26th May - Credit Guest: Japanese Whispers

Credit guest post from Macronomics, have fun!

Japanese Whispers

"Success consists of going from failure to failure without loss of enthusiasm." - Winston Churchill 

Japanese Whispers is a 1983 singles album by British group The Cure. Looking at how the markets hope were slightly dented this week with the plus 7% drop on the Nikkei index, we thought we would use this reference to British group's album title and also given their convenient name in our "Abenomics" case namely "The Cure", given everyone and his dog have "delusional" hopes on Abenomics success in reviving Japan we think.

Back in January 2012 in our conversation "Bayesian thoughts" we quoted Dr. Constantin Gurdgiev, from his post entitled "Great Moderation or Great Delusion":
"when investors "infer the persistence of low volatility from empirical evidence" (in other words when knowledge is imperfect and there is a probabilistic scenario under which the moderation can be permanent, then "Bayesian learning can deliver a strong rise in asset prices by up to 80%. Moreover, the end of the low volatility period leads to a strong and sudden crash in prices."

This week's Bayesian lesson comes from Japan given our Japanese Chuck Yeager has indeed reached record altitude in true jet pilot fashion when one looks at the "Bayesian" surge in the Nikkei index which, apart from the recent stall, has passed the Dow for the first time since 2010 as indicated by Bloomberg:

"The CHART OF THE DAY shows the Nikkei 225 soaring 80 percent as the yen plunged after then-opposition leader Shinzo Abe said in November the Bank of Japan should carry out unlimited monetary easing. That allowed the Japanese stocks gauge to close a gap that was about 4,000 points. Abe became prime minster after his Liberal Democratic Party won a landslide victory in parliamentary elections. The BOJ, led by Abe’s nominee Haruhiko Kuroda, unveiled plans last month to double the money supply in two years to end deflation." - source Bloomberg.

More importantly we watched with interest the move on the Japanese VIX equivalent on Thursday at the same time of the sell-off, in true "sucker punch" fashion - source Bloomberg:

From 25 to as high as 48.35 in one move, or that's what happen when you have over confident central bankers/pilots pushing the envelope so to speak, as we discussed using Chuck Yeager crashing his NF-104 Lockheed Starfighter on the 4th of December 1963 as an analogy in our conversation "The Coffin Corner".

And does this move compare to 2008? It is indeed a fairly large movement in volatility as indicated in the below graph from Bloomberg displaying the VNKY index from May 2007 to today:

While reading the excellent FT Alphaville on Japan's mini crash we came upon an excellent comment from one of their reader:

"This equity mini crash is all fine and well, but what about the rise in JGB yields? I would be grateful if somebody could enlighten me how this whole allegedly Superman-like Abenomics plan can possibly not end in tears for all involved. The math just doesn't add up.

Japan has about 990 trillion yen in JGB outstanding. There is even more public debt (local, regional, SOE etc), but let's focus just on the JGB's, which already amount to some 180% of GDP, so there is aplenty. They have been able to finance this very cheaply (nominally speaking) and largely domestically at about 0.50% pa nominal yield for the past two decades. This was largely possible because of deflationary pressures, meaning that real yields were not so bad at all (1.5~3%, depending on where, when and how you measure). So this system more or less worked, at least for domestic parties, who hold 95% of the JGB's. 

But now, Monsieur Abe has got it into his head that he is going to end those deflationary pressures, and the BoJ is with him. It looks like the latter is succeeding in credibly promising 2% pa inflation, to be delivered within 2 years. And they have the means, it is more of a matter of will indeed, so why not indeed. Now, if I am a Japanese domestic investor (say a pension fund), why on earth would I continue to hold and keep buying JGB's at below 1% pa nominal yield for 10 years while I know the BoJ is going to do everything it can to ensure at least 2% inflation, and thus meaning a real yield of -1%. 

And in fact, let's not forget that the whole point of Abenomics' grand inflation chase is precisely that effect: driving individual (in aggregate) and corporate savers out of safe-haven investments like JGB's and getting them to invest in more productive assets. Now you may say, no worries, you don't need to have those parties to buy JGB's, or they won't have a choice but to accept negative real yields, since the BoJ will just 'financially repress' yields anyway. But this is where the maths go off track. What works for the Fed, does not work for the BoJ in this case. The average maturity of the JGB debt is relatively short (about 6 years). The Japanese government therefore does quite a bit of rolling over, and is still running a huge deficit as well, so lots of issuance going on. In FY2013 alone, they are scheduled to issue JPY 170 trillion in JGB's. The BoJ has specifically committed itself to buy some JPY 70 trillion of JGB's this year, which makes sense given its commitment to double the monetary base in two years, and which was originally JPY 135 trillion when they made that commitment. 

So we have JPY 990 trillion (and growing) in existing outstanding JGB's, JPY 170 (of which) being rolled over/newly issued this year, and the BoJ will buy 'only' 70 trillion of that (even assuming they only buy primary issues, which is by no means a given). At the same time, we have the possibility that the domestic investor base that has been diligently buying JGB's in the past 20 years will stop doing that (and even start selling existing holdings too): because they don't want to bear negative real yields (and again: this is precisely the purpose of Abenomics, to get that money working rather than just gathering paltry JGB yield). Foreign investors? No way. They wouldn't want the negative JPY yields either, and with a declining yen (at the very least a all-but-certain side-effect of Abenomics), they would want them even less.

I can only see three possible scenarios here, but would be very pleased to be proven wrong by a flaw in my reasoning:

(1) Abenomics and the BoJ's efforts don't work. Inflation does not materialise. Deflation or 0% price stability is here to stay. Nominal JGB yields remain low (or go back to even lower). Real JGB yields thus remain more or less attractive for domestic parties. All stays as it was. The JPY strengthens again. Abenomics fails, but nobody gets really hurt. 

(2) Abenomics and the BoJ's efforts do work. Inflation picks up and gets to 2% like the BoJ wants. Nominal JGB yields therefore go up as well, since the BoJ is not buying nearly enough to successfully keep yields down (10-year JGB at 3%? 4%?). At this point, the BoJ even stops the bond purchases and/or may even tighten. This will mean the government cannot sustainably (or at all) finance its deficit and the debt it needs to roll over. It will either have implement the kind of austerity that would Greece seem like child's play, which it can't/won't for it would kill the recovery, or it will have to consider default/restructuring. Abenomics fails, and has brought the Japanese government to the brink of an IMF-bailout, or worse. 

(3) Abenomics and the BoJ's efforts do work. Inflation picks up and gets to 2% like the BoJ wants. Nominal JGB yields go up with it (10-year JGB at 3%? 4%, see above). At this point, the BoJ continues to buy debt, for the government has no other way to sustainably finance itself, and Abe has already de facto ended central bank independence. It will have to even buy a lot more than it is currently planning. A whole lot more. The monetary base continues to grow. It's effectively debt monetisation. Inflation gets out of hand, even into double digits. Debt-to-GDP is getting healthier, but the JPY goes to hell. Exports are good, but resource-poor Japan can barely afford its oil and gas imports. Japan becomes the first developed nation to move back into a middle-income trap economic situation. Abenomics fails and has brought economic misery for the Japanese people, especially the asset-rich pensioners who see their purchasing power destroyed. 

In short: Abenomics and its three arrows perhaps are not such a bad idea if your debt-to-GDP ratio is well below 100%, your debt maturity profile is long-ish, and you're running a government surplus (or at least just a modest deficit), and you can therefore handle an uptick in government debt financing costs, especially if it also comes with a gradual nominal increase in tax revenue. When your debt-to-GDP is closer to 200%, and you run a huge deficit, you can't. You will be back against the wall very quickly and face a stark choice: either your central bank will have to begin monetising debt and let inflation get out of hand, or you will have to implement some form of austerity with/without debt restructuring that will have an economic impact that is the polar opposite of what you were trying to achieve." - source FT Alphaville comment from j.v.e 

We could not agree more with the above great comments. Yet, foreign investors continue to buy Japanese stocks to the tune of JPY 716 billion versus JPY 879 billion as reported by JP Morgan, from Japan's MoF released weekly update of portfolio flows:
"Foreign investors have bought a total of JPY4.6trn in Japanese stocks in April and May so far." - source JP Morgan.

But more interestingly was the following:

"Japan’s MoF released the weekly update of portfolio flows. Japanese net sold JPY804bn in foreign bonds last week (May 13-17), more than undoing the net buying in the three weeks prior (which totaled JPY692bn). Japanese sold JPY137bn of foreign stocks last week as well, which is also more than the net buying amount in the previous two weeks (which sums up to JPY47bn)." - source JP Morgan

In conjunction to the heightened volatility in the Japanese JBG market, we have been looking with interest at the roller coaster moves in the 30 year Japanese bond space versus the Swiss equivalent - source Bloomberg:

So while equities our enjoying the Japanese show, even after the following recent stall of the Japanese "Starfighter", we have been busy watching with interest the credit space given we still believe Japanese financials CDS to be "cheap" as displayed in the below graph from CMA, part of S&P Capital IQ:

Flying a "Central Bank" or a NF-104 Starfighter requires strict and delicate airplane/monetary control...

We would therefore like to re-iterate what we said in Last week's conversation "It's a Wonderful Life":
"Given that for these Japanese banks profits are tied up to substantial trading and "unrealised" investment bond gains from abroad and looking at the recent rise of JGB yields since the arrival of Mr Kuroda at the Bank of Japan, and knowing the very large size of JGB portfolios for these Japanese banks, in the absence of investment bond gains (which would mean selling some European government bond holdings...yikes!), unrealised losses on their JGB portfolios will not doubt put pressure, not only on their shareholder's equity and regulatory capital, but on their CDS spreads as well and their earnings. The CDS for these Japanese banks is trading closer to the more highly rated Australian banks but also Korean counterparts such as Kookmin according to CreditSights. Therefore, should "Abenomics" disappoint, there is indeed some room for these Japanese banks CDS to widen "significantly" at some point...(sorry we are not paper fortune tellers)." - source Macronomics

Nikkei Index - 3 Month 100% Moneyness Implied Vol versus Japan 5 year CDS since January 2010 until today - source Bloomberg:

Should the volatility in the Japanese space continue to trend higher, which is currently the case, we would expect credit spreads to continue to widen, particularly for Japanese financials.

"If at first you don't succeed, try, try again. Then quit. There's no point in being a damn fool about it." - W. C. Fields

Stay tuned!