- Between now and the JAN 22nd BOJ meeting and from then until the APR ’13 replacements of the BOJ governorship and two deputy-governorships, Japan’s fiscal POLICY outlook will take center stage in our TREND/TAIL call for a demonstrably weaker yen.
- Ahead of the APR 1st fiscal new year, Abe and Aso will craft a “large-scale” supplementary budget for the FY12 year (likely > ¥10 trillion), as well as a FY13 federal budget. Regarding the latter, the previously-imposed ¥71 trillion spending cap for FY13 was recently disregarded by the LDP, suggesting Abe is poised to take public expenditures to new heights. In short, we think Japan’s pending fiscal and monetary POLICY mix risks igniting a backup in JGB yields that could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis.
- Regarding the yen specifically, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date).
- To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.
While we were away, Japan’s parliament approved Shinzo Abe as the nation’s seventh prime minster throughout the past six years, returning him to a post he abandoned in 2007. Coming in hot, Abe was quick to name Taro Aso as his minister of finance – Japan’s sixth finance chief throughout the past three years. With political turnover like that, it’s no wonder Japan is struggling mightily to get its fiscal house in order.
Aso, a former prime minster in his own right in the 12 months through SEP ’09, will also serve as deputy prime minster and financial services minister in Abe’s cabinet. This give the LDP a strong 1-2 spending punch atop Japanese leadership, as both Abe and Aso are champions of Keynesian-style, countercyclically-expansionary fiscal POLICY.
During his brief stint as prime minster, Aso introduced three extra budgets worth about ¥20 TRILLION, abandoned a pledge to balance the budget by March 2012 and distributed a ¥12,000 per-person cash handout. A supporter of the “by any means necessary” fiscal POLICY that has plagued the Japanese sovereign balance sheet for much of the past ~20 years, Aso has developed a reputation for signing off on seemingly wasteful stimulus initiatives (such as authorizing ¥12.4 BILLION in 2009 for the cleanup of fishing gear).
It should be noted that Abe, Aso and their underlings will be hard at work on crafting a “large scale” supplementary budget for the FY12 year (ending in MAR ’13), as well as a FY13 budget that takes Japanese public expenditures to new heights. The party has already abandoned the previously-imposed ¥71 trillion spending cap for the upcoming fiscal year (starting in APR ’13); following through with that pledge would grow Japan’s primary public expenditures by roughly +4% YoY in nominal terms.
Importantly, doing that in a time of economic calamity as Japan currently is in (second recession in the last two years; third in the last four) would likely impose a greater reliance on sovereign debt issuance to fund public expenditures. We consider it crucial that Japan is poised to surpass the 50% mark with regards to the sovereign’s bond dependency ratio in the upcoming fiscal year – i.e. over half of public expenditures will be funded via debt issuance, as opposed to more traditional revenue sources such as tax and fee collection.
Indeed, historical trends for the growth of sovereign debt service and total tax & fee revenue suggest long-term holders of JGB’s should be very leery of the Abe/Aso duo. Extrapolating CAGRs from the previous five years suggests Japan’s sovereign debt service is poised to completely consume all traditional revenues in 15 years – i.e. the “point of no return” or the sovereign “endgame”, so to speak. There are a myriad of reasons why 15 years is a really aggressive assumption (i.e. the point of intersection is likely much further into the future), but it is a fun theoretical exercise nonetheless.
What is not theoretical is the fact that both Japan’s sovereign debt service (currently 24.3% of total public expenditures) and interest expense (currently 44.7% of total debt service) continue to grow in nominal terms – despite the sovereign’s weighted average cost of capital plunging to new lows in recent years (1-1.2% by our estimates, down from 2% ten years ago and 5.8% twenty years ago).
To the extent Abe makes good on his promise for +3% nominal GROWTH and +2% consumer price INFLATION or if his POLICY mix induces a stagflationary concoction of said “monetary math” (i.e. +1% GROWTH and +4% INFLATION), a demonstrable backup across the JGB yield curve could make the aforementioned theoretical exercise a lot closer to reality than what we think is currently implied by a sovereign CDS quote of 81bps. It should be duly noted that the trailing 10-year averages for Japan’s nominal GDP growth and CPI are -0.7% and -0.2%, respectively.
This is why we continue to express caution regarding Japan’s pending monetary and fiscal POLICY mix – specifically in that a backup in JGB yields could threaten Japan’s fiscal sustainability, potentially triggering a European-style sovereign debt crisis. Fear not, however. Our interpretation of market chatter suggests Abe fundamentally believes Japan can avert a meaningful jump in bond yields a long as the central bank is committed to unlimited financing of the sovereign; per the latest data (3Q12), BOJ holdings of JGBs increased to the highest on record (¥104.9 TRILLION or 11.1% of all sovereign debt).
To the extent investors start to anticipate anything meaningfully in the direction of a 1930’s-style debt monetization scheme over the long-term TAIL, it could be “look out below” with respect to the market PRICE of the Japanese yen and the market PRICE(s) of Japanese sovereign debt. We wouldn’t want to be holding the bag on Japanese equities in that scenario, which is exactly why we continue to anticipate reflation in the months ahead, but refuse to endorse the trade explicitly.
On the monetary POLICY front, the latest developments suggest that the LDP will consider revising the BOJ’s mandate if the board fails to double its INFLATION target at the JAN ’13 meeting. Abe also suggested that he plans to nominate a BOJ governor that favors the policies of his party and explicitly stated that it was vital for Japan to resist the strengthening of the yen which he sees as a likely result of other countries weakening their currencies.
Be careful what you wish for Misters Abe and Aso; you just might receive it. On that note, the JPY has fallen for six consecutive weeks vs. the USD as is now at multi-year lows of ~¥85.61 per USD. In the spirit of keeping score, Japan’s currency has plunged -9.4% vs. the USD since we outlined our TREND-duration bearish thesis on 9/27; that compares to regional median gain of +0.2%.
From a sentiment perspective, sell-side consensus and Japanese exporters do not yet agree with our call for sustained yen weakness over the intermediate-to-long term. Sell-side consensus expects the currency to strengthen to ¥83 per USD by the end of 1Q13 and Japan’s large manufacturers expect it to average ¥78.73 per USD in the fiscal half year through the end of MAR ’13 (up from the current average of ¥81 in the fiscal-half-year-to-date). To the extent the latter party joins the “party” we could see another meaningful leg down in the yen over the next few months, as commercial traders remain positioned long of the JPY to the tune of two standard deviations relative to the trailing 52-week average.
Lastly, to review the POLICY and PRICE catalysts embedded in our bearish thesis on the Japanese yen, we view each one of the following risks as probable over the next 12-18 months:
- A +2-3% joint Diet-BOJ INFLATION target (JAN ’13?);
- A meaningful expansion of public expenditures and “large scale” stimulus package (1Q13?);
- A VAT hike delay (2H13?);
- The LDP wins a majority in the Upper House pending elections (JUL or AUG?);
- An erosion of BOJ independence, with the BOJ governorship and two deputy governorships eventually assumed by LDP puppets (1H13?);
- Experimental monetary POLICY – particularly a foreign asset purchase program (1H13?); and
- The UST 2Y-JGB 2Y yield spread widens in any meaningful way (2013?).
Stay tuned; if the market is telling us anything, it’s that this train is just getting started.