to do whatever it takes to achieve our 2 percent inflation target at the earliest date possible…. It won’t do much good in trying to shake off the public’s deflation mindset if you just say inflation will reach 2 percent someday.”
I guess using the phrase whatever it takes is working so well in Europe that Kuroda decided to try it out in Japan. At least the currency market believes him: the yen is getting thrashed as I write this.
Local analysts give him almost no chance of approaching 2% inflation in the first part of next year. Household spending fell another 5.6% in September, and another round of consumption tax increases is due to kick in next year. The consumption tax was raised from 5% to 8% last April, which resulted in a 7% contraction of the economy in the second quarter. The tax will rise another 2% (to a total of 10%, or double the original amount) next October. Seriously, if you are in the middle of a recession, the general prescription is to cut taxes, not double the national sales tax over a period of a year and a half. Taking away 5% of Japanese consumption is not going to be good for GDP or the inflation rate, especially when so much of your aging nation is living off fixed incomes that essentially pay them no interest.
Real wages have been falling for well over a year and are now down 3% year-over-year. I’ve written extensively on the deflationary impact of Japanese demographics. All of this data, taken together, is not the stuff of which inflationary fears are made.
And thus Kuroda’s ostensible reason for increasing the money supply: we need more inflation, and economic theory says quantitative easing is the way to get it. The argument from the Bank of Japan is that it is simply applying the same strategy that the United States, Great Britain, and Europe have used to such stunning effect.
Except.
Japanese debt-to-GDP is approaching 250%. This year the government deficit is 7.6% – or the US equivalent of a deficit of about $1.3 trillion. (The actual US deficit in 2014 was $463 billion.) And Japanese government budgetary requests amount to a spending increase of about 6% for 2015 … although Prime Minister Abe assures us that Japan will be close to a primary balance by 2020. Rots o’ ruck on that one, Abe.
Ten-year Japanese bonds are now yielding 0.45%, and five-year JGBs yield a minuscule 0.11%. The Bank of Japan has essentially become the Japanese bond market. The balance sheet of the Bank of Japan will rise about 1.4% of GDP each month for the foreseeable future. That is easily more than twice the amount of debt the government of Japan will issue. That means they will have to go into the market and buy already-issued bonds. Thus, the government pension fund announces that they will serendipitously sell their bonds (at a profit, of course) to the Bank of Japan and purchase equities. Such fortuitous timing for the Bank of Japan.
Marcel Thieliant of Capital Economics notes that the BoJ already owns a quarter of all Japanese state bonds and a third of short-term notes (The Telegraph).
The actual Japanese strategy, over time, is to move the bulk of government debt off the books of banks, insurance companies, and pension funds, so that when, in some distant future, the Bank of Japan allows interest rates to rise, it will not devastate the balance sheets of Japan’s most important institutions.
Head ’Em Up and Move ’Em Out
And this is where the move by the Japanese pension funds is so important. At the end of the day, the pension funds are moving out of JGBs and into equity and especially foreign equity precisely because they have lost faith in their ability to meet their obligations in an environment of continual and rising QE. The pension funds have forced the Bank of Japan to boost its QE support in order to absorb the amount of JGBs that will be put back on the market.
This is precisely what I predicted in both Endgame and Code Red and in this letter over the past four years. Investors, and that includes pension funds and insurance companies, have no choice but to diversify outside of Japanese bonds. Not to do so would be a dereliction of duty, but their shift forces the BoJ to increase its quantitative easing perhaps faster than it would like to.
This dynamic has the potential to spiral out of control. The more the yen falls, the more apparent it becomes that Japanese individuals and institutions are fleeing the Japanese bond market, and the greater will be the move to sell bonds. Unless the Bank of Japan can absorb all those bonds, interest rates will have nowhere to go but up, which would be devastating to the government of Japan.
Will the current level of JGB absorption, which is about 4% of total government debt per year over and above newly issued debt, be enough one year or two years from now? If it isn’t, I fully expect another announcement increasing QE to an even more stratospheric level. Japan is still behaving in a gentlemanly fashion, to be sure. The pension funds will give the Bank of Japan a heads-up as to their plans, and it is likely there will be some give and take, but the direction is certain. This is not something that can happen overnight, as moving hundreds of billions of dollars into equity markets without radically roiling the markets is not possible. But this cattle drive is getting rolling – “head ’em up and move ’em out.”
The debt-to-GDP ratio of Japan will rise another 25% in the next few years, but the amount of that debt on the balance sheet of the BoJ will increase by over 50% in just the next three years. By comparison, that would be the equivalent of the Federal Reserve’s purchasing $8 trillion worth of government bonds and equities. That amount of money beggars the imagination … but it will still leave the Japanese government owing just a shade under 200% of GDP.
Since the government of Japan simply cannot survive in an environment of significantly rising interest rates without serious intervention by the Bank of Japan, QED, the BoJ is going to go on quantitatively easing well into the next decade. They will literally need to monetize 200% of GDP (or more!) while the government of Japan somehow manages to get into an actual surplus, so that the BoJ can withdraw from the markets and allow interest rates to rise to market levels. And if that debt-to-GDP ratio is pulled down to a more normal 40 to 50% (70%? – pick your favorite level for “reasonable”) and they have a balanced budget, then interest rates will actually remain reasonable from the perspective of the government.
But if the Bank of Japan withdraws anytime soon from the bond market, there will be no Japanese bond market for the foreseeable future. Interest rates will rise with the same market force brought to bear by Jay Gould’s corner on the gold market. I know I’ve been beating this drum for a number of years, but you can see this coming. Japan’s past reckless spending leaves them with no other choice than to monetize their debt and destroy their currency.
The Bank of Japan is now the Japanese bond market. There is no one else. Japanese pension funds and investors are fleeing the Japanese bond market and putting money into “hard” assets like the local stock market or real estate if they want to keep the money in Japan, or they are moving it into investments denominated in other currencies.
The chart below shows the fall of the Japanese yen against the dollar in the last two years. Note that the dollar has risen some 40% against the yen. Since its recent high, the yen has dropped a similar amount against the euro and the Korean won. It is even 50% lower against the Chinese renminbi. That is a breathtaking move for a currency in so short a time.
The yen is now almost 114 to the dollar as I write early Monday morning, continuing its drop of last Friday. Expect to read about pushback from many countries over the next few weeks. They will become even more vocal when the yen crosses 120. And then 130 and at every point until the yen is at 200 to the dollar. The only question in my mind is, will the Bank of Japan monetize enough Japanese debt so that it can withdraw its quantitative easing before the yen reaches 200? I actually have real money in 10-year yen put options that says they can’t. But then again, that assumes that a response by the Federal Reserve for QE4 doesn’t develop. Please note that I’m not saying that the yen will go straight to 120, much less 200, from here. It will probably do so in an uneven and volatile manner similar to what we’ve seen in the past few years. But it is my belief that the overall direction is for an ever-depreciating currency.
If the yen depreciates only 10% a year, that exerts an inflationary force of less than 0.5% a year. Given the market dynamics already at work in Japan and given the stated goal of 2% inflation, that is nowhere near enough. There will come a time in the not-too-distant future when inflation again starts to recede uncomfortably below 1%, and the only way Governor Kuroda will be able to maintain his credibility will be to double down on even more aggressive QE. Whatever it takes, indeed!
These are not simple men at the helm of the BoJ. They fully will understand that they are eroding the value of their currency – and that, in fact, is part of their intention. In his comments after the meeting, Gov. Kuroda came right out and said, “Overall, a week yen is positive for Japan’s economy.” He hopes that by weakening it he will put some competitive zing back into Japan’s exporting industries. By targeting equities, Japanese leaders hope to alleviate much of the pain to investors and their pension funds by fomenting a rising market. And Japanese corporate profits are up significantly – far more than those of their European and US counterparts – over the last two years as the yen has fallen.
I am sure the “unintended” consequences of Japanese actions are discussed at the monthly meeting of central bankers at the Bank of International Settlements in Basel. Perhaps they are even discussed aggressively. But at the end of the day, all Kuroda-san can do is shrug his shoulders and tell the other members he has no choice.
And he doesn’t. If he does not continue in his present course, he will face a deflationary depression of the first-order, and that would have an even greater negative impact on the world than what he is attempting to do now.
But it is remarkably naïve for the market to believe in the illusion that the central bankers of the world have it all under control, that they have this all thought out, that they have modeled it perfectly, and that these new Japanese actions are simply part of the plan.
The Japanese are attempting to export the one Japanese product the world does not want: their deflation. It is not clear how the central banks of the world will react to the yen at 130, let alone 140 or 150. With proper fiscal, regulatory, and tax reform, the United States can cope with a rising dollar. I’ve been writing for a long time that the dollar is going to become stronger than any of us can possibly imagine. And not just against the yen. But monetary policy alone is not enough to deal with the challenges that a strong dollar presents.
I am not sanguine about Europe, where QE is still streng verboten. Neither is it clear what the proper course for China should be. Allowing the renminbi to strengthen along with the dollar would create deflationary impulses in China and weaken their own export competitiveness. But to allow their currency to fall would threaten the dollar relationship of their internal debt financing. Properly understood, Chinese government debt may be approaching 200% of GDP (when total government obligations are taken into account). That is a staggering sum for an emerging, growing economy, even one with China’s dollar reserves. My guess is they’re going to need every penny of those reserves. The good news, I suppose, is that they have them.
To think that the Japanese are not busy triggering a major currency war is to favor hope over political reality. It is true naïveté. Politicians are going to want to be seen doing something about currency fluctuations that hurt their local businesses. This will put pressure on their central banks and prompt urgent calls for protection. The bad news is that we’re sliding into this currency crisis at a time when debt is at nosebleed levels and still rising, when Europe seems ineluctably headed for another phase of its crisis (and another recession), and China is struggling to balance a most unbalanced economy.
In the same way that we connected farmers and bankers in every corner of the United States back in the 1870s, we have now connected businesses at every level in every corner of the world. To think that we can somehow manage our Brave New World economy with any greater success than President Grant and his Treasury Secretary achieved is to rely on a huge dollop of hope, and hope is not an economic management strategy.
How do we recognize where and when the serious problems will develop? We’ll close with a slightly edited version (from Endgame) of Michael Pettis’s timeless list of “five things that matter”:
1. Debt levels matter. The best way to measure them is as total debt to
GDP or external debt to exports. As a general rule, the more debt you have, the more difficulty you are going to have servicing it. Coupons matter, too. Low rates are much more serviceable than high rates.
2. The structure of the balance sheet matters, and this may be much more important than the actual level of debt. Not all debt is equal. An investor has to distinguish between inverted debt and hedged debt. With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times and rise in bad times. With hedged debt, they are negatively correlated.
Foreign currency and short-term borrowings are examples of inverted debt. This makes the good times better and the bad times worse. Long-term fixed-rate local-currency
