Japan is all that matters right now

It seems many have come to accept the macro environment we'll face for many quarters, if not years, to come. Central banks have firmly planted their policies into the market and they won't be uprooting them anytime soon.

The only hiccups will come if the market says so.

And the market may say so only if unprecedented policy breeds instability, tangible unintended consequences.

We've talked before about how emerging markets tend to see this instability arise in their economies since their central banks cannot keep pace with developed-market central banks, and their capital markets cannot absorb policy measures the same way more developed capital markets can. 

But it seems there may be some risk of instability in a major economy where the central bank has committed itself to making monetary policy the answer.

That economy is Japan.

A friend, reader and Member of Black Swan Capital asked me some questions about Japan a few weeks ago:

If Japan reaches their 2% inflation in a year or two, will that force them to also raise yields on their bonds?

If yes, how will they be able to afford paying all that interest on their 220% of GDP debt?

Seems like the increased interest costs will bankrupt them?

Here was my answer to him:

Of course, we do have to see inflation ACTUALLY increase in Japan – easier said than done for them!

If interest rates do go up, Japan will run into some issues. Remember: they can print money. And they do have some flexibility to generate tax revenue, at least relative to Europe, but if the market forces the interest rate issue then the pressure may become too much too soon. That, though, would then reduce growth in the economy and conceivably reduce inflation pressure as well. So it’s a fine line they walk. 

If interest rates do rise, for whatever reason, Japan will feel pressure. And they realize this is a risk even though they do have some buffer to handle initial financing pressures. The recent volatility in JGBs is already raising warning flags.

Apparently, the Bank of Japan has been in the market trying to suppress interest rates nearly every day since April 4th. And the BOJ is pledging to buy up even more bonds.

Basically, there is a risk to the markets if interest rate increases are based entirely on inflation expectations rather than economic growth expectations. Those risks already seem to be emerging as the Nikkei has lost about 7% in the last two days and the yen has begun to strengthen.

Despite all the risks in Europe and the apparent disconnect between US stocks and the US economy, it seems Japan is/will be the catalyst for any market downside in the near future.

Besides any direct influence a reversal in the yen or JGBs or the Nikkei will have on capital flows, it may actually bring to light some other issues these yen-based capital flows have helped to mask. Namely, the unwarranted positioning in European sovereign bonds. The recent action has helped bring Greek yields down to levels unimaginable after what's happened to that economy. Yields on Italian and Spanish bonds have also fallen for this reason.

With no change in the underlying recessionary economies across the Eurozone, rising interest rates would bring back pressure on the banking system and show that no progress has been made (even as it was reported the US has pumped over $1 trillion into foreign banks.)

This really has the potential to get ugly in a hurry, which may come as a surprise for so many who see central bank policy as an unwavering and unshakeable force driving global asset prices higher.

Can Japan keep investors from getting spooked?

Jack just sent a piece of technical analysis to his Members of Black Swan Forex. It lays out a pattern that suggests USD/JPY has a lot of room to fall in the near-term. If you'd like to receive this analysis, his commentary, and specific trading alerts, you can read more here ... or sign up using any one of the buttons below.

 

-JR Crooks

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