CONCLUSION: By authorizing BOJ purchases of foreign currency assets, Japanese policymakers risk materially elevating the risk of sustained yen depreciation and inflation within the JGB market. Though we have yet to receive anything concrete on the policy front, we will be paying close attention to the next two BOJ monetary policy board meetings for signs of official movement in this direction.
As both economic growth and inflation slow from a cyclical perspective in Japan, nominal JGB yields are trading at/near multi-year lows across the curve (8yrs for 2s; 9yrs for 10s; 2yrs for 30s) on heightened expectations for BOJ balance sheet expansion. While we continue to anticipate they’ll be on hold throughout the immediate term (next meeting AUG 8-9), we do think such speculation is warranted and will ultimately prove prescient by the BOJ’s SEP 18-19 meeting. Then, the BOJ will have had the opportunity to mull over a heaping helping of [likely] nasty economic data and incrementally dovish inflation data in making its policy decision. Key catalysts on this front include:
- 7/29: JUN Industrial Production;
- 7/30: JUL Manufacturing PMI; JUN Jobs Report;
- 8/7: JUL Economy Watchers Survey;
- 8/8: JUN Machine Orders;
- 8/9: JUL Consumer Confidence; JUL Machine Tool Orders; JUL Manufacturing PPI;
- 8/12: 2Q GDP;
- 8/21: JUL Trade Data;
- 8/23: JUL Services PPI;
- 8/29: JUL Retail Sales;
- 8/30: JUL Jobs Report; JUL CPI; JUL Industrial Production;
- 8/31: 2Q Corporate CapEx;
- 9/9: 2Q GDP – 2nd reading;
- 9/10: AUG Economy Watchers Survey; 3Q Business Sentiment Index; and
- 9/11: JUL Machine Orders; AUG Manufacturing PPI.
We reiterate our bearish TRADE and TREND fundamental thesis on Japanese equities; more details can be found in the hyperlinked note above. Turning back to JGBs, we received two very interesting data points in the last 24-36 hours that pose varying degrees of risk to this market. The first risk is an acceleration of sales by Japan’s Government Pension Investment Fund (GPIF). The second, and far more serious risk, is outright BOJ purchases of foreign currency denominated assets, such as Eurozone periphery sovereign debt.
On Thursday, Takahiro Mitani, president of GPIF (the world’s largest public pension fund, overseeing 113.6 trillion yen ($1.44 trillion)), plainly stated: “Payouts are getting bigger than insurance revenue, so we need to sell Japanese government bonds to raise cash.” While this trend (i.e. waning pension and insurance fund demand for JGBs) in and of itself is not new news (they’ve been selling JGBs intermittently since 3Q10), it is a stark reminder that the clock is indeed ticking from a demographics/household assets perspective as it relates to the Japanese economy’s ability to domestically absorb incremental stock of JGBs. Our generous calculations give the Diet ~10yrs before they pass the “point of no return”.
For reference, GPIF has ¥71.9 trillion of its assets in JGBs or 8% of all JGBs outstanding; the other pension funds in Japan own an additional 1.3% of outstanding JGBs and Japanese insurance firms own an additional 22.4%. JGBs remain at risk over the long term to the extent these market participants are incrementally forced to supplement cash balances by chasing yield abroad or by selling what they can (i.e. what’s been working; i.e. JGBs).
Regarding these points, Mitani agrees that liquidity may increasingly become an issue – forcing some combination of the aforementioned strategies: “To boost returns, we may have to consider investing in new assets beyond conventional ones.” We’ve been vocal in our work on the JGB market in lauding the inflation-adjusted, FX-adjusted returns JGBs provide to domestic Japanese investors. With the yen’s secular appreciation story still intact (up +50.8% vs. the USD and +67.3% vs. the EUR over the last 5yrs), it has made little economic sense for Japanese investors to chase returns offshore. As such, it’s no surprise to see that, despite such low nominal yields in the Japanese bond market and poor domestic equity returns, less than one-fifth (19.7%) of the GPIF portfolio is in foreign currency denominated assets.
That could potentially change in a major way over the intermediate-to-long term, leaving both domestic equities and JGBs at risk of increased institutional selling pressure. The key catalyst on this front takes us to the second, more material risk we alluded to above – outright BOJ purchases of foreign currency denominated assets, which former Ministry of Finance official Takatoshi Ito is urging his cronies at the BOJ to consider. His logic is simple: sustained BOJ purchases of foreign currency denominated assets (like Spanish and Italian sovereign debt) should, in theory, sustainably weaken the yen and boost exports, while at the same time coming to aid of the Eurozone – a key source of global economic demand.
Obviously, the key side-effect of pursuing such a policy (and perhaps why the BOJ has yet to openly consider it) is that it would, in fact, weaken the yen – perhaps too much too soon. Secular currency depreciation and inflation are two risks that haven’t been priced into the JGB market for many, many years and we’d be remiss to not flag the downside risk of investors having to account for those factors at current, historically-elevated prices.
For more details specifically on these and other catalysts that pose a material threat to the JGB market, please email us at ; we have a compendium of work that we’d be happy to share. The word “catalysts” is specifically bolded because we continue to see heightened risk in lazily succumbing to the consensus bearish thesis on Japanese sovereign debt (fiscal imbalances, yada, yada, yada…). Rather, we continue to mine for and vet specific catalysts – like the ones documented above – to determine whether or not investors should be adequately hedged for a sharp JGB sell-off. One key long-term risk we see is the APR ’13 term expiration of current BOJ Governor Masaaki Shirakawa. Replacing him with an aggressive dove would, in fact, put the risks of secular currency depreciation and inflation squarely on the table.
Have a great weekend,