As Black Swans loom, can Japan’s bonds defy doom?

TOKYO – Bank of Japan Governor Haruhiko Kuroda isn’t known for his juggling or acrobatic skills. Yet keeping Asia’s No. 2 economy aloft is requiring Cirque du Soleil-caliber balancing acts. As the yen plunges to 24-year lows, Kuroda finds his contortion abilities being put to the test as never before. It’s near impossible to hold government bond yields at 0.25% amid a free-falling exchange rate at a moment when the inflation rate is surging at its fastest pace in 40 years. This stunt becomes harder and harder to pull off as worries about the health of Japan’s bond market grab the spotlight — again. This risk isn’t building in a vacuum. The Italian government’s latest bout of debt trouble is quickly spilling over into domestic banks. In the decade since Italy shook markets in the early 2010s, lenders worked to reduce holdings of state-issued bonds, cut bad loans and built stronger capital buffers. The highest 10-year Italian sovereign bond yields since 2013 are the last thing markets from New York to Tokyo need. To be sure, the global investing game knows few more obvious widow-maker trades than betting on a Japanese government bond market crash. The list of well-known hedge fund managers who made that bet — and failed — over the last decade includes Kyle Bass of Hayman Capital Management. So a Japanse Government Bond, or JGB, implosion is not a dead cert. But Deutsche Bank economist George Saravelos makes a valid point that the math — and the demographics — are not on Tokyo’s side. “If it becomes obvious to the market that the clearing level of JGB yields is above the BOJ’s 25 basis-point target, what is the incentive to hold bonds anymore?” he asks. The Japanese yen’ is plummeting in value. Photo: AFP / Xie Zhengyi / Imaginechina The BOJ’s wobbly posture The problem is that, for 23 years now, the BOJ has been building arguably the globe’s biggest pyramid scheme. And like all schemes based on top-level members recruiting newer ones who prop things up with new capital, the BOJ is having a very hard time keeping things going. Hence the BOJ’s decision Friday to do nothing disappointed world markets that had been hoping Kuroda’s team would preview a new act to maintain calm in yen and JGB trading. The BOJ, it seems, is petrified of making a false step. The fallout from Japanese bonds crashing would destabilize assets everywhere. The yen is a top-three currency – one of speculators’ favorite sources of funding – and it underpins the developed nation with the world’s biggest debt burden. Japan’s risk, of course, has been a long time coming. The BOJ first cut official interest rates to zero in 1999. In 2000 and 2001, Tokyo pioneered quantitative easing. By 2013, when Kuroda took the controls, the BOJ was pushing its liquidity schemes into entirely new stratospheres. Operating in this new atmosphere is growing harder by the day. Over the last nine years, Kuroda swelled the BOJ’s balance sheet to the point where it topped the size of Japan’s entire annual output — a first for a Group of Seven economy. After cornering the bond market, becoming the top holder of Japanese stocks and hoarding assets across sectors, the BOJ is essentially trapped. If it stops adding to its $10 trillion-plus of monetary firepower, Japan’s newest export could be financial contagion. Under attack from all sides The yen’s plunge is now putting Kuroda’s team on the spot, as it scrambles to stay ahead of the short sellers with increased asset purchases. At the current pace, the BOJ will end up buying about 10 trillion yen, or $75 billion, this month. In a report titled “The printer is on overdrive,” FX Strategist Saravelos wrote: “To put that number in context, it is roughly equivalent to the Fed doing more than $300 billion of QE per month when adjusting for GDP!” And its easier said than done, logistically speaking. Already, the BOJ holds well over half of outstanding JGBs. This outsized role by the central bank warped typical bond-market dynamics, making yield spreads between assets almost useless as barometers of risk. In recent years, there have been countless days when not a single JGB has traded. All this liquidity, coupled with the Federal Reserve’s tightening moves, is virtually ensuring the yen’s trajectory toward 150 to the dollar, or even further. Overseas investors are, broadly speaking, dumping yen assets. That’s especially so for futures and derivatives. So intense are the outflows that the BOJ upped efforts to keep a 0.25% cap on 10-year government bond yields. If private capital won’t keep this pyramid scheme going, it falls to the BOJ. Along with further distorting yield dynamics, the effort is adding downward pressure on the yen exchange rate. That’s making Japan vulnerable to imported inflation, risking damage to business and household confidence. Because traders know the BOJ can’t readily hike interest rates along with the Fed, speculative attacks

As Black Swans loom, can Japan’s bonds defy doom?

TOKYO – Bank of Japan Governor Haruhiko Kuroda isn’t known for his juggling or acrobatic skills. Yet keeping Asia’s No. 2 economy aloft is requiring Cirque du Soleil-caliber balancing acts.

As the yen plunges to 24-year lows, Kuroda finds his contortion abilities being put to the test as never before. It’s near impossible to hold government bond yields at 0.25% amid a free-falling exchange rate at a moment when the inflation rate is surging at its fastest pace in 40 years.

This stunt becomes harder and harder to pull off as worries about the health of Japan’s bond market grab the spotlight — again.

This risk isn’t building in a vacuum.

The Italian government’s latest bout of debt trouble is quickly spilling over into domestic banks. In the decade since Italy shook markets in the early 2010s, lenders worked to reduce holdings of state-issued bonds, cut bad loans and built stronger capital buffers.

The highest 10-year Italian sovereign bond yields since 2013 are the last thing markets from New York to Tokyo need.

To be sure, the global investing game knows few more obvious widow-maker trades than betting on a Japanese government bond market crash. The list of well-known hedge fund managers who made that bet — and failed — over the last decade includes Kyle Bass of Hayman Capital Management.

So a Japanse Government Bond, or JGB, implosion is not a dead cert. But Deutsche Bank economist George Saravelos makes a valid point that the math — and the demographics — are not on Tokyo’s side.

“If it becomes obvious to the market that the clearing level of JGB yields is above the BOJ’s 25 basis-point target, what is the incentive to hold bonds anymore?” he asks.

The Japanese yen’ is plummeting in value. Photo: AFP / Xie Zhengyi / Imaginechina

The BOJ’s wobbly posture

The problem is that, for 23 years now, the BOJ has been building arguably the globe’s biggest pyramid scheme. And like all schemes based on top-level members recruiting newer ones who prop things up with new capital, the BOJ is having a very hard time keeping things going.

Hence the BOJ’s decision Friday to do nothing disappointed world markets that had been hoping Kuroda’s team would preview a new act to maintain calm in yen and JGB trading.

The BOJ, it seems, is petrified of making a false step. The fallout from Japanese bonds crashing would destabilize assets everywhere. The yen is a top-three currency – one of speculators’ favorite sources of funding – and it underpins the developed nation with the world’s biggest debt burden.

Japan’s risk, of course, has been a long time coming. The BOJ first cut official interest rates to zero in 1999. In 2000 and 2001, Tokyo pioneered quantitative easing. By 2013, when Kuroda took the controls, the BOJ was pushing its liquidity schemes into entirely new stratospheres.

Operating in this new atmosphere is growing harder by the day. Over the last nine years, Kuroda swelled the BOJ’s balance sheet to the point where it topped the size of Japan’s entire annual output — a first for a Group of Seven economy.

After cornering the bond market, becoming the top holder of Japanese stocks and hoarding assets across sectors, the BOJ is essentially trapped. If it stops adding to its $10 trillion-plus of monetary firepower, Japan’s newest export could be financial contagion.

Under attack from all sides

The yen’s plunge is now putting Kuroda’s team on the spot, as it scrambles to stay ahead of the short sellers with increased asset purchases. At the current pace, the BOJ will end up buying about 10 trillion yen, or $75 billion, this month.

In a report titled “The printer is on overdrive,” FX Strategist Saravelos wrote: “To put that number in context, it is roughly equivalent to the Fed doing more than $300 billion of QE per month when adjusting for GDP!”

And its easier said than done, logistically speaking. Already, the BOJ holds well over half of outstanding JGBs. This outsized role by the central bank warped typical bond-market dynamics, making yield spreads between assets almost useless as barometers of risk. In recent years, there have been countless days when not a single JGB has traded.

All this liquidity, coupled with the Federal Reserve’s tightening moves, is virtually ensuring the yen’s trajectory toward 150 to the dollar, or even further.

Overseas investors are, broadly speaking, dumping yen assets. That’s especially so for futures and derivatives. So intense are the outflows that the BOJ upped efforts to keep a 0.25% cap on 10-year government bond yields. If private capital won’t keep this pyramid scheme going, it falls to the BOJ.

Along with further distorting yield dynamics, the effort is adding downward pressure on the yen exchange rate. That’s making Japan vulnerable to imported inflation, risking damage to business and household confidence.

Because traders know the BOJ can’t readily hike interest rates along with the Fed, speculative attacks are sure to continue. The months ahead could prove rather chaotic for a market that operates by its own rules.

Historically, about 90% of JGBs have been held domestically. This essentially rids Japan of the capital flight risk that toppled East Asian markets amid the region’s 1997-1997 financial crisis.

Yet Japan might now have a domestic confidence catastrophe on its hands.

JGBs are both the lifeblood of Japan Inc. and the oxygen that’s allowed the world’s No. 3 economy to avoid big reforms. It’s the linchpin asset held by banks, companies, local governments, pension and insurance funds, endowments, universities, the massive postal system and the growing ranks of retirees.

This has long perpetuated a mutually-assured-destruction dynamic. If yields surge, essentially everybody would be in harm’s way. The catch, though, is that some of these major JGBs holders might decide to use their first-mover advantage to reduce their liabilities.

That could be akin to pulling at a pivotal Jenga piece from the bottom of the tower. The risks involved would force Kuroda to come up with new stunts on the fly to avoid disaster.

Beset by financial risk on all fronts, how long can Japan Inc keep the bright lights on? Photo: WikiCommons

Short-term risks add to long-term problems

Yet much of the financial tension that Kuroda is trying to tame is the result of complacency at the highest levels of government. The reason the BOJ resorted to zero was a failure by a succession of governments to internationalize the economy or address banks’ bad loans from the 1980s.

That left it to late-1990s-early-2000s BOJ Governor Masaru Hayami to adopt QE. That extreme step was meant to be temporary — a kind of intensive-care stay for what was then Asia’s top economic power.

Japan is on its 12th prime minister since 1999 and the current one, Fumio Kishida, is also doubling down on the BOJ’s role to paper over cracks in Japan’s economic system.

One of the most worrisome is a widening divergence between Tokyo’s crushing debt load and a rapidly shrinking population.

In the fiscal year ended in March, Japan’s long-term debt topped 1 quadrillion yen, or US$7.6 trillion, for the first time. That dramatized the industrial world’s heaviest public debt, making the 18th consecutive annual increase in outstanding long-term IOUs.

In recent years, Kishida’s Liberal Democratic Party routinely made a pledge for the national budget to be balanced by 2025. This week, Kishida’s government dropped that language from its economic policy plans.

The timing collides with news that Japan’s population saw its biggest-ever drop in 2021, falling by 644,000 to just over 125.5 million. It was the 11th consecutive year of decline and the biggest since credible data started being kept in 1950.

Japan’s fertility rate is also chronically below the 2.1 “replacement rate.”

Tesla billionaire Elon Musk drew attention to this disconnect in a recent tweet, stating: “At the risk of stating the obvious, unless something changes to cause the birth rate to exceed the death rate, Japan will eventually cease to exist.”

Hyperbole aside, top Asia investors have made a similar point over the years. Jim Rogers, chairman of Beeland Interests Inc., has long avoided Japanese government bonds on demographic grounds. As he often remarks: “There will be no Japanese. Who will pay the enormous debt?”

The BOJ has sought to paper over this debt/demographics timebomb with arguably the globe’s biggest experiment in so-called “Modern Monetary Theory” to date. This is the idea that nations with sovereign currencies and monetary policies are not constrained by revenues when it comes to spending, as they can print as much money as needed.

But even amidst MMT, “there is no such thing as a free lunch, and in Japan’s case, it is future generations who will be left with the bill,” says Takatoshi Ito, a former Japanese deputy vice minister of finance who’s now at Columbia University. One such bill could be rising JGB rates.

Economist Randall Wray at the Levy Institute argues that the BOJ’s policies are not as straightforward as MMT boosters like to think. In many ways, Wray says, “the Japanese approach to policy has been the antithesis of MMT. Instead of a strong fiscal boost, which could have gotten its economy out of the recession that followed the 1980s speculative boom, Japan has implemented small and inconsistent fiscal measures, reversing course more than once.”

This, Wray, says, “has led to higher deficits and debt due to automatic stabilizers while growth has stalled. Instead of learning from this experience, Japan has moved further away from MMT’s prescriptions by relying on unconventional monetary policy measures, such as QE, which have been largely ineffective in boosting growth or reflating the economy.”

MMT has many potential side effects, including massive overheating. “This policy combination has a strong potential of besieging an economy with hyperinflation,” warns economist Ahn Dong-hyun at Seoul National University.

Japan isn’t suffering hyperinflation. In April, consumer prices rose 2.2%, the highest in seven years. Yet the sudden surge in chatter about trouble in the JGBs market is an ominous sign.

It’s one that investors would be wise to take seriously as Kuroda’s balancing act gets old – and Black Swan talk reaches bigger audiences.

Follow this writer on Twitter @William.Pesek