We’ve long said that a dramatic and sustained spike in JGB yields would be catastrophic for Japan, whose central bank is onboarding the entirety of gross issuance onto its balance sheet and whose government is running what is effectively the largest ponzi scheme the world has ever known. Here’s WSJ summing up the situation:
Japan’s government debt is roughly 240% of gross domestic product, according to the latest International Monetary Fund figures. That is the highest in the developed world, and many analysts contend that rising interest rates could stress the government’s finances with higher borrowing costs and hamper the banking system by causing Japanese lenders to see large capital losses on the pile of government bonds they hold.
Given this scenario, the logical conclusion is that there is no viable exit strategy for the BoJ, a sentiment that was echoed this week by Japan’s former chief of foreign exchange policy at the Ministry of Finance who told Bloomberg that unwinding QE simply isn’t an option:
Makoto Utsumi, who oversaw foreign-exchange policy at the Ministry of Finance from 1989-1991, said the Bank of Japan’s expansion of its balance sheet into debt with an average remaining maturity of up to 10 years makes it impossible for Kuroda to pare stimulus “for the foreseeable future” without causing bond yields to surge. Speculation that the BOJ will accelerate its note purchases helped push two-year yields below zero percent on Wednesday for the first time since January.
“The thought of exit itself is a nightmare for Japan, not whether it’s premature to talk about it,” Utsumi, 80, said in an interview in Tokyo on April 15. “There is no choice but to keep issuing bonds for financing, and with buying of longer dated JGBs, a natural exit is out of question as is unwinding.”
Meanwhile, the very same asset purchases that have driven down yields have ironically created the conditions for a sudden spike. As we’ve discussed on numerous occasions, BoJ purchases have sucked nearly all liquidity from the JGB market causing traders to report widening bid-asks and increased volatility. If market depth collapses then the impact on price of any one trade is magnified, increasing the chances that a few sellers could create carnage in the market and effectively collapse the entire house of cards in relatively short order. As such, it isn’t entirely clear how an “exit” will ever really work. Indeed, even the most optimistic (in terms of betting on Abenomics to free Japan from deflation) analysts acknowledge that JGB liquidity is impaired to the point of absurdity and will be the “major theme” going forward. Here’s some color from a recent Morgan Stanley note:
Our economics team expects the BoJ to start winding back QQE from October 2016, and cannot rule out a commencement of tapering as early as the first quarter of next year under an economic bull-case scenario of oil prices rebounding strongly and wages providing a solid boost for consumption. Markets are likely to start focusing greater attention on improving macroeconomic conditions and the prospect of BoJ tapering as the inflation rate climbs from this summer onwards, but our base-case scenario is for JGB yields to climb only gradually through the end of 2015, with BoJ operations to continue providing substantial support until tapering actually gets under way.
The underlying inflation rate looks likely to hover around zero through this summer, thereby fueling hopes for further BoJ easing. However, the inflation rate should start climbing year- on-year once the impact of previous falls in oil prices begins to drop out. Our economics team expects the core CPI inflation rate to reach +0.7% by year-end and then approach +1.2% level in 1Q 2016, reflecting both base-year effects and solid growth in household spending if wages do indeed keep rising. Macroeconomic conditions have actually been improving since last summer, with real exports and production rising since September while Cabinet Office Economy Watchers Survey results and other measures of sentiment have picked up sharply over the past few months.
It goes without saying that we are skeptical of the degree to which Abenomics will be successful at either altering inflation expectations or creating anything that even approximates prosperity for Japan’s Middle Class (in fact, we recently outlined how Abe’s policies are destroying Middle Class Japanese citizens), what we can agree with MS on however, is the following assessment of JGB liquidity:
Market liquidity—or lack thereof as trading continues to thin out—is also likely to be a major theme.
BoJ operations have surpassed even the Fed’s QE when measured relative to either GDP or total issuance, with secondary market availability—the total amount of JGBs held outside the BoJ’s hands—dwindling since the April 2013 introduction of QQE and shrinking at an even faster pace under QQE2 (launched last October). The resultant decline in market liquidity means that price action is now being driven mostly by the supply/demand pressures associated with MoF auctions and BoJ purchases.
As discussed in our report Japan Interest Rate Strategist: Outlook for JGB Supply and Absorption (05 Mar 2015), if the BoJ persists with its current pace of JGB purchases, then the incentive for investors to reduce their holdings any further is likely to dwindle away within the next 18–24 months, at which point liquidity may evaporate altogether as a consequence of unprecedentedly tight supply/demand.
This loss of market functionality is liable to come just as a rising inflation rate starts to make BoJ tapering look like a real possibility. Upside to JGB yields should be limited to at least some degree by demand from banks (who are currently earning just 0.9% or thereabouts on their loans) and life insurers (who have been comparatively modest net buyers over the past couple of years), but it is nevertheless likely that JGB market participants will start to demand a risk premium when confronted with rising interest rates, high volatility, and the prospect of the BoJ winding back its monetary stimulus in foreseeable future.
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Perhaps Yoshiyuki Suzuki, the head of fixed income at Fukoku Mutual Life Insurance Co. said it best when he told Bloomberg the following:
“If somebody sells, yields can jump.”
