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Today’s Points:

• Bond investors aren’t missing the government — yields fell on the shutdown's first day.
• The Supreme Court isn't making it easy to fire Lisa Cook from the Fed.
• In Japan, the new question is whether companies can be profitable...
• And if  inflation is really back, or just a reflection of the rice harvest.
• AND: It’s time to celebrate Yom Kippur.

A Shutdown Premium

Government shutdowns seldom occur without warning. It’s literally obvious from miles away, allowing investors to fully price in its occurrence. This helps explain why they have limited impact on financial markets, but Wednesday’s sharp dip in Treasury yields underscored why a funding lapse cannot be discounted.

The 10-year yield traded four basis points lower at 4.106%, while the 30-year bond was two basis points lower at 4.714%. This isn’t like the nonchalance that accompanied previous shutdowns. The primary reason is that it’s causing a delay of September’s payroll release, which was due Friday. Thus the premium investors place on private employment data is rising. A nasty surprise in ADP’s estimate of private-sector payrolls, showing an outright decline, reinforced the Federal Reserve’s cooling-labor-market narrative, following the low-hiring, low-firing economy picture that emerged from the August Bureau of Labor Statistics data:

Beyond trying to read the future from the ADP report, markets remained largely subdued, as they typically do during shutdowns. Deutsche Bank analysts note that in the last six funding lapses, the S&P 500 finished higher every time, with the most recent episode coinciding with a 10% surge that was driven by other factors, including Jerome Powell’s dovish pivot at the start of 2019. 

Whether the calm can prevail will depend on how long it takes Congress to agree to a deal. The administration’s threat to permanently eliminate selected federal jobs, rather than the characteristic furloughs, raises the stakes. Each passing day without an agreement potentially brings these DOGE-esque job cuts a step closer to reality. For the long term, a slimmer federal government might be a great thing; in the shorter term, it would mean higher unemployment and added risks to growth.

A protracted funding lapse could also raise doubts about the US’s credit quality, and raise Treasury yields. Still, Jonas Golterman at Capital Economics expects market participants to see through the political theater while staying on the fence:

A prolonged shutdown lasting months rather than weeks, or the Trump administration’s threat to make permanent cuts to federal employment, could conceivably have a more damaging effect this time around. But the more likely outcome, in our assessment, is that some sort of political compromise is reached before there is much impact on the economy or markets.

Still, the talk about potential permanent layoffs does create a low-probability, high-impact tail risk. This development, according to Daniela Hathorn, senior analyst at Capital.com, could trigger a mini growth shock, keeping risk appetite subdued at the margin. On its own, this should not strengthen the case for more rate cuts, but neither does it detract from it. However, fed funds futures imply that the chance for such cuts has just improved considerably:

Investors are fully pricing in a 25-basis-points cut later this month, with the odds rising further as they contemplated the possibility that the shutdown would force them to rely on relatively noisy private sector data. Hathorn noted:

If the meeting approaches without fresh official data, the Fed will have to lean on what’s already in hand — evidence of a cooler labor market alongside inflation still above target but within range. In that scenario, a cut remains the base case, but uncertainty around the path beyond October rises and so does volatility. 

Peter Tchir of Academy Securities suggests that a long shutdown accompanied by federal layoffs should help bonds while weighing on stocks and credit spreads. That news hasn't reached the stock market yet. The S&P 500 rose for a fourth consecutive day, touching yet another all-time high, in a sign that investors are ignoring the drama in Washington:

Where do we go from here? Golterman expects the economy to continue to hold up, allowing the AI-driven stock market boom to run further:

We also think that the fall in US interest rate expectations and the dollar are now somewhat overdone – our forecasts imply a rebound over the coming months. That said, the gloomy US labour market picture is a growing downside risk to our forecasts.

Arguably, the biggest question is how close is a deal. Unlike the shutdown in 2018-2019, which lasted 35 days, Signum Global’s Lew Lukens projects this one should be over within two weeks. He argues that Democrats, although under pressure from their base to be more combative, “want to avert extended shutdowns and keep attention on the harms of the president’s policies to their constituents.”

Ultimately, any resolution is likely to hinge on a durable pact between Senate Minority Leader Chuck Schumer and President Donald Trump that reopens the government while kicking off negotiations on extending subsidies for health care. Lukens points out that the real determinant of how long the standoff lasts may be less about policy than politics: What do Democrats fear more, backlash from their base or the risks of a protracted shutdown?

—Richard Abbey

The Return of Japan

It’s just possible that Japan is back; Gearoid Reidy goes into great detail on this question in the latest Bloomberg Markets. But at least as far as investors are concerned, two nagging questions remain to be answered:

Can Japanese companies operate profitably?

While Corporate Japan has produced admired companies that make great products, they tend not to make big profits. That has been true this century throughout waves of reform attempts, and continues to be the case. 

Return on shareholders’ equity, the simplest measure of profitability, and MSCI’s regional indexes show that Japan is significantly less profitable than the US. That might be expected. The rise in US margins since the pandemic is a phenomenon of the age. Less obviously, Japanese ROE lags both Europe and the emerging markets:

There are some honorable exceptions, but mostly with companies that long ago established themselves. Toyota’s ROE has been overhauled by BYD, China’s dominant electric vehicle manufacturer, but remains well ahead of most of its global rivals (including Elon Musk’s Tesla Inc.): 

The status quo persists despite changes in corporate governance that have seen independent directors take up almost half the seats on Japanese boards, while foreign buyers concentrate their minds.

Nicholas Smith of CLSA Securities in Tokyo offers a barrage of reasons for the continuing lackluster profits. One is that Japan is instinctively cohesive and egalitarian. This is good for social harmony and makes the country the reverse image of the increasingly divided US. Unfortunately, the distinction also applies to company profits. According to Smith:

US CEO compensation is 7.2x Japan’s, and even France’s is 3.0x. Worse, Japanese compensation has a higher fixed-pay component, incentivizing riskless attendance over bold excellence. Terms in office are short and fixed, with the period rarely tied to performance.

If US CEOs get too rich, Japan’s don’t have the chance to be rich enough. A further problem is that many companies are burdened by non-core units that don’t make money. Labor laws make it expensive to fire people, so the response has been to create divisions to house those who were no longer useful to the core business — and that now act as a lead weight on earnings. Then there is the issue of competition. If US industries are too concentrated, Japan has the opposite problem, leading to price competition that makes profits harder to come by. This CLSA chart shows the least concentrated Japanese industries, measured by the Herfndahl-Herschel index, where smaller figures show more competition:

The way to deal with this, ultimately, is to push up profit margins, which is a bloody and difficult business. It does mean that there are gains to be made for any strategic or private equity buyers who think they can do this. 

Has deflation finally been beaten, or hasn't it? 

Look at Japan’s standard definition of core inflation, and it’s actually exceeded US CPI of late. It would seem that the decades of deflationary slump are over. As the Bank of Japan is still holding overnight rates at only 0.5%, normalization should be able to proceed apace:

But it’s not as simple as that. Breaking down the consumer price index into its main constituent parts using the Bloomberg Economic Analysis (ECAN <GO> on the terminal), reveals that inflation is dominated by food prices. No other category is particularly elevated:

The current high inflation, on closer inspection, owes almost everything to exceptionally steep rises in the price of rice, which has doubled inside a year. The harvest has became a political issue, with the agriculture minister receiving plaudits for beginning to bring the problem under control. But rice still contributes a full half percentage point to inflation on its own:  

Now the definitional issue. Japan’s core inflation excludes energy and fresh food. Adjust this to exclude all food, and it no longer exceeds the US core. Indeed, it drops to 1.6%, still well below the BOJ’s 2% target: 

Beyond the rice issue, there’s the currency. As detailed earlier this week, the yen is currently spectacularly weak, and has been since the central bank opted to keep monetary policy very easy as other countries started raising rates in 2022. “Before then, the dollar was at 105 yen; that’s fair value. Then it went to 160 yen and everything became expensive,” says former member of the BOJ’s policy board Sayuri Shirai, now a professor at Keio University in Tokyo. “We import almost everything.”

A normalization should reverse that effect. The Bank of Japan has been described as “behind the curve” by US Treasury Secretary Scott Bessent, but Shirai says “he doesn't understand that it’s almost all food.” As US politicians can attest, the serious pain that people feel from food inflation is hard to ignore. But the BOJ doesn’t want to take responsibility for a resumed deflationary slump. The market currently puts a 57% chance of a hike later this month, which shows that the policy dilemma is evenly balanced — but those odds look too high.

Survival Tips

You receive this as the world’s Jews have embarked on Yom Kippur, the Day of Atonement, the holiest day of the year. It’s a holiday that involves fasting for 25 hours and spending almost all the time trying to come to terms with the bad things you’ve done over the previous year. Non-Jews accurately suggest that this doesn’t sound like much fun. To try to explain why rational people in this day and age still put themselves through this seemingly archaic ritual, I offer On Yom Kippur by Daniel Cainer (whose output, as in Bad Rabbi, is usually more cheerful), Avenu Malkeinu by Phish (their version of one of the most solemn prayers of the day), and Book of Good Life, sung completely a cappella by Washington Heights’ own Maccabeats. The video is in my neighborhood. A good fast to all those who take part, and equally good wishes to everyone else. 

More From Bloomberg Opinion

• Marc Champion: Trump’s Gaza Plan Needs Israel’s Neighbors To Buy It
• Gearoid Reidy: Is Japan Back? That’s the Wrong Question
• Lionel Laurent: Digital Dollar Dominance Is a Euro Call to Arms

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