Conclusion: Ichiro Ozawa’s exoneration affords him an opportunity to derail fiscal consolidation efforts in Japan – a key risk as relates to potential sovereign downgrades and a subsequent increase in bank capital requirements.
“OZAWA RISK” IS REAL
The title of this note is intended to be a pun on the name “Ichiro” – a name made popular in America by eventual hall-of-famer Ichiro Suzuki, who has manned the right field for my hometown Seattle Mariners for the past 11yrs. Unfortunately for Ichiro’s home country, Japan’s precarious fiscal and monetary policy situation have not and will not be relieved any time soon.
Taking a short-to-intermediate-term perspective, today’s exoneration of the other famous Ichiro in Japan (Ozawa) may move the country one step closer to the key intermediate-term catalyst in our Japan’s Debt, Deficit and Demographic Reckoning thesis: a sovereign downgrade to the single-A level and a subsequent increase bank capital requirements.
As mentioned in our 100-page slide deck, Japan’s VAT remains the key area of focus in the near term by the major international ratings agencies. To the extent the VAT isn’t passed/ Japan succumbs to further partisan gridlock and continues favoring short-term politics at the expense of the long-term health of the country, we would expect to see two or more of the agencies downgrade Japanese sovereign debt at some point over the NTM (though pinpointing timing can be difficult). The current session of the Diet ends in JUN, meaning that Japanese bureaucrats have until then to at least send a signal to the ratings agencies that they are indeed committed to fiscal retrenchment.
As it stands now, Ozawa, who remains one of the most influential members of the ruling Democratic Party of Japan (w/ influence over up to a third of the party by some estimates), opposes the DPJ’s VAT hike bill. His exoneration means he is now free to stir the pot and rally support to defeat the bill from within. Further, his platform centers on expansionary fiscal policy, which, in addition to wanting a shot at regaining full control of the Diet via a snap election, is preventing the LDP from coming to the table to negotiate with the DPJ on its VAT hike proposal.
A successful bid to slow discussions is a risk to the JGB market; during his 2010 attempt to overthrow then-PM Naoto Kan 10yr yields jumped +28bps over brief span of eight days, as market participants feared a long-term acceleration in supply. Needless to say, there’s a lot more at stake this time around. Keep “Ozawa risk” on your radar as it relates to Japan’s probability of being the next domino to fall in our Sovereign Debt Dichotomy theme, as it is unclear to us how much more patience the ratings agencies will have regarding Japan’s woeful fiscal outlook.
As always, we stand ready to answer any questions regarding our thesis; in the event you may have missed them come through, the relevant follow-up analyses are hyperlinked below:
- MAR 2: Japan’s Debt, Deficit and Demographic Reckoning
- MAR 6: Shorting the Pusuit of Inflation – FXY Trade Update
- APR 3: Digging Deeper Into Japanese Sovereign Debt Risk
- APR 11: Will Pressure bust Pipes in Japan?
MARKET RISK UPDATE
As we concluded in our APR 11 note titled “Will Pressure Bust Pipes in Japan”, risk in the JGB marketplace has been receding fairly dramatically in recent weeks – consistent with our view that you’re unlikely to see any material moves in this historically-bulletproof market in the absence of the catalysts above.
While the Nikkei 225 Index is now broken from an immediate-term TRADE duration, the data would suggest that’s not necessary on the strength of JGB risk, but rather recent yen strength (+3.6% from its cyclical trough on MAR 14):
Japanese CDS (5yr tenor), have come in materially in recent months, falling -22% (-27bps) over the last two months vs. a regional median decline of -2.8%:
Japanese L/T yield spreads have actually tightened in recent months:
Japan’s latest LT/ bond auction posted stellar results; the 20yr sale was met with a bid-to-cover ratio of 3.3x (highest since OCT) and a sequentially-declining average yield of 1.71%. There still aren’t any signs of decreased demand for new JGB issues:
The one risk we would flag is the combination of Japanese bank CDS widening alongside the underperformance of their public shares. Still, in the face of ebbing risk in the JGB market, it can be argued that this is a natural byproduct of weakness in Japanese equities and equities globally:
Net-net-net, JGB risk is clearly taking a back seat for now, and as Keith has remarked in the past, “credit risk is not a factor until bonds start going down in price”. That said, however, we have yet to get to and through a few noteworthy catalysts, so we wouldn’t feel comfortable dismissing this risk it in its entirety. We’ll be sure to flag to you in real-time if and when the markets begin signaling to us that intermediate-term JGB sell-off risk is firmly back on the table.
Additionally, we remain long-term bears of the Japanese yen, as we ultimately expect the policy prescriptions that are likely to be introduced to address Japan’s woeful economic outlook and [potential] sovereign debt crisis will lead to JPY weakness vs. peer currencies. You could, however, see some yen strength over the short-to-intermediate term if we prove right on our call for a global growth slowdown to impact liquid asset prices globally over the intermediate term. The chart below highlights the relationship between global interest rate differentials and the yen’s spot price vs. various currencies – a particularly strong relationship we’d expect to continue absent a material increase in near-term Japanese sovereign debt risk.