Why The Japanese Market Freakout Might Be Good For Car Buyers

I didn’t go to sleep planning to talk about the ‘carry trade’ or the ‘Sahm rule’ or ‘circuit breakers’ or any of that this morning, but I looked at social media around 2:00 am and saw that the Japanese markets continued to take it on the chin. People are freaking out, or getting excited about ‘buying the dip,’ or whatever. What does it all mean?

This is a car website, not a macroeconomic website or even a market website. I’m going to try make some sense of what’s going on, briefly, in the overall economy and then talk about what’s happening in the car market. Then I’m going to explain how it’s going to impact the car market… perhaps positively!

But are rate cuts actually going to happen? What does it all mean?

Are We Headed For A Recession?

You’re laughing? A pod blew up on the yen carry trade unwind and you’re laughing? pic.twitter.com/Zu9g0rfcpg

— Tommy O’Dwyer (@TommyOKid) August 5, 2024

Today would be a bad day to look at your 401k if your money is in the usual mix of index funds or even something slightly more exotic like QQQ. Based on what futures are looking like, my expectation is that the markets here in the United States will probably already be falling by the time this is published. Gains will be wiped out. Numbers will go down. Et cetera, et cetera.

What’s going on, here? A few things.

Let’s start with the mother of all hand waves, which is that there is ‘geopolitical risk.’ The biggest risk, to the surprise of no one, is that Iran and its proxies are expected to respond to an incredibly embarrassing assassination in Tehran of a Hamas political leader by Israel. Iran looks weak and it’s expected it’ll respond, perhaps as soon as tonight, with a barrage of missiles and drones. The general vibe seems to be that Iran will do enough to cause a fuss, but not enough to cause a devastating war. No one knows for sure what’ll happen, least of all the parties involved.

That’s the easier factor to explain. Here’s where it gets trickier. Last week the U.S Federal Reserve Bank had its regularly scheduled meeting, and there was an assumption that the ‘Fed’ would cut the higher interest rates we’ve been all dealing with. In fact, given that inflation has generally cooled (minus ‘shelter’) it was a bummer for many that the Fed didn’t do so at its last meeting, though there was an intimation from Fed Chair Jerome Powell that a small cut might happen in September. That was last Wednesday.

What’s funky about everything is that markets have been expecting rate cuts for almost a year, but they haven’t happened, and yet unemployment has remained relatively low, markets have expanded rapidly, and corporate earnings have mostly stayed high. This is kind of impressive. Coming off of a pandemic, huge government stimulus, the resulting inflation, and everything else it feels like the Fed has come close to achieving its “soft landing” goal of getting the economy back to normal without some massive issue.

Again, that was Wednesday. On Friday the July jobs report came out and the numbers were a little worse than expected. This triggered the so-called ‘Sahm Rule’ and I’ll let CNBC explain what that means:

The so-called “Sahm rule” has observed without fail that the initial phase of a recession has started when the three-month moving average of the U.S. unemployment rate is at least a half a percentage point higher than the 12-month low.

Does that mean a recession is going to happen? Economist Claudia Sahm of the ‘Sahm Rule’ says it probably doesn’t:

“We are not in a recession now — contrary the historical signal from the Sahm rule — but the momentum is in that direction,” Sahm told CNBC by email on Friday. “A recession is not inevitable and there is substantial scope to reduce interest rates.”

The important thing to note here is that the ‘Sahm Rule’ is meant to be prescriptive, i.e. if it’s triggered it’s more of a countdown clock on a time bomb than the explosion itself. What it’s telling the Fed is it needs to cut the blue wire… err, it needs to cut interest rates.

Much of the Fed policy up to this point, whether in regards to rates or its other tools (we’ve talked about quantitative tightening here before) has been designed to give the central bank room to adjust when necessary. By keeping rates high and taking money out of the market the Fed now has room to act, which wasn’t the case when rates were effectively zero.

So why is everyone freaking out now? Is it just the Middle East and U.S. unemployment? Nope.

There was a place where the rates were effectively zero for an extremely long time: Japan.

One theme of this year in TMD has been more intervention in the economy by bankers and other market players in Japan. For the most part, Japan’s central bank, the Bank of Japan (BOJ) has kept rates down, thus we’ve seen the yen drop to the U.S. dollar. This has been a windfall for exporters like Toyota but carries its own risk in Japan.

While everyone was waiting for the U.S. Federal Reserve Bank to lower its rates, the BOJ kinda surprised everyone by raising rates substantially to avoid the yen collapsing and to try to avoid inflation for consumers in Japan. It worked to some degree because the yen is now way up compared to the dollar.

It gets wackier, and this is where I’m going to try to find the briefest explanation for the ‘carry trade’ that I can. This is from CNBC:

The rising yen has fueled speculation about whether this could mark the end of the popular so-called “carry trade” — wherein an investor borrows in a currency with low interest rates, such as the yen, and reinvests the proceeds in a currency with a higher rate of return.

Does that make sense? You borrow money in yen, which has a low interest rate, and then go buy other stuff. The yen being low for so long made this a popular trade, but even then the yields aren’t that great, so the assumption is that hedge funds have been doing what hedge funds do and have been using significant leverage to make even more money.

That worked until it didn’t, and the BOJ move is now causing all of those trades to “unwind” and it’s leading to all the havoc we’re seeing in markets around the world. Is this like 2008? Hopefully not.  A lot of what markets have been doing doesn’t make a lot of sense, and corrections like this, while temporarily painful, can sometimes bring a little more logic to the universe.

I’m not an economist and I’m not a markets reporter. That’s just my rough explanation of what’s happening, please add more nuance to the comments if you wish. This is my way of setting up the next two stories.

Automotive Inventory Is Way Up

Let’s look at cars. This is a car website. According to S&P Global Mobility, there are a lot of new cars on dealer lots. So many cars. In fact, there were 2.84 million cars advertised in retail inventory at the end of June, which is up 57% year-over-year.

This makes sense. Pandemic shortages are over, and plants are producing cars again. Simultaneously, interest rates are high. While cars are getting cheaper, they can only get so cheap for so long. People clearly want to buy new vehicles, and the one piece that’s holding people back seems to be interest rates.

Just look at the discounts:

Those are big discounts! The average advertised discount is $3,236.

My guess here is that the only thing left to do is lower rates in order to bring more buyers out.

There Are ‘Warning Signs’ In The Credit Market: Jonathan Smoke

Did you know that there are economists whose whole job is to just look at the car market? One of those economists is Jonathan Smoke, at Cox Automotive, and he put out a prescient piece last week that warned about keeping interest rates up any longer.

I suggest you read the whole thing, but here’s what struck me:

Consumers prioritize their auto debt in the U.S., as we Americans are very dependent on private transportation. Lose your vehicle and you lose mobility and potentially your livelihood. Yet with a “strong economy,” defaults are on track to be their worst since the Great Recession. That is not a good sign.

Keeping rates at this restrictive level too long is a risky strategy. The good news is that if credit card rates follow the Fed’s rate cuts as quickly as they followed their increases, that debt service will decline rapidly once the Fed starts cutting. That would be a tailwind for consumers.

However, I am not encouraged by today’s decision to wait being the 17th straight unanimous decision by the Fed. There should be more debate, as the economics community is divided on this topic. In my opinion, we are risking the economy over a questionable target based on an imprecise and imperfect measure of inflation. My worry is that conditions will deteriorate more at an accelerating pace before the Fed finally decides to cut.

This makes sense to me. The Fed has decided to focus seemingly all its attention on one economic measure (PCE) even though all sorts of other alarms are going off right now, including in consumer credit.

So What Happens Next? How Does This Help Car Buyers?

It’s now five minutes until markets open as of writing this and all indications are that we’re going to open down. Honestly, things are so volatile right now, I wouldn’t be surprised if some indication from the Fed of a rate cut causes things to reverse.

So what’s the Fed going to do? Here’s something this morning from Chicago Federal Reserve President Austan Goolsbee to CNBC:

Asked whether weakening in the labor market and manufacturing sector could prompt a response from the Fed, Goolsbee did not commit to a specific course of action but said it doesn’t make sense to keep a “restrictive” policy stance if the economy is weakening. He also declined comment on whether the Fed would institute an emergency intermeeting cut.

“The Fed’s job is very straightforward, maximize employment, stabilize prices and maintain financial stability. That’s what we’re going to do,” the central bank official said during an interview on CNBC’s “Squawk Box” program. “We’re forward-looking about it. So if the conditions collectively start coming in like that on the through line, there’s deterioration on any of those parts, we’re going to fix it.”

That’s not nothing, I guess.

A rate cut, of course, should eventually lead to lower interest rates for car buyers, which will bring down car payments to a level where more people are expected to then be able to enter the market for new cars.

Consumers are generally understood to be most sensitive to a monthly price, and if they purchased a car when interest rates were near 0% then having to pay more per month for a car that’s cheaper doesn’t work for a lot of people.

Will a Fed rate cut suddenly make cars cheaper? Not exactly.

Smoke, in his piece, warns that even if the Fed lowers rates today it doesn’t mean that rates for car buyers will suddenly lower overnight as there are a lot of factors that go into setting those rates. Also, lower rates don’t matter as much if the Fed blows it and the economy stumbles and people lose their jobs or wages drop.

Still, in an ideal world, the Fed cuts quickly, markets stabilize, companies don’t lay people off, and rates for new cars come down before the end of the year and spur more sales growth.

What I’m Listening To While Writing TMD

Of course I’m not actually writing TMD while listening to “Tubthumping” by Chumbawamba, are you mad? It’s just an apt song for this morning.

The Big Question

Am I wrong? How do you feel about the economy right now? Are rate cuts coming? Is the sky falling?