“Japan Government Bonds Rise as Market Shrugs Off Downgrade,” the Wall Street Journal headline said with some astonishment after Moody’s had dared to downgrade Japan’s credit rating to A1 – fifth notch from the top. But there was a big assumption in the headline: that there’s still a market for Japanese Government Bonds.
The last time Moody’s had downgraded Japan was in August, 2011. At the time, JGBs yielded 1.02%; the market was, as the media put it with its usual astonishment, “unfazed” by the downgrade. Since then, every metric of the country’s fiscal health has sharply deteriorated, leading to an ever larger mountain of government debt. Yet the government’s cost of borrowing has dropped to near zero.
This time, Moody’s reasons for the downgrade include the “heightened uncertainty over the achievability of fiscal deficit reduction goals,” along with the swoon of the economy, which raises doubts about the “timing and effectiveness of growth enhancing policy measures.”
Presumably, when sovereign bonds get downgraded, their value should fall and their yields should rise as investors suddenly see the additional risks and the overall crappiness of the paper.
Yet the opposite happened. JGBs rose and yields edged down. The 10-year yield wobbled to a ludicrously low 0.41% by Wednesday before edging up again to 0.43% on Thursday. The five-year yield hit a new all-time low of 0.07% by Wednesday before ticking up to 0.08% on Thursday. At these rates, the government can borrow for essentially free. And if inflation is considered – 2.9% overall and 4% on goods – it’s actually making money by borrowing money.
But why the heck would market participants accept a guaranteed loss after inflation on these risky bonds?
Japan’s love affair with free markets has been brief and largely cosmetic. While the country has opened up quite a bit over the last two decades, it remains hermetically sealed off to imports of various kinds, including from US automakers, in order to protect Japanese companies, farmers, etc. As a society, the Japanese treasure their insularity and the protection they feel it gives them. Free markets are fine and dandy, as long as they fit into the Japanese scenario.
But what if the scenario is centered on funding in the cheapest way possible for as long as possible a system that is totally addicted to corporate and social welfare, subsidies, and bailouts that no one ever wants to pay for?
A free market would rebel. Market participants would want to be paid double-digit junk-bond yields to take on the risks and fund that system, with the possibility of a debt crisis and default hovering over their heads on a daily basis. Those free-market costs of funding would have driven Japan long ago either to mend its ways or to slither into a debt crisis, followed by financial collapse and chaos.
Every government in the world knows this: The debt of over-indebted governments cannot be left to the free markets. Yields must be manipulated down by all means. Central banks impose their zero-interest-rate policy often combined with outright market manipulation, such as purchases of government debt and other assets, and constant jawboning.
Japan is no different. Just more extreme.
Since early 2013, the Bank of Japan has been telling banks to dump their JGBs, and banks have done that. The BOJ has told the Government Pension Investment Fund (GPIF) to slash its vast holdings of JGBs, and a month ago, the GPIF confirmed that it would do just that. A central bank telling the largest institutional investors of the country to dump their government bonds would normally have triggered a mega-crash with yields spiking into the stratosphere.
Not in Japan: because the BOJ promised to buy them all under the pretext of wanting to stimulate inflation, though there is already plenty of inflation in the system – just ask the average Japanese household whose real income has been shrinking at a dizzying speed. The BOJ has become the relentless bid in the market. And it recently redoubled its efforts [read… Bank of Japandemonium Resorts to “Monetary Shamanism,” and all Heck Breaks Loose].
Its relentless bid has driven yields to near zero, now increasingly for longer-dated maturities as well. In this process, the Bank of Japandemonium, as I’ve come to call it, has tightened its iron grip on the government bond market to where the market ran out of air and died.
Takeshi Fujimaki, an opposition lawmaker, explained the phenomenon this way:
The BOJ used consumer prices as an excuse to add stimulus and continues to hide that it’s monetizing government debt. But the truth is that Japan will default unless the BOJ continues to buy JGBs even after inflation accelerates beyond its intended target.
Alas, to monetize ever larger portions of government debt, the BOJ is selling freshly printed yen into a market it can manipulate but not control: the global currency market. Once big players around the world start dumping the yen, and once scared Japanese folks start dumping their yen too, the yen might do what the ruble is doing now: spiraling down uncontrollably.
When Abenomics became a noun in late 2012, it took ¥75 to buy $1. Today it takes ¥121. With the effect that 37% of Japan’s yen-denominated wealth has gone up in smoke.
But once the BOJ decides that the yen has fallen enough, it might not be able to stop its fall. It would have to sell its international reserves and buy yen – the opposite of QE. If it decided to buy yen to prop up the currency, instead of printing yen, it would thereby surrender control over the government bond market. The relentless bid would disappear even as the flood of new JGBs would continue. There would be no other buyers, not with yields at near zero. Chaos would break out instantly.
The BOJ might try for a minute or two, and it might try to talk up the yen, but it can’t actually prop up the yen with yen purchases without causing JGBs to spiral out of control, which it would never allow to happen. It would never allow a debt crisis to throw Japan into chaos. Instead, it will continue to guarantee the nominal value of the debt by buying up every JGB that comes on the market, while keeping yields at near zero. And to heck with the yen.
Fujimaki sees ¥200 to the dollar.
It would eradicate much of the wealth of Japanese society. It would cause hardship and misery. People would be paying the price for decades of government profligacy and free lunches. But there would be no chaos and no debt crisis.
And those who’re short JGBs will continue to lose money. The BOJ has no compunction about torturing JGB shorts. Some day it may well be the only entity left from which shorts will have to buy back their JGBs to unwind their positions, at a hefty loss. That said, for traders whose Monopoly money is something other than the yen, a JGB short position also means shorting the yen. And that second part of the trade has a good chance of working.
But for the Japanese, it turns out that destroying the purchasing power and wealth of the people also drags down the real economy. Read… Media “Shocked” by Japan’s GDP Fiasco?
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I think you have this exactly right except for the denouement. At USD/JPY 250 (or maybe it’s 400, I don’t know) the BOJ will HAVE to stop printing and simply haircut the debt overnight. My guess is that the haircut is 40% because being the cautious bureaucrats that they are they won’t do the 75% they NEED to do.
That’s why for a patient, lightly leveraged investor a 10-year JGB short @ 43 bp is the most asymmetrical trade in the world right now. For instance, a drop in yield to 30bp only increases the bond price by around 1%.
And in MarketWatch there’s an article under the headline “Japan’s Abe set for landslide victory, polls suggest”.
Yep, it al makes perfect sense. Don’t the Japanese understand that you’re at least supposed to vote against those who actively strive to take down your national currency and with it, a substantial part of the post war wealth the people have worked so hard to accumulate?
I get that the Japanese are a special breed, remaining stoic in the face of adversity and all that, but this is getting downright ridiculous. Can we please have some outrage over there?
Wolf, you make it sound like the situation in Japan is worse than in the U.S. But how is it any different in this country, other than that we allow other countries to dump goods here?
Why do you say 37% of Japan’s wealth has gone up in smoke just because the yen had declined that much vs. the dollar? What has the yen done vs. the yuan? Were you aware that the dollar is down 2% vs. the yuan this year?
What has the yen vs. the euro or the loonie or the pound?
Can you perhaps quantify in $ terms how much Government debt Japan has purchased vs. how much debt the U.S. has purchased?
Finally, how is the U.S. economy any more open to free markets than is Japan?
Dave, some of your questions are answered in my prior articles, including the two I linked.
Didn’t the Yen reach 75 because of Fukushima? So they got richer? I think a more appropriate benchmark is probably 84 which is the Yen before the event.
There were articles online about the Japanese hiding behind a strong Yen to make the size of their economy bigger in terms of US Dollars. Such articles aside which is hard to prove/disprove, it’s hard to say that the Yen wasn’t overvalued.
While we lived in Japan (until early 2006), the exchange rate was between ¥120 and ¥130 to the USD, and the BOJ was trying to prop up the yen, both by talking it up and by buying it. If I remember right, this lasted until maybe early 2007, before the yen started rising on its own. So yes, Japan has been there before. But last time, it COULD buy yen without blowing up their government bond market. This time, the BOJ can’t. It’ll have to continue to SELL yen to keep JGBs from blowing up, which will further exacerbate the yen’s decline. When that spiral starts, it can get very ugly quickly.
Russia can and does prop up the ruble – even so, look how it has plunged in 6 months. Now imagine what would happen if Russia were forced to sell rubles into this swoon. But that’s what the BOJ will have to do to keep its bond market under control.
Wolf, I am sure you’ll be right in the end, and to be honest my actions actually reflect your thoughts. For example, I am long a bunch of out of the money puts on FXY. I am also short the JGB ETF, although I think that may be a loser i.e. the Yen could crater, but no way they would allow interest rate to rise.
BUT, I also have not forgotten that a lot of macro traders have been carted off while screwing around with Japan.
Totally agree with your last line, NotSoSure. I learned one rule: Don’t ever end up on the other side of the BOJ when it comes to bonds. Bonds are sacred to the Japanese. It’s THEIR wealth. Hardly anyone else owns them.
If I understand your article correctly it sounds like the Japanese are exporting their debt and advising their internal investors to avoid their own government bonds like the Plague so as not to be holding the bag. Let the Gai Jin take the losses. How Machiavellian. But the end result will be the same when their marks can’t afford their Toyotas etc. Am I missing something?
Hi, i’m currently trying to understand some basic economics and i’ve found your article about JGB market very interesting.
I would like if you don’t mind to ask some simple questions.
«Alas, to monetize ever larger portions of government debt, the BOJ is selling freshly printed yen into a market it can manipulate but not control: the global currency market.»
Why BOJ need to sell yen? Can’t they just buy JGB and wait :-) (and cancel the debt in the far futur when Japan can’t repay it) ?
Do they have some sort of balance sheet they need to “balance” by “exporting” the newly created yen? Then could they manipulate the numbers pretending there were buyers somewhere?
Pardon me if my questions sound stupid but I want to clarify those issues.
words escape me to comment on global economy. My new investment strategery is the buyback index and non gaap accounting index.
Dave and Wolf: I think we need to look at proportionate size of QE for Japan and I think theirs is 3x what ours was. Hence, proportionate size matters.
I keep seeing early 1920’s Germany in my mind. How often do we see the 3rd largest economy collapsing before our eyes. And with little fanfare or recognition beyond the folks like us.
And then the EU lining up, as well as UK and US. Buehler, anybody, tell me how we extricate ourselves from this without pain.
In 1971 the exchange rate of the yen to the US dollar was around 330 yen to $1. The sooner the yen gets back to that exchange rate – where it should have stayed all along – the better.