by James Gruber
Japan is the only game in town right now and for good reason. First, it was the yen’s +20% move in less than six months and now there’s the extraordinary volatility in Japanese stock and bond markets. What’s behind the recent action? Nobel laureate Paul Krugman points to false alarm over rising bond yields which is actually reflective of increased optimism in a Japanese economic recovery. One can only assume Krugman wrote this with a straight face, all the while ignoring the real reasons for Japan’s dysfunctional bond market: 1) investors bailing due to 10-year government bonds yielding just 0.85% when the central bank is targeting 2% inflation 2) And that snowballing into liquidity concerns as the central bank increasingly crowds out other players in the bond market, leading to increased yield volatility.
These first signs of investors’ losing of faith in Japan’s bond market not only spell trouble for the world’s third largest economy. They’re also likely to prove a prelude to what will later happen in other developed markets, including Europe and America. Namely, the unprecedented economic measures of the developed world will reach their limits when investors no longer view government bond markets as safe havens and yields spike on supply concerns. The jig will then be up and it’ll have huge spill-over effects for the world’s currencies, including the reserve currency, as well as stock markets. Hang onto your seatbelts; it’s going to make for a wild ride.
Paul Krugman can’t be serious
I played tennis at a high level as a teenager and one of my then heroes was the irrepressible John McEnroe. During one of his famous temper tantrums, McEnroe was so furious with an umpire at the Wimbledon championships that he uttered the immortal line, “you cannot be serious”, before treating the centre court crowd to a more colourful diatribe.
I couldn’t help but think of the McEnroe line when reading Paul Krugman’s latest take on Japan. In the column in The New York Times, Krugman lauds Japan’s unprecedented stimulus efforts:
“A short term boost to growth won’t cure all of Japan’s ills but, if it can be achieved, it can be the first step to a much brighter future.”
This isn’t a surprise given that Krugman, like the majority of the economics profession, believes that during an economic downturn, government stimulus and reduced interest rates can help to boost GDP growth as reduce unemployment (the Keynesian school of thought in crude terms). I won’t debate that here, but as noted in many prior newsletters, there’s little historical evidence that it actually works.
Krugman then goes to suggest that the stimulus efforts in Japan are starting to bear fruit:
“The good news starts with the surprisingly rapid Japanese economic growth in the first quarter of this year – actually, substantially faster growth than that in the United States, while Europe’s economy continues to shrink. You never want to make much of one quarter’s numbers, but that’s the kind of thing that we want to see.”
Here Krugman is on shakier ground for he knows (or should) that GDP growth isn’t reflective of economic health (didn’t we learn that from the 2008 financial crisis?). And he conveniently ignores the latest inflation statistics which show Japan remains mired in deflation.
Then we get to the more interesting part of the column. Krugman notes other positives in Japan including a steep rise in the stock market (prior to when the column appeared on May 23) and a sharp fall in the yen, aiding the country’s exporters. Of the bond market volatility, he writes:
“Some observers have raised the alarm over rising Japanese long-term interest rates, even though those rates are still less than 1 percent. But the combination of rising stock prices and rising interest rates suggest that both reflect an increase in optimism, not worries about Japan’s solvency.”
Let’s put aside the skewed logic that rising stock markets are a sign that Japan’s economy is getting back on track (supposedly paper wealth via stock markets will trickle down into economic spending).
Let’s instead focus on Krugman’s claim that rising bond yields in Japan are sign of increased optimism. By the way, this is a view shared by most of his Keynesian brethren too.
If this claim leaves you scratching your head, you’re not alone. Apparently we’re supposed to believe that after 23 years of economic stagnation, bond investors (94% of them domestic at last count) now see better times ahead. That 10-year government bond (JGB) yields spiking from 0.35% to 1% in around 7 weeks is a sign of a healthy market. And that the bond market being halted on numerous occasions due to unprecedented volatility is a further sign of a healthy market.
Better reasons for a dysfunctional market
There are other, more plausible reasons why Japan’s bond market has become dysfunctional – and I don’t think that’s too strong a word for its current state. The first reason is that there are some investors who are clearly unhappy with getting paltry returns of 0.85% from 10-year JGBs. Why own them when the government is intent on producing 2% inflation, implying a -1.15% real return? Particularly when the bonds are denominated in yen, whose further decline seems assured given the central bank’s extraordinary actions.
The second reason is that these extraordinary actions, involving the Bank of Japan (BoJ) printing money to buy JGBs, mean the central bank is becoming the dominant player in the JGB market, crowding out other investors. This crowding out effect reduces liquidity and heightens volatility. An illiquid market means that banks can’t quickly find counterparties with which to trade large volumes of bonds.
The situation is likely to worsen as the BoJ intervenes more heavily in the bond market going forward. And it may have little choice, just to prevent a more substantial crash in the market.
There’s also the possibility that the volatility in the JGB market will lead to rising yields in other developed world bond markets as investors look for better returns for the risks that they’re taking on. This in turn could put further upward pressure on JGB yields.
The significance of the tumultuous action in Japan’s bond market can’t be understated. As I’ve said on many occasions, the interest of Japanese government debt already takes up 25% of government revenues. If yields were to rise to just 2.8%, that figures becomes 100%. A bond market crash would happen well before it got to that point though.
The more immediate concern is with Japanese banks which hold massive JGB portfolios. According to the BoJ, a 100 basis point increase across all bond maturities would lead to mark-to-market losses of 10% of tier 1 capital for the major banks. Reduced capital means banks wouldn’t be able to lend as much. This in turn would blunt the impact of Japan’s quantitative easing (QE) policies.
A template for what’s to come
Few investors realise it yet, but the action in Japanese markets is likely a prelude to what will happen in other developed countries, including the U.S.
To understand why let’s briefly take a step back. The 2008 financial crisis resulted in governments in many developed markets taking over the enormous debts accumulated in the private sector. Whether this was right or wrong has been endlessly debated and we won’t do that here – it’s done.
Cutting these enormous debts would probably have sent the world into depression. Instead, governments chose to try to inflate these debts away. That’s where QE came into play. QE involved printing money to buy bonds off financial institutions. Theoretically, these institutions would use this money to lend more, thereby stimulating the economy. This would also produce inflation, thereby reducing government debts in local currency terms. Cutting interest rates at the same time would amplify the stimulus.
The problem is that banks haven’t lent the money out to the extent that central banks would like. That’s because consumers have been busy paying off debt and they’ve been frightened to take on more again. They’ve learned their lesson, in other words.
Because stimulus has failed to kick-start economies, government debt in developed markets has continued to skyrocket, and total debt remains on an uptrend too. In fact, total debt to developed market GDP is 270%, 21 basis points higher than it was in 2008!
Not to be deterred, governments in these developed markets don’t view QE as a failed experiment. They believe that it’s prevented a sharper economic downturn. And that more QE will help their economies recover faster. That means governments and their central banks everywhere are ramping up stimulus. It’s a coordinated effort that’s not been seen in modern history, not even during the Great Depression.
Therefore, it’s highly likely that QE will be incrementally increased so long as economies don’t recover to the satisfaction of central bankers. That’s why you shouldn’t expect any imminent cut to stimulus in the U.S. either.
In may respects, Japan is the template for what’s to come in other developed markets. After an enormous credit bubble which burst in 1990, Japan has refused to restructure its economy in order for it to grow in a sustainable manner. Instead, it’s chosen the less painful route of printing money to try to revive the economy and reduce debts in yen terms.
It’s been unsuccessful at previous attempts at QE, including in the early 1990s and 2001-2006. Now it’s got to the point where the debt load is so large at 245% of GDP, and the interest burden so excessive, that there are no good choices left. So Japan has chosen to print even more money, at the not-so-subtle urging of developed countries, particularly the U.S.
The trouble with this is that there comes a point where bond investors lose confidence in the ability of the government to repay the money. These investors then refuse to rollover government debt at low rates. When bond markets dry up, they normally do so quickly. The current wobbles in the Japanese bond market can be seen as a prelude to this endgame.
Though Japan has escaped its day of reckoning for a long time, other developed markets are unlikely to be as lucky, given the extent of their indebtedness and continued commitment to flawed policies.
No comments:
Post a Comment