Japan: An ugly self-reinforcing cycle in the making?

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“The casual connections [in the currency market] are reflexive, the participants’ bias may engender, sustain, or destroy a vicious or benign circle.”

                                                                                    George Soros, Alchemy of Finance

Commentary & Analysis

Japan: An ugly self-reinforcing cycle in the making?

LONDON, Jan 22 (Reuters) - The yen rose on Tuesday after the Bank of Japan said its open-ended commitment to buy assets would kick in only next year, disappointing those who expected more aggressive monetary easing.


The yen was sharply higher this morning on news the BOJ did implement a 2% inflation target, but didn’t announce immediate open-ended bond buying.  Instead, the BOJ collective was foolish enough to show a modicum of concern about doing too much already, because should even a tiny-weeny bit of inflation emerge in now tranquil sea of liquidity, it could get very ugly very fast. I think the BOJ clearly understands that a self-reinforcing vicious cycle isn’t the type of animal they care to tangle with. 

Obviously the big-brains on the BOJ board haven’t been paying attention, some traders say.  And Prime Minister Abe definitely seems to lack creativity in these matters.  Instead of cajoling the BOJ into the dirty deed, it’s time to “look West young man.”  That is your future. 

Yup, it’s time Mr. Abe called in the Zen Master of open-ended bond buying – Super Mario Draghi-san, now head of the European Central Bank (ECB).  Risk to the central bank balance sheet?  No problem.  The BOJ could start taking left-over sushi bowls and old pachinko machines for collateral and all would be good.  And just look at all that real estate siting there in the East China Sea that could be used to back all kinds of loans to the government.  You guys in Japan need some vision.

“Heck, I’m now accepting cheese wheels, crippled goats, and uncorked sangria for collateral at the ECB.  I can show you guys how to really crank it up,” said Super Mario Draghi-san when asked about the rumor Prime Minister Abe may be looking to take him in the first round the next central bank draft. [Of course anyone with a hard money bone in his body is praying Abe drafts Bernanke instead.  Take our central banker, please!  Apologies to Henny Youngman… ]

In reality, with gross debt-to-gdp standing at around 230% it’s hard to believe the BOJ’s board has been hanging out in Karaoke bars.  Heck no, they’ve been pumping away.  But instead of the 24-year regime of fiscal and monetary stimulus from the Japanese government and central bank being an incitement on failure, proving that trying to save legacy assets is a disastrous formula for the real economy, the usual suspects of Keynesian-clap-trap continue the mantra chant for “more…more…more.”  If this isn’t yet another in a recent series of “beam me up Scottie” moments in economic folly I don’t know what is?


Wither thy Current Account.  Why is this dangerous?  It may be a contributing factor that makes it harder for Japan to fund its huge debt needs internally, along with a fall in the domestic savings rate. 


Despite the fall in the savings rate, there still seems to be plenty of household savings available.  Notice how closely this series has tracked on the build-up in debt.   

Japanese Government Bond – 10-year Yield:  Inversely correlated with the household savings pool above.  Thus, why everyone is watching the household savings number for a heads up that yields in Japan may be going higher.


Prime Minister Abe has to be concerned he might get what he is wishing for, a little inflation.

Whether or not Japan creates inflation this time around (just because it is targeting doesn’t make it so), it may succeed in triggering a run out of its own bonds.  That is the danger, as a run out of bonds would drive funding costs higher and higher.  Abe’s new policy initiatives could engender a nasty self-reinforcing vicious circle of pain.  


One potential script might be…The yen weakens, so Japanese savers take those built up savings and send them someplace else in order diversify out of yen to maintain purchasing power (keep in mind during the entire 24-years of recession, Japanese consumer purchasing power relative to other major currencies rose as the yen rose in value).  This process in turn would further weaken yen and lead to more Japanese savings sent offshore. As the yen weakens, the economy becomes exposed to imported inflation (Japan imports a few raw materials in case you didn’t know). 

The pool of domestic savings may morph into a rising tide of money chasing yield outside of Japan.  Thus, without domestic savings pouring into Japanese government like clockwork, interest rates would likely be pressured higher on JGBs in order to attract external capital; all thanks to that rising inflation that looked so important to target. 

And you can bet that most buying JGBs at a higher and more enticing yield will be hedging the yen exposure.  So, by hedging the yen exposure, they effectively sow the seeds of higher inflation (weaker yen), leading to losses on bond positions taken.  This concern means any demand for Japanese bonds will be of short duration, which would be an increasing mismatch for Japan funding needs.  That mismatch raises risk in its own right. 

Plus, there would be additional pressure on the yen from speculative funds shorting JGBs in size—shorting a Japanese bond is equivalent to selling yen. 

Japan Yield Curve:


Just maybe one or two people at the BOJ have formulated similar ugly scenarios in their heads.  And maybe that is why they chose to wait until 2014 before they take such an open-ended risk with one of the world’s biggest and most important economies.  I hope so. 

Despite our long-term view, along with many other now in this crowded trade, $-yen goes higher, for now, our bet is we see more correction lower in USD/JPY.  Even a shallow 23.6% reaction from the swing low suggests a move down to 87.17, as you can see in the chart below.  Even at that level the pair would be a whopping 5-6 yen above its 200-day moving average.

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