If you want to understand the current price action in the markets you need to study Japan.
Everything that’s happening at the moment is a function of the huge monetary stimulus recently unleashed by the Bank of Japan (BOJ).
I’ve known it was important to understand, and I’ve followed proceedings closely. But it’s now becoming clear that most of the moves we’re seeing in markets world-wide can be explained by the enormous money printing by the BOJ.
Therefore, we can only decipher the road forward by analysing the Japanese currency and bond markets…
Imagine you’re a fund manager and the Bank of Japan and the Prime Minister of Japan tell you they have an explicit policy to print a huge amount of currency to incite inflation and lower the currency.
You borrow in that currency at incredibly low rates. You then invest offshore and receive much higher interest rates. You do this safe in the knowledge that the currency you’re borrowing in will most likely be weaker by the time you have to repay the loan.
That trade would have to be the ultimate ‘no brainer’. You can leverage that trade many times over. But this isn’t theory. This is reality. I can assure you this is what every man and his dog is doing at the moment.
Let me show you with an example. In the last few months Italian government bond yields have rallied from 5% yield to below 4% in yield:
Spanish yields have had a similar move. The carry trade out of Japan has been pinpointed as the main reason for the size of the rally. I see no reason to argue with that view.
This chart of the ASX 200 in relation to the carry trade currencies of the Euro/Yen and the Aussie/Yen is very compelling. I have shown it many times in the past so if you’re a regular reader you’ve seen it before.
When the only thing driving the market is currency movements due to central bank policy in another country, it makes a mockery of fundamental or even technical analysis.
So the first question we must ask is will the central bank of Japan continue on this path for the foreseeable future? If the answer is yes then you should expect the current trends to continue.
I found it interesting that the economy minister, Amari, came out during the week to say that he thought the Yen may be getting closer to the ‘right’ level. Of course a comment like that shows you they’re starting to get concerned that the moves in the Yen may get out of control.
I have a feeling that the future for the Japanese bond market and the Japanese currency is going to be a very volatile one.
Reverberations that Will Shake the World
Bond yields have risen in a disorderly fashion despite the huge amount of BOJ buying. Volatility circuit breakers have been hit on numerous occasions since the new policy was announced. Yields have spiked from a low of about 35bps to the current 90bps. That’s a more than doubling in yields in the last few months.
30% of tax revenues now go towards paying interest on Japan’s debt, which is approaching 240% of debt/GDP. If interest rates hit 2.8% then 100% of tax revenues will go towards paying interest on debt. In other words: lights out.
Of course we’re a long way from that scenario with yields still under 1%, but it will be very interesting watching how their bonds behave once they start heading above a 1% yield. When markets do turn they always move faster and go further than anyone predicts.
I was in the trading pits in Sydney when the US Federal Reserve did their surprise interest rate rise in February 1994. We all watched in horror for the rest of the year as bonds kept going down and down and down.
No one predicted the size of the fall in bonds that year and I saw many traders ‘killed’ trying to catch the falling knife.
When Japan’s bonds turn, a trickle will become a flood.
Japan’s bond market is the second biggest in the world, with about US$10 trillion outstanding. Italy is a very distant third with about US$2 trillion outstanding. If we get some serious convulsions in that market the reverberations will be felt all the way around the world.
If the pension funds and banks in Japan that own most of the debt start hitting the sell button en masse and allocate some of that money offshore we could be staring down the barrel of a potential currency crash.
What happens to markets in that scenario? Will bonds ex-Japan continue to rally massively due to the flood of money exiting Japan combined with the carry trades? And will that continue to levitate stocks for the foreseeable future? Who knows but I think we’ll find out within the next few years.
Is QE Working for Japan Domestically?
The lower Yen is supposed to feed into a better balance of trade for Japan but it looks like that isn’t happening. Preliminary figures from the Finance Ministry yesterday showed that Japan posted a deficit of US$8.6bn in its trade balance last month.
This is 70% wider than the previous months balance and ‘the most for the month of April since at least 1979‘ according to the Sydney Morning Herald.
The cost of importing energy, food and clothing is skyrocketing with the weak currency and exports aren’t increasing at the desired or expected pace.
So the standard of living of the Japanese is going down due to the increase in energy, food and clothing costs. The desired aim of the BOJ is to create 2% inflation within two years. Are the rising costs of necessities for the Japanese a cause for celebration? Will a rising electricity bill really inspire the Japanese to go out and spend? Or will it cause them to count their pennies?
This policy by the Bank of Japan will end up having some huge unintended consequences.
Everything seems to be working out well at the moment because the Yen going down is seen as a good thing. The rising stock market in Japan is seen as a good thing (even though a 60% rally in six months should be ringing alarm bells), the falling yields on bonds around the world are seen as a good thing.
So what could go wrong? Plenty.
Once the fall in the Yen starts accelerating and the powers that be in Japan start sticking their nose in trying to stem the fall we could see some incredibly volatile moves. When traders unwind carry trades it can cause huge volatility.
Everyone tries to get out of the door at the same time, and we all know how that ends. If the government tries to force the Yen higher from what they consider oversold levels they could inspire a sell-off in markets worldwide.
We haven’t reached that point yet. But the comments from Amari during the week show that the government is getting nervous.
And there is no guarantee that they can stem the fall in the Yen once it accelerates. A weaker Yen may be desirable, but a crashing Yen isn’t what they or the world will want to see.
Japan is at the forefront of the Keynesian dream, so it will be the first to unravel. Their policies are bringing forward the day of reckoning, but most are oblivious to the threat.
The underlying convulsions in JGB’s should be watched very closely going forward.
Murray Dawes
Editor, Slipstream Trader
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