Japan: Land Of The Rising Crisis Risk: Bond Yields Soaring
In an otherwise relatively quiet week in China, Europe, and the US, Japan’s bond yield spike has provided the most ominous cause for concern.
It began in response to the news the Fed was considering curtailing QE and thus its bond purchases. That caused both US and Japanese yields to rise.
Japan’s 10 year note yields remain among the lowest among the leading economies (0.85% vs. 2.16 on 10 year US notes), but it NEEDS those rates to stay down. As everyone following Japan knows, its debt levels are unsustainable; the only question is how long it can continue. John Mauldin has been putting out a number of good summaries of Japan’s dilemma at mauldineconomics.com if you want a more detailed description of the following.
Japan has the highest debt/GDP, 245%, (vs. 101.5% for the US in 2012), in the developed world or anywhere else except for maybe Zimbabwe and perhaps a few other forgotten economic basket cases.
In the past, Japan has managed to keep rates low because it had a huge domestic market of savers to buy those bonds and a large trade surplus that suggested Japan’s heavy debt expense was sustainable. Now however, about 25% of that population of savers is over 65 and those retirees will be net sellers, not buyers, of JGBs, and Japan has started running a trade deficit.
Japan needs to keep selling bonds to someone:
- Japan funds about half of its budget with new bonds
- Its debt service expense alone accounts for ~24% of that budget. A mere doubling of rates to a still low 1.7% would make debt service over half its budget.
- It now issues more bonds than it pays in interest. In other words, it needs to sell new bonds just to pay interest on the old ones. When the only way you can pay existing investors is to bring in new ones, that’s the basic definition of an unsustainable Ponzi scheme.
Moreover, Japan is trying to increase inflation, which makes its bonds worth less and will cause its rates to rise at some point as investors want compensation for being repaid in Yen that will be worth less.
At some point either JGB bond rates rise. Japan can then either:
- Default
- Print thousands of billions of JPY to pay its interest cost, the JPY depreciates to the point of worthlessness, and then Japan defaults.
Either way, the current path is unsustainable. Japan can’t promise to increase inflation to 2% and expect bond yields to stay down. The only question is how long the game can continue? Unless Japan can get bond rates down, without overprinting the JPY, then the game can’t last much longer.
Japan is the third largest economy in the world, implying in short, a new contagion risk.
We’re not there yet, but rising JGB bond rates get us closer.
Continued Hints Of Capital Controls, Capital Flight
From seekingalpha.com’s market currents for Wednesday, two points worth noting.
WED 3:05 AM Bank of Japan Governor Haruhiko Kuroda expresses support for allowing emerging countries to impose capital controls in order to protect themselves from financial crises. Kuroda’s view is in line with a relatively recent change of heart from the IMF, which had long been a crusader for the free movement of cash before relenting.
WED 3:47 PM Depositors pulled €3.2B from Cypriot banks and €2.8B from Greek banks last month in the wake of Cyprus’ bungled bailout. Critically, the figure for Cyprus does not include the haircuts imposed on deposits as part of the rescue effort. Elsewhere, Spanish deposits fell 1.5% to a seven-month low and customers in Slovenia yanked nearly 2% of their cash amid worries about the stability of the country’s financial sector.
Technical Picture
The Fed QE hints halted the rally in global equities last week.
The uptrend for most major indexes is so well established that it remains well intact on the weekly charts, as shown in the example of the S&P 500 weekly chart below.
Source: MetaQuotes Software Corp, thesensibleguidetoforex.com
Click to enlarge
However the daily chart shows more damage.
Source: MetaQuotes Software Corp, thesensibleguidetoforex.com
Click to enlarge
Conclusions & What To Do
For now all depends on sentiment about QE continuing. As noted above, we don’t believe the Fed will do much, if anything, because there is neither the growth nor inflation threat to justify it. That makes any sustained pullback unlikely until markets have additional reasons to do so, or actually start paying attention to the weak global economic and earnings picture.
With former technical resistance broken over a month ago (1550 on the S&P 500, for example), we have to view the recent pullback as a temporary halt in the long term uptrend until we have more evidence that either:
- markets believe there will be material curtailment in QE, and as yet we don’t
- markets believe that the weak global economic and earnings growth figures don’t justify this rally
That means either standing aside until the anxiety passes and the uptrend resumes, or, for those seeking to deploy cash in new longs, do so with caution:
- Partial positions spread out over the coming weeks or months at your chosen support levels
- Clear stop loss orders entered in advance at chosen support levels (or mental stop loss levels if the shares aren’t liquid enough)
- Stick to reliable dividend payers that hedge currency and inflation risk. The strong dollar has put certain foreign assets on sale.
Remember that in the past weeks no fewer than 14 central banks have cut rates, as central banks remain in overall easing mode. That will cut the purchasing power of most currencies, and of portfolios denominated in them. See here for an award winning guide on how to protect your assets from being dragged down with your currency.