorts of different things as well with the UK economy because the UK economy is also much more affected by changes in interest rate because most mortgages in the UK are – Britain doesn't have the 30-year fixed rate mortgage like Americans do, right?

55:21So in the UK, when interest rates go up and down, it instantly hits the homeowner. They have less money to spend or, you know, if rates came down, they have more money to spend. But the Bank of England, and I guess it has a greater reach into the UK economy, but also just means that the UK economy is more interest rate sensitive than the US is. Patrick, you sort of ended with this, you know, rather brilliant description of, you know, quite how irrational both the physical economy, you know, China running perpetual surpluses and the financial economy. You know, America issuing, you know, more and more and more tradable debt against a backdrop of, you know, American government obligations rising, you know, exponentially higher into the into the future.

56:30I've just sort of struck that you broadly say the reason it survives is because if at any point, for example, investors just decided, right, we're going to dump the dollar. That is the equivalent in a sort of economic sense of, you know, thermonuclear global destruction. The shock is so big for everybody that nobody will ever allow the button to be pushed. Even so, if we are trapped, we do know from history that, you know, at some point, you know, grotesque, enormous irrationality comes to an end. And that is what we're living through. Yeah, I guess the thing that's interesting, though, is that often there's sort of this perspective with markets where we look at it and we expect it all to be rational.

57:21And we kind of think there are rules and the rules should be followed and everything will work if the rules are followed. But in the real world, actually, everything moves around. The rules get changed constantly. And it's, you know, nothing works the way you'd expect it to. And that's kind of why markets are interesting, right? Like if everything just was orderly and everything worked as it should, we wouldn't even have anything to talk about here. You know, the market is, there are all sorts of strange things in today's market, but there will always be, you know, because there's always people trying to position for advantage, trying to change things.

58:01There's, you know, when a borrower or a lender gets into trouble, they start, you know, pushing buttons that you'd say, oh, you shouldn't push that, but they've kind of got nothing to lose. And so, you know, the world is not, and markets are not stable by nature. You know, and we've seen this through history, that, you know, often there's bubbles and busts. There's, you know, transfers of power around the world. You know, this will continue. You know, I don't know that we should sort of fill ourselves with panic that the world is about to end. There's always markets and economies are always sort of a negotiating process where people are sort of seeking advantage.

58:48And, you know, there's winners and losers and the rules get changed from time to time. Whenever people get overly negative, I always point out, you know, a guy I used to work with years ago used to always say, you know, that he used to really be bothered by the idea of shorting stocks, for example, in the long run, because he said what you're doing is you're betting against humanity. Like everyone, you know, every business out there is filled with people. They come into work every day. They need to work to make money, to feed their families. The businesses need to succeed. When businesses do the wrong thing, there is a recognition and, you know, the CEO gets changed or, you know, something happens or the work culture changes or whatever and things recover because all of us are doing our best to sort of to make money, to survive, to feed our families, to, you know, to grow and do better.

59:42And that is sort of this wave of human energy that sort of pushes things in a positive direction. So even when you worry about, you know, sort of mass chaos, for example, I think you shouldn't expect that to happen just because even when things do get chaotic, it just means that a new guard come in to try and improve things, to try and make things better. So, you know, that's sort of how I would end on a positive note is that we shouldn't become doomers about everything because it's in everyone's interest that, you know, a doomsday doesn't arrive. I think that's a fabulous place to end, Patrick.

1:00:24Thank you. That feels like a, you know, inspirational speech for us to now lead our lives by. Great. Absolutely right. Patrick, thank you so much for being with us today. I thought that was fascinating. Thank you. And that's it from us on The Rest is Money. Bye bye. Goodbye.

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