Japan is an Engine of Economic Pain
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“For 20 long years of deflation, Japan suffered a deep loss
of confidence. It is now time to become an engine of economic
Those are the words of Shinzo Abe, the Prime Minister of Japan.
But Mr. Abe failed to heed the words of another prime minister,
Winston Churchill:
“There is no worse course in leadership than to hold out
false hopes soon to be swept away.”
Now Japan is an engine not of growth, but pain…
Mr. Abe promised to fix Japan’s problems, and fix them quickly,
through a shock and awe program of currency devaluation,
inflation creation, outright market intervention, and structural
Most of this was supposed to happen through the implementation of
super-QE (quantitative easing on steroids).
But now it has become apparent that 1) structural reform
was always going to be the hardest part, and 2)
all Mr. Abe may have succeeded in doing was to get a
bunch of money managers excited.
The Nikkei started rising late last year, when Mr. Abe started
talking about major change in his political platform. This
captured the imagination of Japan observers, who have long
envisioned a monetary policy blast-off that would unlock the
value of Japanese equities.
You can see this in the chart of DXJ, the main US vehicle for
non-specialists to play Japan:
, we can see
that Japanese volatility is at its highest since the Fukushima
We see a plausible multi-pronged explanation for what is going on
Buy the rumor, sell the news.
It was the
anticipation of major reform, on monetary and structural fronts,
that led to the big bull run in Japanese equities. “Buy the
rumor” kicked in as Abenomics went on tour. But once the easy
part was over — making fiat changes in central bank leadership
and policy — only the massively hard part was left. Hence, “sell
the news” of super-QE being carried out.
The JGB Sword of Damocles.
amassed gargantuan amounts of debt (in terms of debt to GDP).
This in turn has created massive service costs for that mountain
of debt. As it turns out, when the Prime Minister and Central
Bank Chief promise inflation “no matter what,” bonds respond by
selling off, thus threatening the recovery with spiking rates.
Who’da thunk it?
Carnage at the hedge fund
Lots of money managers (and not
just hedgies) piled into Japan in size, looking as hard as they
can for the closest thing to a new AAPL in this low yield, low
returns environment. Japan seemed to fit the bill perfectly, and
everyone got uber-long — just in time for the trap to spring
shut. Now you have the negative feedback loop possibility of
Japanese equity sell-offs fueling US equity sell-offs, and vice
versa, via the “portfolio contagion” paradigm of linked money
manager portfolios.
The brick wall of structural reform. As
mentioned, talking about policy was the easy part. Changing out
the head of the BOJ (Bank of Japan) was the easy part. Making
huge promises of hope and change (sound familiar) was the easy
part. Actually doing something about the deadly serious
structural issues keeping Japan in the muck? Brick wall. Good
luck breaking through.
Deja Vu All Over Again.
Via : “This time is different for Japan, right?
Well, maybe. Since the Nikkei stock market bubble burst
on New Year’s Day 1990 — at a level of almost 40,000 — we’ve see
rally attempts of 22%, 37%, 50%, 36%, 60%, 62%, 138% and most
recently, from November of last year until late May this year,
84%.” Investors have seen this movie before, and the ending has
always sucked.
All Aboard
the Pain Train
Japan’s plunge is spreading plenty of pain, as :
Hedge funds and other overseas buyers pumped more than $25
billion into Tokyo’s stock market in the seven months before the
Las Vegas conference, according to EPFR Global, which tracks such
flows. They were lured by a new government’s plans for radical
action to boost Japan’s economy after two decades of stagnant
growth and falling prices known as deflation.
The bet paid off big, at first: The benchmark Nikkei 225 index
soared 83% over the seven months to late May. Foreigners fell in
love again with a market they had long ago left for dead.
Then, the rally turned with a vengeance. The Nikkei sank 7.3% on
Thursday, May 23. It fell 3.2% the next Monday, 5.2% the
following Thursday and then 3.7% on Monday of this week. It has
fallen 15% in just eight trading days. Mr. Novogratz didn’t
return phone calls seeking to determine what he has done with his
investments.
Ordinarily, this kind of heart-thumping decline is spurred by a
crisis, such as Japan’s March 2011 earthquake. But this time, no
analysts had trouble explaining why stocks
were down.
Doh! But it is not just caught-out money managers feeling the
pain. “Abenomics” is also inherently deflationary — and
potentially painful — for the rest of the world…
Consider the following:
Abe wants Japan to become an “engine of economic
But a large part of the plan to make this happen is devaluing
the currency… bringing about a weaker Japanese yen.
A weaker Japanese yen means more competitive Japanese
exports… which means lower profits and wages for major export
competitors. This is partly why Ford
— it could no longer compete with Japanese
imports (which are at a record) into the Australian
South Korea will have no choice but to match, or at least
mitigate, Japan’s yen devaluation efforts to keep its own export
flow competitive. Germany, the world’s second largest exporter,
is under the same pressure. Not only will currencies get devalued
(the old arms race), profit margins will be squeezed. Wages will
be frozen or cut.
And thus, via the land of the rising sun, deflation is exported…
The Horror, The Horror (of Rising JGB Yields)
Another serious problem Japan faces is the threat of rising
Japanese Government Bond yields.
As JGBs sell off, interest rates go up.
If rates rise too much, Japan’s economic recovery is crushed.
If rates rise high enough, Japan can no longer make debt
service payments.
Some observers, like Kyle Bass, see the JGB markets as primed for
a spectacular crash. But JGBs do not have to “crash”
to block Japan’s recovery. They simply have to act as a
frustration ceiling…
Can the Bank of Japan support the JGB market in a pinch? Yes,
most likely.
As with the United States Federal Reserve, the BOJ is
“unconstrained.” It can buy unlimited quantities of bonds with
printed yen… and Abenomics already has a vested interest in
seeing the yen fall (which, as we described above, increases
Japanese competitiveness by exporting deflation to the rest of
the world).
But the ability to buy JGBs will not keep rates from occasionally
spiking. It is only a last-ditch means of heading off
catastrophe.
And so, in result, you potentially get a really nasty feedback
JGBs sell off as economic optimism improves.
This is a function of capital rotating out of JGBs / back
into the economy.
Yields spike on the sell-off.
Everyone gets freaked out by the spiking yields.
Rising rates put a damper on the recovery.
The BOJ intervenes to support the JGB market.
Wash, rinse, repeat.
Every time the recovery approaches critical mass,
yields spike.
JGBs thus act as an impenetrable “frustration
ceiling.”
The full-blown recovery doesn’t happen.
No Easy, Just Hard
The following also helps the UST case — :
Some of the world’s biggest quant hedge funds have suffered steep
losses in the past two weeks following the sell-off in global
bond markets.
So-called “CTAs”, which use computer models to automatically spot
and ride market trends, were caught out as investors anticipated
an end to the Federal Reserve’s measures to stimulate the US
economy, triggering a global rout in fixed income investments.
Bond yields have risen sharply from some of their lowest levels
in decades in the past fortnight, leaving funds with large
holdings badly hit. Many quant funds have been major buyers of
bonds over the past few years as their algorithms have followed
yields lower.
“Since mid-May it has been a perfect storm of some of the biggest
trends in markets reversing all at once,” said a senior manager
at one large quant fund. “It has been particularly brutal.”
AHL, the $16.4bn flagship fund of Man Group, the world’s
second-largest hedge fund by assets, lost more than 11 per cent
of its net asset value in the past two weeks alone as a result of
its huge bond holdings, according to an investor…
Why is the above bullish, not bearish, for USTs? A couple
First, the selloff in USTs was predicated on the idea that things
were going well — they aren’t — and that the Fed would soon begin
“tapering” aggressively — they may well not. It was a massive
juke… a headfake / wrong-direction.
Second, the serious pain inflicted on various bondholders means
that the “weak hands,” along with some not-so-weak hands, have
experienced a major bloodletting. US Treasurys have experienced a
major “wash and rinse” in their violent move to the downside,
which have again made them a value proposition.
And last but not least, USTs may be “cheap” again — good value —
relative to their medium term prospects after their sell-off, and
as “risk on” evaporates in the wake of Abenomics disappointment.
On the relative cheapness of treasurys — in the context of
this particular environment, not historically —
consider the following (via AGF Investments):
…A third major crisis took place in the United States in the
1870s. In both prior American instances, long-term bond yields
persisted in a sub-3% range for approximately 20 to 30 years, far
more than the four years we have experienced so far, or the seven
years that the consensus is expecting. In fact, these are the
only periods in the last 200 years during which yields have been
below 3%, so the yields we are experiencing are indicative of an
abnormal period of prolonged disinflationary economic activity
following a financial crisis.
If you want to see how we’re playing all this in real time, by
the way, hop on the
streams of yours truly… or better yet,
check out the .
Domo Arigato Mr. Roboto,
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