As investors we’ve grown accustomed to European financial crises triggering volatility in our markets. But the epicenter for last week’s volatility came from across the Pacific instead.
A 7.3 percent mid-week flash-crash in Japanese stocks — the biggest decline since the 2011 Tsunami and earthquake — was triggered by a more troubling sell-off in Japanese government bonds. This should serve as your wakeup call that the global financial system remains subject to plenty of event risk, in spite of the complacent rally in global stocks.
Not to be outdone by the Fed’s open-ended quantitative easing (QE) or the European Central Bank’s latest shenanigans, recall that it was the Bank of Japan (BOJ) that originated QE decades ago. In a bid to engineer inflation and jump start its slumbering economy, Japan became the record holder for dispensing easy money.
Two lost-decades later, the BOJ is back for more. This time Prime Minister Abe has put a new spin on the same old strategy with hopes to jump-start Japan’s economy, stagnant since its real estate and stock market bubbles burst in 1990.
This latest (and greatest) plan calls for the BOJ to purchase $70 billion a month in Japanese government bonds (JGBs) to support credit in the economy until inflation hits 2 percent.
|Prime Minister Abe’s strategy to revive Japan’s economy has caused yields to more than triple since April.|
Note: This is nearly the same dollar-amount of QE the Fed is pursuing … but in an economy that’s just one-third the size of the U.S.
A Great Risk on the Horizon
A potential unintended consequence of this policy is that fears of inflation could lead to a bond market collapse … taking Japan’s financial system down with it … just like in Europe.
File this under the heading: “Be careful what you wish for” in the twilight-zone of modern, unconventional monetary policy.
Hedge fund manager J. Kyle Bass, among others, has warned about this downside scenario which is precisely what triggered the selloff in Tokyo last week. Japanese government bond vigilantes “overwhelmed” the market with sell orders, according to an interview with Bass by Bloomberg.
Yields on benchmark 10-year Japanese government bonds spiked dramatically higher in the process, with more investors selling than the BOJ is able to buy. From a low of 0.3 percent in April, 10-year JGB yields topped more than 1 percent last week for the first time in over a year … rates more than tripled off the record low reached just a month ago.
To put this massive bond market volatility in context … it would be as if 10-year U.S. Treasury yields suddenly and without warning shot up to 4.8 percent from the recent low of 1.6 percent.
The problem lies in the fact that JGBs are mostly locally owned. Japanese banks, pension funds and insurance companies are loaded up and appear to be dumping them for fear of being caught on the wrong side of a Japanese bond market rout.
A bond market crash in Japan would likewise set off another banking crisis in Japan, similar to what has been slowly simmering in Europe for the past several years.
Japanese banks alone hold JGBs equal to 80 percent of the country’s economy, as measured by GDP. This means a huge potential loss in mark-to-market accounting value if bond yields continue to spike higher. The International Monetary Fund estimates that just a 1 percent rise in yields would result in a 20 percent haircut for regional banks’ capital.
The famous line from the movie Jaws uttered by Chief Brody after he spots the enormous shark for the first time is a fitting analogy for the difficult task faced by the BOJ …
“You’re Gonna Need a Bigger Boat”
Japanese lenders may only be starting to unwind their massive JGB holdings, recently reducing them to 164 trillion yen, down from a record 171 trillion yen a year ago. As Bass told Bloomberg:
“Everyone that holds JGBs will likely act rationally and sell a portion … to buy foreign bonds or domestic equities. If holders sell a mere 5 percent of their holdings (50 trillion yen), then the BOJ’s new plan isn’t large enough.”
Japan cannot tolerate higher interest rates. Tokyo’s debt-service costs would rise by 100 billion yen for every one-tenth of one percent increase in bond yields. Japan’s outstanding debt was 991.6 trillion yen at the end of the first quarter, and is likely to reach a record 245 percent of the country’s GDP this year.
Nomura economist Richard Koo, an expert on Japan’s lost decades sees the recent bond market sell-off as a potential warning sign of an intensifying financial crisis.
If enough JGB investors vote with their feet and sell, the BOJ may no longer be able to hold the line on interest rates “no matter how many bonds it buys,” leading to a “loss of faith in the Japanese government … and the beginning of the end.”
To potentially profit from rising yields in Japanese bonds, you might consider PowerShares DB 3x Inverse Japanese Govt Bond Futures Exchange Trade Notes (JGBD). This ETN is meant to rise 3 percent for each 1 percent fall in the price of Japan’s 10-year government bond.