Well, it is official. The LDP and Shinzo Abe are back. This election and Abe's past comments on pressuring the BOJ into massive amounts of money printing will have traders watching the yen closely in the coming days. Do I expect massive moves in yen and JGB futures tonight when markets open? No, actually I don't because I really don't see this move by Japanese voters as a big surprise.
The yen has taken an awfully good beating vs the USD since November 14 so this election may be "baked in the cake" for the moment, to use a bit of trader speak. Do I expect the currency to collapse in the coming weeks? No, of course not. What I do expect is for the yen to remain under pressure moving forward. Consider what is going on in Japan. This move by voters to elect an official promising a new round of stimulus is just doubling (or even tripling) down on complete failure. I have spoken to many Japanese who know they have a debt problem, but no electorate is ever going to vote for pain and fiscal responsibility. Japan is past the point of no return and we are seeing the words of Alexis de Tocqueville play out in reality rather than philosophy.
Try and remember that every time Shinzo Abe opens his mouth, it will be part of a large misdirection play. The Japanese government has no intention of cutting spending and adopting any fiscal responsibility. The Japanese government has no intention or ability of ever paying back its crushing debt. The policy makers in Japan are never going to admit that the greatest example of Keynesian economic theory is a complete failure.
When we hear Abe and the LDP talk about "needed stimulus", it is to avoid making hard and painful decisions. When we hear Abe talk tough about China, this is to avoid talking about the nation's crushing debt and the drain that debt is having on the economy. Can you imagine what the impact would be to productivity and GDP if all that dead money lent to the government was actually invested? When we hear Abe talk about improving exports by weakening the yen, once again he is trying to redirect focus to anything and everything other than the hard decisions that must be made. Policy makers are avoiding those decisions and at some point, the market is going to make them pay for it. The Japanese seem content to suffer mild pain now, which will turn into severe pain later.
I am still very much in favor of buying long term out of the money yen futures puts. If Abe insists he is going to destroy the currency, then by all means, I will let him. If Abe gets what he wants, I see levels in the yen that I doubt anyone thinks are possible. Let's start with a target of 1000 yen to the dollar for starters. Why not 10,000? The December 2013 puts just came on the board for trading at the CME, so this lets investors own protection against the yen until December 6 of next year. If the market gets a severe break, then I would favor converting those outright puts into a synthetic put position for reasons I am happy to explain in a future article. I am still in strong favor of rolling put positions against JGB futures. Traders can accumulate what I think are very cheap options that only need an increase in 10 year JGB rates of 50 basis points to be in the money. Implied volatility on the yen options for next December is only around 10.5% and the JGB options are still trading at an unfathomable sub 1.5% implied volatility.
I often get asked the question, "Tres, what single event starts the big sell off in Japanese Government Bonds?" The person asking me this knows I cannot possibly answer that question with any accuracy, but I usually tell them the same thing. Bond markets and banking systems require one thing-- confidence. What single event will fracture that confidence? Losses. When that confidence is fractured, then the limited participants in the bond market are not going to have anyone to sell to. Some suggest that since Japan finances its debt internally (selling its debt to its citizens and its corporations), this is a reason the market will hold up. I actually view this as a major source of vulnerability for Japan. Who is left? Who can buy if any of the limited market participants turn into a seller? All the plates at the table are full.
I speak with a variety of other traders in Japanese Government debt on a regular basis and I floated a theory of a "two tiered market" for JGBs developing in any sort of sharp selloff in the bond market. It would not surprise me to see rates on the primary market stay near zero, while rates on the secondary market skyrocket. The reason this theory seems logical is I see no reason for the BOJ to support the secondary market. The government has already borrowed the money, why would they give it back? If the banks start selling, then why would the BOJ buy bonds that are already trading. I would expect the BOJ to support the primary market which is all the new issuance. The BOJ is doing it already and in some kind of bond crisis I would imagine this would go into hyperdrive as the government tries to meet all its obligations.....yes, this is what the endgame would look like.
There has been much talk of Japan's trade deficit being a catalyst to setting off a panic in JGBs. If the trade deficit is the problem, then one must think long and hard about the energy market. Japan has turned off its nuclear reactors, and the country does not have massive amounts of energy resources to draw from. What kind of event would accelerate the decay of Japan's balance of trade? A massive spike in oil prices. Imagine if oil were to jump to $120 a barrel at the same time Japan is weakening its currency. This would help crush Japan's balance of trade. Am I suggesting oil will cause a JGB panic? No, but I am certainly not ruling it out. There are countless things that continue to tighten the vice on Japan's bond market, but I certainly would not rule out the energy market as a major contributing factor. What if energy suppliers stop accepting payment in yen? Now we are really venturing into some interesting ground.
Additional disclosure: Tres Knippa is a trader on the floor of the CME. Tres is a principal of Kenai Capital Management which is a registered CTA. Tres owns the website ShortJapanDebt.com