How Soon Will Abe Economics Produce Unintended Consequences?

Includes: FXY, JGBD
by: Ralph Shell

Japan received some goods news today. According to Times Higher Education Rankings of the top 100 universities in the world, the University of Tokyo ranks number 9, just behind UCLA and ahead of Yale. All of the top 20 ranking schools are either in the U.S. or the UK, with the exception of this one in Japan and one in Canada.

Of greater short-term importance to the Japanese economy, the new PM Shinzo Abe, unlike his predecessors who were prone to dither and procrastinate, is moving quickly to re-staff the Bank of Japan. The nominee for the new Governor of the BOJ is Haruhiko Kuroda, who says:

"If the BOJ were to ease policy, it would therefore be most natural for it to increase government debt purchases and target longer-dated bonds... It would be natural for the BOJ to buy longer-dated government bonds in huge amounts. "

This confirms the new BOJ Governor intends to commence the Japanese version of QE, using monetary policy to stimulate the economy and end deflation. Nominated for deputy governors are Kikuo Iwata and Hiroshi Nakaso. Iwata is an academic who has done research on inflation targeting, and testifies that the BOJ should purchase five-year and longer-term bonds. His views are so strong, he suggests this should be the law in Japan. It sounds like he would be the equivalent support to the governor as Yellen is to Fed Chairman Bernanke.

Nakaso, the other nominee for deputy BOJ governor, is a career bank official. His testimony shows him to be more cautious, probably reflecting the approach of the current BOJ officials.

There is no doubt the intensity of Abe's passion for a change in the moribund economy has produced some results. The current value of the USD to the yen, over 93 yen per USD, has made many Japanese products more competitive. This will help the Japanese trade account, which last year turned negative for the first time in over 20 years.

The weaker yen might pave the way for a revival of tourism in Japan. In 2012, there were only 8.36 million tourists to Japan, about the same as visited Taiwan, and less than the 10 million that visited South Korea, or the 19 million to Thailand, 22 million to Hong Kong and about 35 million to Malaysia. Granted, the earthquake and tsunami disaster, combined with the nuclear power plant meltdown held back tourism this past year.

The weaker yen and the promise to increase the money supply have also been a stimulant for the Japanese stock market. The Nikkei 225 has rallied over 2000 points to 11,660. No doubt some funds were unweighted in Japan when Abe economics was announced.

There was also the "Abe trade" best described by its initiator:

"Asoka Woehrmann, co-chief investment officer of asset management at Deutsche Bank AG, also started the 'Abe trade' late last year. Assuming that the yen would decline, Woehrmann bought shares in Japanese export-oriented companies and reduced the bank's holdings of Japanese government bonds to a minimum.

His reason for selling JGBs, however, is troubling: the possibility of a sharp downgrade. As soon as investors believe that the BOJ is buying government bonds to plug the fiscal hole, market confidence in the government's debt will collapse.

Woehrmann does not think Japan's sovereign debt will be downgraded to a non-investment grade within a year, but he warns about the possibility that the market may reach an 'inflection point' that triggers a decline in confidence."

So the Abe plan is working well thus far, stocks and bonds are up, the yen is down, and everyone is happy. Yet should this plan work, and the inflation rate goes up to just 1%, what happens to the bond yields then? Currently, the 10 JGB yields .63%. Certainly, that will not be the yield with 1% inflation.

Japan finances over 50% of their current budget with deficit financing, and Abe wants to spend more. With current debt at 225% of the GDP, growing, higher rates would be a recipe for absolute chaos. Eventually, the bonds are a short, but you cannot sell them in front of the BOJ's buying program. Monitoring the Japanese Government Bond Futures ETN (NYSEARCA:JGBD) might be worthwhile.

Is there a trade in the yen (FXY, USDJPY) at this time? The last leg of the bear run has taken the market from 85 to 94, and for about the past month, it has basically gone sideways. Looking at the last COT report, specs are big shorts, over 100K contracts, though they have made minor position reductions.

Looking at the chart, what about the break away gap between 85 and 86? Supposedly, all gaps are filled sometime, but that one is a long way down. Will that be the one that is never filled? The market, after the volatile day on February 25, has been coiling within that range. I am inclined to think the Abe bear news is priced into the market, but I am cautious since we are so close to the .9450 level. Should we test that level again, hopefully break it and fail, this could be a sign the weaker yen has temporarily run its course.

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.