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Over the past thirty years, Japan has gone through tremendous economic headwinds beginning with the asset price bubble of the early 1990s to the financial crisis of 2008 and into the 2011 tsunami and earthquakes. The lack of growth in the country has been a bitter pill to swallow for investors and the Japanese government as the country struggles to get itself back on its feet and out of stagflation.

Japan is off the hook…for now  - JAP3

Despite cautious overtones related to the Japanese economy, we think there are four reasons as to why Japan is on the rebound and will not encounter a government bond-related crisis over the next few years.

1)      We see a diminished threat of future rating agency downgrades beyond critical levels. On May 22, Fitch was the first of the “Big 3” rating companies to downgrade Japan’s long-term local currency issuer rating to single-A status…

2)      On June 17, the Democratic Party of Japan agreed to double the nation’s 5% VAT tax in a two-step process ending on October 2015. While we demonstrated in our April 3 research note titled “DIGGING DEEPER INTO JAPANESE SOVEREIGN DEBT RISK” that hiking the VAT tax will do little for long term fiscal consolidation and debt reduction, positive headline risk associated with the passing of the VAT hike bill will likely buy the government a meaningful amount of time.

3)      On June 16, Prime Minister Noda agreed to restart the first two of Japan’s 50 idled nuclear reactors, implying that all political hurdles had been cleared. As a result, Japan should see a reduced need to import fossil fuels. A lack of support from Japanese voters in poll suggests that the decision was politically motivated. Noda’s decision illustrates a new confidence and willingness on the part of the Japanese government to go against popular sentiment – just last month, Japan issued projections for mandated rolling blackouts, which amount to cuts in consumer and corporate energy consumption.

4)      The slope of Japan’s 5yr breakeven inflation rate has now inflected after a long period of increasing inflation. This inflection coincides with the Bank of Japan’s unwillingness to give in to political and market pressure to ease monetary policy in pursuit of its +1% inflation target. In conjunction with a predictable compression in global interest rates differentials, this leads us to anticipate a bout of strength for the Japanese Yen in the near future.

Japan is off the hook…for now  - JAP2

Whether Japan will be able to shed its long-term low rates policy remains to be seen. But it’s making progress on many economic fronts that are important to keep in mind over the next one to three years. Japan also has committed a large amount of money to the International Monetary Fund ($60 billion currently) , making it one of the largest contributors to the fund. Should the European debt crisis rapidly accelerate at an unexpected rate, those commitments and associated collateral calls could prove to be costly. Japan’s economy is a lot like a game of chess. Dealing with it requires a great amount of patience and fortitude.