IS JAPAN SIGNALING AN END TO THE “END OF THE WORLD” TRADE?

Takeaway: If the crashing yen and tumbling JGB market are signaling anything to us, it’s that the end-of-the-world trade appears to be ending.

SUMMARY BULLETS:

  • JGBs are fast falling in price on a combination of improved domestic and global growth expectations and a parabolic increase in domestic inflation expectations. Credit risk is not a meaningful factor in the recent backup in JGB rates.
  • If the crashing yen and tumbling JGB market are signaling anything to us beyond Japan, it’s that the end-of-the-world trade appears to be ending. To varying degrees, these signals are being confirmed across the US Treasury bond market and in the price of gold, which are also breaking down/broken down quantitatively.
  • Could we see a 1994-style or 2003-style backup in super-sovereign interest rates over the next 12-18 months? Absolutely – especially if you believe in the reflexive @HedgeyeMacro bull thesis for the US economy: #StrongDollar = #ConsumptionTaxCut; #HouseholdFormationAcceleration; #BabyMakingBacklog; #ParabolicHousingMarket; and #LaborMarketImprovement.
  • The key question investors should be asking as it pertains to their US equity exposure is whether today’s setup is more akin to 1994 (SPX down -1.5%) or 2003 (SPX up +26.4%). The Weimar Nikkei 225 doesn’t really care all that much, as it appreciated +13.2% in 1994 and +24.5% in 2003 in spite of the commensurate backups in JGB rates.

It would be an understatement to say that JGB yields are backing up across the curve. From their respective YTD lows (2/12 for 2Y; 4/4 for 10Y and 4/5 for 30Y), nominal JGB yields have backed up +11bps, +41bps and +79bps on the 2Y, 10Y and 30Y tenors, respectively. Looking to the 2Y and 10Y tenors, specifically, the JGB market’s pricing in of the regime change at the BOJ (unprecedented monetary base expansion; longer maturity purchases) has now been completely unwound.

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Looking to the 10Y JGB tenor specifically, the recent selloff has some investors believing that the time is now as it relates to a JGB market swoon. Irrespective of the fact that a lot of those same investors have been inappropriately making that call for years, we are finally inclined to side with them at the current juncture as yields have finally broken out above our long-term TAIL line of resistance (now support).

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From our macro team’s perspective, there are three primary reasons why a super-sovereign debt security like a JGB, UST or Bund would fall in price:

  1. Expectations of #GrowthAccelerating
  2. Expectations of #InflationAccelerating
  3. Credit risk rising

Below, we explore all three from Japan’s perspective and offer up our thoughts on what may be the beginning of the end for the #EOW (end-of-world) trade (i.e. long USTs, JGBs, JPY and Gold).

#GrowthAccelerating?

As we mentioned in a recent research note, the trend in Japanese economic data is finally starting to improve – which is to be expected given that the country is attempting to confirm an escape from its third recession in the past five years. From an international perspective, we continue to sing the praises of our non-consensus bullish thesis on US economic growth. #StrongDollar commodity deflation has proven to be a marvelous offset to analytically-loose fiscal policy fears (sequestration and tax-hikes) in the YTD.

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Jumping back to Japan specifically, BOJ Governor Haruhiko Kuroda today rejected an opposition-party member's argument that the recent surge in the Japanese equity market is out of line with Japan's real economy, stating: "At this moment I do not think they are in a bubble."

As previously mentioned, JGB yields are starting to back up in aggressive fashion – much like they did back in 1994 and 2003, alongside a commensurate backup in yields across the US Treasury curve. Both were positive signals for Japanese equities then and the current signal is likely indicative of the asset allocation shift we have been calling for in recent months.

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To that tune, only 6.8% of Japanese household financial assets are held in equities vs. 14.4% for the Eurozone and 32.8% for the US. Clearly there’s lots of hay to bale for “Mrs. Watanabe” and her 55.2% allocation to currency and deposits – which then are funneled back into JGBs via bank intermediation.

This circuitous  method of sovereign financing has saddled roughly one-fourth of Japanese banks balance sheets with low-yielding JGBs – exposing them to a meaningful degree of interest rate risk. Per a 2H12 report out of the BOJ:

  • Japanese banks would face a total of 6.7 trillion yen ($84 billion) in losses if rates rise by +100bps;
  • Losses at major banks would total 3.7 trillion yen, while those at regional banks would amount to 3 trillion yen; and
  • The average maturity of Japanese debt held by large lenders is about 2.5 years and about 4 years for regional banks.  

Of course, Japanese banks would love for yields to back up in a controlled manner (i.e. at a rate where credit expansion can occur to help offset marked-to-market losses on existing holdings). The average interest rate on new loans across the Japanese banking system has consistently tracked the 10Y JGB yield to new all-time lows over the past 20 years, compressing banks’ NIMs and eroding banks’ earnings power in the process.

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#InflationAccelerating?

You know where we stand on Policies To Inflate and the likely unintended consequences of Japan burning its currency at the stake, so there’s no sense in wasting anyone’s time rehashing that here. What is worth pointing out, however, is the fact that Japanese breakevens have gone absolutely parabolic, closing at 1.84% on the 5Y tenor. The JGB market is taking Abenomics quite seriously.

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On the recently released APR Consumer Confidence report (which ticked down -0.3ppts MoM to 44.5), the percentage of Japanese households that expected consumer prices to rise increased +370bps MoM to 82.8% – good for a ~4.5yr high.

#CreditRiskAccelerating?

This is probably the least likely cause of the recent plunge in JGB prices. At this point, reminding investors of Japan’s bleak sovereign fiscal situation is not worth the time it would take to type it. That being said, however, the Japanese sovereign itself is not immune to interest rate risk – particularly if the aforementioned backup in rates is being driven by inflation, rather than economic growth.

It’s worth noting that debt service already consumes 47.2% of tax and fee revenue in Japan, which also equates to about 4.6% of nominal GDP. The sovereign interest expense alone accounts for 44.5% of debt service and 1.8% of nominal GDP – and that’s on a weighted average cost of capital of 1.2%.

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From a credit market perspective, buyers and sellers of CDS contracts on the Japanese sovereign continue to see waning risk of a sovereign default. That’s bad news for crisis sellers across the investment landscape. Again, you won’t ever see us #timestamp a call on sovereign credit risk without some confirming evidence from the credit market itself – of which there is none in Japan at the current juncture.

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All told, we see limited signs that the recent backup in JGB yields is being driven by credit risk. The only new news on the Japanese fiscal policy front worth mentioning is the Ministry of Finance’s decision to punt the announcement of its medium-term fiscal reconstruction plan to the SEP G-20 Summit in Russia, originally scheduled for next month’s G-8 meeting in the UK.

That’s an extremely loose catalyst for the credit risk camp to hang their hats on here. In fact, the only bearish credit risk scenario we can piece together from that is the fact that it will come after the Upper House elections in late-JUL. By then the LDP will have a likely majority there as well, giving it full reign to enact whatever fiscal policies it pleases – including kicking the can down the road on the first VAT hike, which is scheduled to occur early next year. Recall that former DPJ Prime Minster Yoshihiko Noda staked his political career on getting that piece of legislation ratified.

#EOW Ending?

If the crashing yen and tumbling JGB market are signaling anything to us, it’s that the end-of-the-world trade appears to be ending. To varying degrees, these signals are being confirmed across the US Treasury bond market and in the price of gold, which are also breaking down/broken down quantitatively.

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Could we see a 1994-style or 2003-style backup in super-sovereign interest rates over the next 12-18 months? Absolutely – especially if you believe in the reflexive @HedgeyeMacro bull thesis for the US economy: #StrongDollar = #ConsumptionTaxCut; #HouseholdFormationAcceleration; #BabyMakingBacklog; #ParabolicHousingMarket; and #LaborMarketImprovement.

The key question investors should be asking as it pertains to their US equity exposure is whether today’s setup is more akin to 1994 (SPX down -1.5%) or 2003 (SPX up +26.4%). The Weimar Nikkei 225 doesn’t really care all that much, as it appreciated +13.2% in 1994 and +24.5% in 2003 in spite of the commensurate backups in JGB rates.

Darius Dale

Senior Analyst