In today’s issue:

  • A fragile system will fail eventually. Does it really matter how?
  • Chaos caused by the yen is but a warning of what comes next
  • China’s exchange rate surprise could make the yen look boring

A fragile system will fail eventually. Does it really matter how?

That’s the lesson you should’ve learned from last week’s stock market chaos. The fragility of financial markets puts them one surprise away from a crash at all times.

In September 2022, it was fragility in the UK bond market. Bonds had already crashed badly that year. But a mini-budget was all it took to tip pension funds over the edge.

In 2023, US banks went bust. They were holding vast losses on bonds too. When depositors wanted their money out, the bank had to sell those bonds and realise the losses. But they were too big to handle. Like that famous scene in Mary Poppins, all it took to trigger the bank run was fear.

Indeed, banks are inherently fragile. They rely on confidence. If depositors lose that confidence and demand their money out, there’s a crisis.

Companies that borrow a lot of money are the same. They must regularly roll over their debts, which means repaying old borrowings with new ones. But if lenders lose confidence and refuse the loan, few such firms have the capacity to repay their debt as it comes due.

The point here is not the specific examples. (Although the fact that they tend to involve banks is a big hint.) It’s the underlying fragility that matters. If it only takes a change in perception to unravel markets, are they really something to be punting your retirement money on?

But you’ve got to invest somewhere, right?

Yes, that’s the nefarious side effect of inflation targeting. If you want to save money, you’ve got to jump onto the hamster wheel and hope you can keep up with inflation.

This week, we’ll reveal how to deal with the incongruity of it all. How do you profit enough from financial markets that are always one nasty surprise away from a crash?

But, as ever, people want to know what the crash will be. Which specific domino will fall first?

So, let me take a crack at what blows up our fragile financial markets next…

Proof of currency chaos concept

The yen’s instability is not our first rodeo with exchange rates wreaking havoc. And it won’t be the last.

I just watched a video by Russell Napier – the master of such situations. He predicted and tracked the Asian Financial Crisis of 1997 from inside a koala’s bottom.

To be more precise, his Hong Kong office was located in a tower the shape of glass koalas. And his desk was at the rear end of one of them.

From here, Napier used trade and international currency flow data to analyse the booms and busts of Asia’s famous infamous tiger economies. At the time, using trade and foreign investment flow data was considered about as credible as using astrology. But Napier was proven right.

The Asian markets’ boom and the bust wasn’t driven by economic growth. It was exchange rate manipulation and inflows of capital. That made it a bubble which would eventually pop. And so Napier’s newsletter readers didn’t get mauled when the flows reversed. But the shock even blew up Western financial markets as a result. Thereby proving my point above about fragility from earlier.

The story of the Asian Financial Crisis should remind us of what happened last week. Currency flows in the Japanese yen suddenly reversed and that pulled the rug out from under global stock markets.

No doubt Russell is busy writing a book about it by now, again. After all, he did predict trouble for Japan in the video I watched. Which was released the day after the yen bottomed and began its rather disruptive surge back in July.

Coincidence? Yes – Napier has a knack of being early with his warnings. This one was unusually prescient.

Anyway, Japan was only a secondary part of Napier’s presentation. He actually focused on China. And implied that Japan’s currency chaos would be left in the shade by China’s.

Given both sets of analysis echoes Napier’s warnings from before the Asian Financial Crisis, it’s time we sit up and listen. He’s building up quite a track record.

China’s coming currency chaos

Just as the Bank of Japan’s incredibly loose monetary policy inflated asset prices around the world via the yen carry trade, China’s exchange rate manipulation has created a vast distortion too.

You might know the Chinese create a lot of money out of thin air to keep their exchange rate low. It’s the source of their booming economy and dominant exports.

But the money they create has to be invested somewhere. It becomes demand for foreign investments that the Chinese buy with the proceeds of their foreign exchange intervention. That’s why the Chinese own so much stuff around the world. They printed the money to buy it.

Should this exchange rate policy ever reverse, it would yank demand from Western financial markets, just as the yen’s sudden surge did.

And Napier is worried that China is on the cusp of doing just that. Because China’s exchange rate policies are causing economic turmoil inside China.

We are talking about moves in markets akin to last week, but much larger and more sustained.

The big question will be how the world reacts to this. We didn’t exactly accuse the Bank of Japan of executing a Pearl Harbour surprise attack on Western financial markets when it raised rates and let the yen explode like a bomb beneath our stocks.

But how will our politicians react if China does much the same? If it unleashes its currency and demand evaporates from under Western stocks and bonds while the cost of “Made in China” goes through the roof faster than the price of free renewable energy, what will our leaders do?

Find out in our upcoming presentation soon.

Until next time,

Nick Hubble
Editor, Fortune & Freedom