THE NEXT JAPAN TRADE
2017-02-07 6pm EDT | #Japan #JGB #JOF #TOPIX
Last week I received a lot of feedback regarding the potential rolling over of the Japanese bond market. Although readers were kind, the overwhelming consensus was that instead of the JGB market declining, the Japanese government would allow the currency to take the adjustment.
It was interesting to observe the uniformity of this belief. Although most were willing to accept the inevitability of Japan’s financial problems, there appears a consensus Japan will not even attempt to normalize rates. Instead Japan will leave their yield curve (all the way out to 10 years) pinned to zero while their currency collapses in an inflationary death spiral.
Yeah, I get it. There does not seem to be a ton of room in Japan’s budget for higher borrowing costs. It doesn’t take much of a rate increase for Japan to reach a point where their entire budget would go to servicing their debt. It is tempting to assume that given the lopsided over-indebted government balance sheet, the end game is for the currency to be inflated away with a massive currency collapse.
Yet I wonder if too many investors are mixing time frames. I have no doubt the monstrous Japanese government debt will be paid back with deeply inflated currency, but why does that need to happen anytime soon? Investors were busy predicting Japan’s demise when its debt to GDP ratio hit 100%. When that didn’t usher in the next great collapse, investors said surely 150% would be the end for Japan. Then 175%, 200%, and so on… Each time was going to finally be “the trigger” that pushed Japan over the edge into the hyper-inflationary death loop.
The recent breach by the Japanese 10 year government bond rate of the 0.10% upper ceiling might seem ominous, but it really should have been expected. In fact, it should be welcomed. Sometimes yields increase because creditors are worried about the return of their capital. Other times yields increase because there is a demand for credit.
What if this isn’t the start of the secular collapse of Japan, but merely a cyclical upturn in their economic cycle? Japan has been mired in such stagnation for so long most market participants no longer believe Japan has an economic cycle. But I am not nearly as pessimistic. I suspect yields are increasing in Japan for the right reasons.
I know it is fashionable to shit all over Abeconomics as a failed plan by an aging leader who doesn’t understand the dire economic situation of his country. Yet I am not quite so negative.
I don’t want to bother contemplating the Japanese end game. It probably ends in a hyper-inflationary melt up. But who cares? Chances are that is years, and maybe even decades away. As traders we need to focus on the fact there will be a bunch of tradeable moves before that happens.
And this is what I want to focus on.
Market participants are convinced that as credit is created, the BoJ will leave rates pinned to zero, more yen will be created, the value of the Yen will plummet, creating inflationary pressures which will only encourage more borrowing in Yen, repeating the cycle until the whole thing collapses in on itself.
But why does it have to be so “all or nothing?”
What about a good ‘ole fashion cyclical economic uptick?
I understand the reasons for the cynicism. Heck even the Japanese people themselves have given up believing.
And it’s easy to see why. For the last two decades Japan has been mired in a slow growth malaise.
But what if Japan pinned their 10 year rate at 0% in panic lows and will now simply walk it back up as credit is demanded?
After all, inflationary pressures are building. Have a look at this chart from BCA Research about the state of the Japanese workforce.
Throw enough money at it, and eventually you create inflation.
The amount of quantitative easing by the Bank of Japan is in a class of its own.
At some point this insane monetary bbq will light, and when that happens, the inflationary fires will explode.
And this is why everyone thinks you should be short Yen. The supply of Yen will skyrocket.
Yet we have already witnessed Trump’s wrath on Mexico, China and Germany for having an undervalued currency. If the Yen starts to decline significantly, how long before Trump’s ire will focus on a new target? After all Trump has a history of going after Japan.
In the wake of Trump’s victory, the BoJ made one final attempt to push down the value of the Yen. I believe this was because they realized from then on, the door for currency devaluation would be closing.
I suspect the days of the Bank of Japan actively rooting for a lower Yen are behind us.
In fact, if the Japanese economy actually restarts, I could easily envision a situation where the Bank of Japan slowly follows market rates higher, and the Yen stops being a funding currency. I know that sounds crazy, but I think many market participants are missing how cheap Japan is.
2016 was a tough year for Kuroda. First he goofed by following the ECB with negative rates. Then, as long term yields plummeted, he panicked and pegged the 10 year at 0%. This did not inspire confidence. At first, instead of being viewed as inflationary, these measures only discouraged risk taking.
Kuroda’s moves were amateur hour. Both of these policy changes were not needed, and did more to halt any economic rebound than help.
But markets adapt.
And so today we have the most stimulative Central Bank on the planet printing Yen like it is going out of style, while their long term 10 year rate is pegged to 0%.
Maybe these policies will cause a Yen crisis. There are certainly a lot of people much smarter than me forecasting a monster Yen decline. Yet I can’t help but wonder if the Yen decline was Japan’s previous story.
Maybe Japan’s next story is an actual economic revival. I know, I know… Demographics, lack of immigration, yada yada yada. I know all the reasons why Japan is doomed. Yet so does everyone else…
Stocks in Japan have been in a two decade relative bear market. Everyone complains there are no more cheap assets out there, but what about Japan?
Japanese equities are dirt cheap. And especially so when you venture away from the large cap stocks the BoJ is buying with their expanded QE program.
The Japanese private sector has not levered up anywhere near to the same degree as America or Europe. There is plenty of room for Japanese companies to issue debt and buy back their cheap equity.
Or heaven forbid - actually invest in the economy.
I am short JGBs (against long US treasuries), but I think an even better trade might be to go long Japanese stocks. Instead of buying the large cap, I am venturing towards the cheaper smaller caps. These things have long been forgotten.
For some accounts I am buying closed end funds like JOF. This fund specializes in small cap Japanese equities and trades at a discount to NAV.
For other accounts, I am going long TOPIX futures (which is more broad based than the more popular Nikkei index) and shorting Russell 2000 futures.
Maybe I shouldn’t be so cute. Maybe I should just short Yen futures like everyone else. But over the years I have learned the Market Gods often find ways to make sure the consensus trade doesn’t work, and it’s the trade no one is looking at that ends up being best. Short JGBs and long TOPIX (both on a spread basis versus American counterparts) fits that bill perfectly…
Thanks for reading,