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CONCLUSION: We continue to flag what we view as heightened risk for a JGB market rout; for now, however, the coast remains clear.

 

POSITION: Short the Japanese yen (FXY).

In the wee hours of the morning (US time) the international ratings agency Fitch downgraded Japan’s long-term local-currency sovereign debt rating one notch to A+; additionally, the agency reduced the country’s long-term foreign currency debt rating two notches to the same level. This action is critical in nature because we are now one step (i.e. a downgrade from another “Big 3” agency: S&P = AA- w/ NEG outlook and Moody’s = Aa3 w/ STABLE outlook) closer to triggering a ~$78B capital shortfall across the Japanese financial system.

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One catalyst we see in accelerating the time frame of additional downgrades is that Japanese bureaucrats may wait until scheduled Upper House elections in the summer of 2013 to hold elections in the Lower House, per Azuma Koshiishi, secretary-general of the DPJ. Unless the LDP has backed off of their demand to dissolve the Diet prior to negotiating on the VAT hike, there will be no progress made on this front for over one full year – a major catalyst for further downgrades of Japanese sovereign debt further per commentary out of both of the remaining agencies.

The most recent downgrade (today) had a fair impact on the currency market, with the USD/JPY cross jumping from ¥79.58 to as high as ¥79.77 within minutes following the downgrade.

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Looking to the Japanese sovereign debt market – which has been a key focus of ours this year as it relates to potentially being the next domino in the context of our Sovereign Debt Dichotomy theme – prices are not confirming Fitch’s worry that “[t]he country’s fiscal consolidation plan looks leisurely relative even to other fiscally-challenged high-income countries, and implementation is subject to political risk.”

Two, ten and thirty-year nominal JGB yields have trended down in recent months to ~7, ~9 and ~2 year lows, respectively. From a market demand perspective, a couple of recent developments highlight the [arguably] well-deserved complacency within that market in that the BOJ failed to receive enough offers from financial institutions for its recent Asset Purchase Program open market operation (only ¥480.5B of a ¥600B target); this is in addition to failing to meet a ¥310B target (¥174.7B offered) for its Rinban operation (purchases of JGBs w/ a maturity < 1yr). For now, Japanese financial institutions can’t get their hands on enough JGBs!

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Given the impressive demand conditions, it’s no surprise to see that L/T-S/T nominal JGB yield spreads have compressed meaningfully over that same duration. Part of this is due to the risk that the BOJ decides on implementing further easing measures in its monetary policy meeting, which is currently underway (results published tomorrow). Increasing the [bond] duration of their purchases and potentially acquiring foreign assets are two policy initiatives we think they may pursue if they do decide to incrementally ease at the current juncture.

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For context, we’re of the view that the Cabinet Office’s recently upgraded 2012 economic outlook and the central bank’s increasingly hawkish fiscal 2012-13 inflation guidance limits the need for them to pursue further easing measures in the near term; a chart of medium term breakeven inflation expectations in Japan confirm our view. On the flip side, the threat of rolling blackouts this summer ranging from 7-20% of peak consumption (depending on region) could force downward pressure on the Japanese economy over the intermediate term and force the central bank to react preemptively to maintain Japanese Real GDP growth, which, after four consecutive quarters of YoY contraction, accelerated to +2.7% YoY in 1Q12.

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Jumping back to JGB risk, Japanese sovereign credit default swaps of the 5yr and 10yr tenors have backed up a fair amount in recent weeks, widening +18bps and +31bps, respectively, from their YTD lows. As the table below highlights, however, the widening seen in Japanese swaps recently has dramatically lagged the region, lending credence to our view that Japanese sovereign debt risk on this metric is merely accelerating as a function of global financial market contagion borne largely out of Europe. The same can be said regarding the recent widening of Japanese bank CDS as well, though perhaps to a lesser degree, given their outsized exposure to JGB risk (25% of total assets).

 

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All told, we continue to flag what we view as heightened risk for a JGB market rout – particularly from current prices. That said, however, our call has not and will not invoke the consensus storytelling that simply focuses on highlighting the unsustainable nature of Japanese fiscal imbalances; rather we will continue to stay finely in tune with any/all catalysts that we find material enough to potentially shift sentiment within this market. For now, the coast remains clear and we remain bearish on the JPY vs. the USD from a long-term TAIL perspective – of course trading it with a bearish bias over the intermediate term, given its preponderance to appreciate in the context of our TREND-duration fundamental Global Macro view.

Darius Dale

Senior Analyst

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