CONCLUSION: As the chart of Japanese sovereign CDS continues to indicate, intermediate-term event risk in the JGB market continues to dissipate. While Japan’s poor sovereign fiscal metrics and heavy debt burden continue to signal heightened TAIL risk, we think it’s safe to conclude that a JGB crisis is less probable from TRADE and TREND perspective than it was just 3-4 months ago. Thus, it is likely to prove prudent to resist saturated consensus storytelling by avoiding the “widow-maker trade” for now.
On slide 59 of our MAR 2 presentation titled: “JAPAN’S DEBT, DEFICIT AND DEMOGRAPHIC RECKONING”, we outlined four catalysts that we felt would expose the JGB market to heightened event risk over the intermediate term:
- The threat of future ratings agency downgrades beyond critical levels (triggering a capital call across the Japanese banking system);
- A deterioration of the country’s current account dynamics eroding the country’s net creditor status;
- A failure to pass meaningful austerity measures that would slow the growth of Japanese sovereign debt below the growth of domestic assets; and
- A structural increase in long-term inflation expectations.
As things stand today, it is our official view that the risks embedded in each of these four catalysts have receded enough to substantially erode our assessment of TREND-duration risks in the JGB market. Moreover, this view is consistent with our work since early APR, which, among other things, has mainly focused on tempering expectations of an intermediate-term Japanese sovereign debt crisis.
As it relates to catalyst #1, on MAY 22, Fitch became the first of the “Big 3” ratings agencies to downgrade Japan’s L/T L/C issuer rating to single-A status (A+ w/ a negative outlook). Moody’s currently has a Japan at Aaa with a stable outlook; Standard and Poor’s has Japan at AA- with a negative outlook. We suspect both agencies will be on hold indefinitely given the resolution of catalyst #3, which is new as of this morning and a major delta from the previous status quo, which centered on LDP demands for a dissolution of the Diet (in hopes to regain the ruling mandate though a popular vote) prior to participating in negotiations on the proposed legislation.
To that point, the DPJ, led by prime minster Yoshihiko Noda, reached an agreement late yesterday night with senior delegates of the two largest opposition groups (LDP and New Komeito Party) on a deal to double the nation’s 5% VAT in a two-step process ending in OCT 2015. Reaching the deal took a fair amount of political compromise on Noda’s behalf, including the recent reshuffling of his cabinet to remove two controversial members from key posts and shelving a DPJ-backed plan to introduce a minimum guaranteed pension. Moreover, hiking the VAT has become increasingly unpopular as Japan’s TREND-duration economic outlook becomes more cloudy (56% of voters opposed the bill in JUN vs. 51% last month per Asahi News). All involved parties hope to have the deal officially ratified by the end of the current Diet session, which concludes on JUN 21.
As we demonstrated in our APR 3 research note titled: “DIGGING DEEPER INTO JAPANESE SOVEREIGN DEBT RISK”, hiking the VAT tax leaves much to be desired in the way of fiscal consolidation and outright debt burden reduction for the Japanese sovereign – using the Cabinet Office’s own official projections! Incorporating more grounded numbers into our scenario analyses, we concluded that Japanese policymakers needed to adopt a far more dramatic fiscal consolidation plan to make a material dent in the growth of Japan’s sovereign debt burden.
That all being said, however, we would be remiss to ignore the positive headline risk associated with agreeing upon and ultimately passing the VAT hike bill in the immediate term, as it is highly likely to buy the Japanese sovereign a meaningful amount of time as it relates to the timing of future ratings downgrades and/or shifts in the supply/demand dynamics of the JGB market itself.
Turing to point #2, we also received resolution on this front as well, with Prime Minister Noda agreeing on JUN 16 to restart the first two of the country’s 50 idled nuclear reactors. Per the statement, two reactors at Kansai Electric Power Co.’s Ohi nuclear plant can now be operated safely. The key takeaway here is that Japanese policymakers have now signaled that A) political hurdles to restart reactors are being cleared, which will increasingly reduce Japan’s need to import fossil fuels (supportive of Japan’s current account surplus, which had posted its two lowest monthly readings ever in the YTD), and B) there exists a new willingness to go against popular sentiment on this front; as recently as last month the government was busy issuing official projections for mandated rolling blackouts, which amount to cuts in consumer and corporate energy consumption.
This change of heart strikes us as being highly politically motivated and reminds us who really runs the show in Japan (i.e. big corporations). The Kansai region of western Japan (accounting for ~20% of Japanese GDP) is home to the industrial cities of Osaka, Kobe and Kyoto, as well as the headquarters of Panasonic Corp., Sharp Corp. and Nintendo Co. As previously mentioned, the decision is quite unpopular among Japanese voters; 71% of respondents in a Mainichi poll opposed an expedited restart to the Ohi reactors; 70% of respondents in a Pew Research Center poll said the country should reduce its reliance on nuclear energy and 52% of respondents of that same poll said they felt that they or members of their family had been exposed to radiation.
Lastly, in accessing the development of point #4, we look no further than the slope of Japan’s 5yr breakeven inflation rate, which we identified earlier in the year as the key indicator to watch as it relates to a structural increase in long-term inflation expectations within the JGB market. That slope, which had been straight up and to the right for nearly 10 months, has now inflected; this inflection coincides quite nicely with the Bank of Japan’s recent unwillingness to succumb to elevated political and market pressure to incrementally ease monetary policy in pursuit its +1% inflation target (adopted in FEB; latest rejection of consensus pleading on JUN 15).
We still see risk, here, but as we have been pointing out in recent notes, the BOJ’s reluctance to acquiesce to consistent demands that it aggressively expand its balance sheet has taken a fair amount of immediate-to-intermediate-term reflation risk off of the table in Japan. That, in conjunction with a proactively-predictable compression in global interest rate differentials, has led us to anticipate the latest bout of JPY strength in spite of our bearish TAIL-duration view.
Pertaining to that duration, it is still our view that personnel changes among the BOJ’s monetary policy board – particularly current governor Shirakawa’s term expiration in APR ’13 – will bring about a new era of meaningful BOJ balance sheet expansion, which is an outcome that has multi-partisan political support out of the Diet. The latest developments on this front are the nominations of Takahide Kiuchi of Nomura Securities Co. and Takehiro Sato of Morgan Stanley MUFG Securities Co. Both are sell-side economists and, most importantly, both are open to the idea of the BOJ being more aggressive in its efforts to help Japan overcome persistent deflation.
We will continue to keep an eye on S/T-L/T JGB nominal yield spreads as indications of A) whether the BOJ will extend the maturities of JGBs targeted as part of its Asset Purchase Program (at 1-3yrs currently) and B) whether the BOJ convinces the JGB market to start pricing in the threat of inflation – something market participants haven’t had to do in decades.
All told, as the chart of Japanese sovereign CDS continues to indicate, intermediate-term event risk in the JGB market continues to dissipate. This is supported by what we feel are either meaningful positive developments within or resolutions of each of the key negative catalysts we outlined back in MAR. While Japan’s poor sovereign fiscal metrics and heavy debt burden continue to signal heightened TAIL risk, we think it’s safe to conclude that a JGB crisis is less probable from TRADE and TREND perspective than it was just 3-4 months ago. Thus, it is likely to prove prudent to resist saturated consensus storytelling by avoiding the “widow-maker trade” for now.