Japanese 10-Year Bond Yields Heading Toward 2% As Yen Slides Further In 2013

by: Sean Maher

The Japanese have a history of proving inventive faced with desperate circumstances, and in fact rarely move forward without their backs to the wall, given inherent cultural inertia. The exceptional factors which have allowed endless deficits, notably the recycling of corporate retained earnings into JGBs to offset falling household savings, and a surprisingly resilient current account surplus despite a long-term deterioration in the country's comparative advantage in manufacturing, are now coming to an end. With the economy slipping back into recession, the BOJ has raised its asset buying and lending program, easing policy for two months in a row for the first time since 2003, as political pressure to avoid yet another deflation episode mounts.

In another radical shift, the central bank issued a joint statement with the government pledging their combined efforts to pull Japan out of deflation. In an unorthodox move, the BOJ also unveiled a plan to supply banks with unlimited amount of cheap, long-term funds under a new scheme initially set at around 15 trillion yen. Markets reacted with a sense of déjà vu to the latest asset buying plans but this has the potential to be very significant in its direct impact on the yen, as a weaker currency is the only way to reflate in the absence of any recovery in domestic credit demand and against a grim secular demographic backdrop. The yen carry trade is back on, backstopped by the BOJ balance sheet…

The soft global demand picture, particularly from the slowdown in China and the euro zone peripheral crisis, and well as an ongoing loss of competitive advantage in consumer manufacturing to S. Korea, have combined with persistent yen strength to undermine export demand. Meanwhile, while Japan directly paid only $26m for the three Senkaku islands, the indirect economic costs of the resultant escalation of a simmering territorial dispute with China have already amounted to many billions as Chinese consumers have boycotted Japanese brands. However, local equities have been discounting the worst. I covered Japan in a client note on the 9th November, concluding that: '…there have been only three occasions in the past 13 years when investors been more underweight than the current reading of -1.4 standard deviations. On each occasion, Japan has outperformed the MSCI World Index over the following quarter, by an average of 7%. Japan is now about as unfashionable among investors as European assets were back In June, when global investors dismissed the possibility of a radical policy breakthrough. In typically ambiguous Japanese fashion, we're probably seeing one…' While it's early days, the prospect of the LDP returning to power and imposing a binding 2-3% inflation target on the BOJ has seen local equities show a rare burst of outperformance.

With Japan currently overtaking China as the biggest foreign holder of US Treasuries (both holding about $1.1trn worth), the rapidly weakening current account has global implications when the Fed finally stands down its QE program. In fact, from Indonesia to Russia EM official reserve growth is slowing markedly and many capital exporters are moving into chronic current account deficit - a key structural theme is that the clearing price of capital is heading upward through mid-decade on these trends and as China's demographic dividend reverses.

There is little doubt after the latest trade and manufacturing data that Japan is back in technical recession in Q4. Even if we see a very rapid settlement with Beijing post-election (and Noda's exit offers China the opportunity for a face saving deal), a sharp inventory adjustment will be sustained into Q1, adversely impacting corporate profits, but the weaker yen trend as well as extremely bearish investor positioning remain key supports for local equities. Despite outgoing Governor Shirakawa's latest assertion of sacrosanct bank independence, the BOJ is likely to add further stimulus at its next meeting on December 20th, four days after the election, as its forecasts come gradually in line with far weaker private sector inflation and growth expectations.

For investors, a continued re-rating of Japanese exporters in line with what will increasingly be seen as a secular turning point for the 'safe haven' yen is a good bet, alongside a steady rise in JGB 10-year yields toward 2% by end 2013 (from a current level just above 70bps) as the yen/USD cross rate rises toward the 90-95 range. Japanese equities now yield over three times more than bonds, so not only is foreign portfolio positioning unusually bearish, but there is scope for domestic retail reallocation as well, as that famed army of housewife investors looks for a domestic inflation hedge, having been burned in foreign exotica like Brazilian real structured products (and the Brazilian real, now trading at a 3-year low, proves how determined policymakers can crash a currency they consider dangerously overvalued). While Japan has been a classic value trap over the past couple of decades (with its economy caught in a liquidity one), increasing desperation from policymakers running out of options offers a window of opportunity to profit…

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.