Bank Of Japan Losing Control Of Bond Market Spells End Game For Japan

 |  Includes: DXJ, FXY, JGBS
by: Nicholas Pardini

On Wednesday (Thursday in Japan) evening, the Bank of Japan chairman announced a $74 billion per month quantitative easing plan that produced massive shocks in Japanese financial markets. The yen (NYSEARCA:FXY) plummeted over 6% since the announcement and Japanese equity markets soared (NYSEARCA:DXJ). Optimism has surged in Japan and investors believe that a cheaper yen will increase exports and end the country's economic malaise.

However, the Japanese government bond market is telling a different story. JGB yields made a record low 10-year yield of 0.32%, but since then rates have been skyrocketed. On Thursday (Friday in Japan), rates doubled to 0.65% and triggered a circuit breaker for the entire JGB market. A circuit breaker also triggered during Monday's and Tuesday's sessions as well. Pension funds and individual investors for years have assumed that deflation added 1%-2% to JGB's "real return" and thus made it more reasonable to carry these bonds. However, with the prospect of inflation in Japan, the script has flipped. JGBs will now have negative real yields and therefore pension funds have been desperate sellers. Even before Kuroda's announcement, pension funds have become net sellers of JGBs due to demographics. His actions only accelerate this trend.

Based on the market reaction so far to the BOJ's easing, it looks as if it is losing control of interest rates. JGBs are continuing to sell off rapidly as the Bank of Japan's goal of combining inflation with record low bond yields is untenable. Inflation does not help Japan, but drastically hurts its situation. Interest payments with yields on 10-year JGBs at 75 basis points make up 24% of tax revenues. Rates are this low in the context of a deflationary Japan. When inflation does take off, yields will rise to meet inflation. If rates rise to just to 3%, then interest payments exceed tax revenues and thus the Japanese state will be bankrupt. The other downside of inflation is that Japan imports nearly all of its food and energy needs. Losses in consumer spending from higher necessity costs will outweigh the benefits of increasing manufacturing exports (based on recent export data, this might not even come to pass).

Abe's and Kuroda's goal is to stimulate exports while keeping interest rates down for a perfect medium that will drive growth. Unfortunately, it seems as if the bond market is not cooperating, and further strains in rights will sink Japan into a debt crisis. Although demographic and social policies were likely to cause this outcome anyway, the actions of the Bank of Japan will be what triggers the investment community's awareness of the country's dire fiscal situation. The best way for investors to capitalize on Japan's collapse is by shorting the yen on a breakout of 100 JPY/USD, or by shorting Japanese government bonds through the PowerShares DB Inverse Japanese Govt Bond Futures ETN (NYSEARCA:JGBS). The Nikkei may go up due to easing, but economic fundamentals of Japan do not call for stocks to rise in real terms. As a result, I am avoiding taking a side on the stock market. However, shorting Japan's bonds and currencies provides enough upside.

Disclosure: I am long JGBS. I may short the yen upon breakout of USD/JPY above 100. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.