Japan: Inflation, Deflation Or Bond Crash?

by: Squeeky Wheel

Japan has had persistent mild deflation for most of the last decade. Along with the deflation has been over a decade of slow to no growth. As we all know, prime minister Shinzo Abe and new Bank of Japan governor Haruhiko Kuroda, have embarked on a 'whatever it takes' plan to get inflation.

The big question is can they get it? Or will they continue to be stuck with deflation? From reading several of the articles on SA about Japan's monetary plans, there seems to be considerable concern that they may get a bond crash in the process.

The monetary plan is conceptually simple - buy ridiculous amounts of assets, increasing to $76 billion in government bond purchases per month. The details are interesting and unusual; not only will the BOJ buy short-term government bonds, it will buy all the way out to 40-year bonds plus it will start buying ETFs and REITs, i.e. buy stocks. The policy objective is now 2% inflation and whatever monetary supply increase needed to get there. The previous limit on the amount of government bonds held has been removed.

The fiscal policy goes hand-in-hand. Public works spending will increase more than 15% from last year, making this a classic infrastructure stimulus budget. The $1 trillion budget plus $100 billion stimulus will require $430 billion in borrowing. If you do the math you'll see that the BOJ bond purchases could cover the entire budget deficit. Thus we have a true fiscal stimulus plan.

Will Japan get a bond crash

The arguments I've seen are that either 1) all this money printing will cause the yen to hyperinflate resulting in a bond market crash, 2) BOJ will reduce interest rates so much that traders will exit bonds to find higher yields elsewhere - perhaps even outside Japan - thus crashing the bond market, or 3) the yen's forex rates will drop so much and confidence in BOJ's willingness or ability to repay that no one - especially outside Japan - will be willing to buy the bonds, sending their value crashing.

As I discuss below, in the face of large monetary expansions in the past, Japan has still been highly resistant to any inflation at all. In fact, Japan's monetary policy has been highly accommodative for around two decades and it continues to get deflation (though it did get a housing bubble in there). Further, the BOJ is likely to have time to counter any excessive increases in inflation. Wages and prices tend to be surprisingly sticky - even deflation has been milder than the deflationists predicted - so it will take some time to go from zero to excessive.

The second argument is self-contradicting. If traders exit bonds to find higher yields, then the bonds will drop in price and thus regain a higher yield. That will keep marginal exits limited. Put another way, BOJ will displace some traders, but others will remain in and the bonds will stay at whatever equilibrium price is warranted by their default safety and yield.

The third does not recognize the major bond buyers. The key point of this enormous easing is that BOJ will be the buyer of last resort - and first resort too. Given the quantities discussed, BOJ could buy essentially all of the new public debt, there will be no lack of demand. It's important to note that foreign buyers of Japanese debt make up only a small portion of the Japanese debt market. Even if they all left, it would make little difference. The next point - yen rates - is less relevant to those accounting in yen. For banks/people/companies counting in yen, there is no loss of value in a depreciating yen. Rather, they will see their non-yen assets appreciating. Capital flows suggest this has been happening - the net capital flow has been about US$6 billion per week into Japan as Japanese firms take profits on their foreign holdings.

Why Japan may get more deflation

As big as the BOJ's quantitative easing plan is - aiming to double the monetary base in two years - it has tried large easing plans before. From 2001 to end 2003, the monetary base was expanded by 70%, yet deflation persisted (graph from Krugman's blog):

The trouble here is that traditional QE methods - buying government bonds from banks - does not "put money in the economy." BOJ takes one asset - bonds - and gives out another - account balance with BOJ. If the bank getting the additional reserves doesn't lend, then the money just sits there the way the bond did. Interest rates drop slightly, but no consumption occurs. This is precisely to be expected in a zero-lower-bound or balance sheet recession. As can be seen in the charts below, Japanese companies borrowed until about 1990 and consumers borrowed until 1997. Weak economic growth caused corporate to deleverage and the property crash caused everyone else to deleverage. No matter how cheap the BOJ makes money, the Japanese are more likely to save than to spend.

If the current quantitative easing followed the same pattern, taking a few more basis points off long-term loans, nothing is going to change. There is still no buyer of consumer products to drive up the prices.

The deflation trap is especially hard to get rid of when consumers have strong expectations of future deflation. If consumers expect cheaper goods in the future they don't spend now; and that repeats in the future. Thus to break out of deflation, the BOJ must create credible expectations that inflation will occur. Here the BOJ is fighting its own history - so far in the 'lost decade' the Japanese government has been very reliable in contracting policy at the first hint of inflation (and ironically creating extra public debt). Will Abenomics have the political will to 'irresponsibly' continue easing even if inflation starts to take hold or will BOJ clamp down and bring back deflation?

Finally, the BOJ's first report card doesn't look good. A 0.5% deflation rate during March is not only the wrong direction, but worse than February. In fact, deflation has increased not just in March, but ever since Abe's election.

Why Japan may get inflation

The current plan is not just swapping cash for bonds. The Bank of Japan is planning to directly support the Nikkei through ETF purchases. Though not extraordinary in size - about US$1 billion per month - the expectation effect is already clear. If the increase in the Nikkei - about 50% over the last six months - is not lost in a market crash, the wealth effect could be enough to generate inflation.

Japan is also planning fiscal stimulus. As expressed above, strictly monetary stimulus may fail to promote spending in a balance sheet recession. However, if the government commits to spending it will contribute to price and wage increases, and may kick-start expenditures by those employed on government work. I cannot say if the planned fiscal stimulus will be sufficient (Singapore was successful with 10% of GDP), but Abe's 'whatever it takes' stance gives one reason to be optimistic.

The private sector deleveraging has continued throughout the lost decade. The private sector now has less debt than it did before the 1980's boom. This suggests at least the possibility that the Japanese may begin to change behavior and start spending.

One of the most critical factors in changing economic behavior is changing expectations. Deflation is very likely when people expect it. If people can be convinced that the government and BOJ will be persistently irresponsible in handling the yen - i.e. running the printing press without fail - they will begin to expect inflation and will spend, thus making it a self-fulfilling prophecy. This is why a change of the BOJ governor was necessary - the past governors could not be counted on to continue quantitative easing until inflation has firmly taken hold; Haruhiko Kuroda is sufficiently dovish to be credible in his plans.

A falling exchange rate also has a similar effect reducing interest rates (and doesn't have a zero lower bound issue). In the last six months the yen has dropped some 20% against the dollar (more on this below), which may create some imported inflation in consumer prices and in producer import costs.

Finally, some high-profile institutions have been convinced. The BOJ has, predictably, raised its expected future inflation rates. More interestingly, IMF has released forecasts of 0.1% inflation this year and a whopping 3% next year. Japan's third-largest life-insurer is now moving US$5billion into foreign bonds - some of it unhedged.

And what about the earlier note that deflation has gotten worse? We should keep in mind that the easing plan has been in effect barely one month and is unlikely to have had much real effect on the most recent economic statistics. Additionally the new fiscal budget does not come into effect until summer and it will likely take some time for the extra spending to influence consumer prices.

Market impacts

I suspect the yen value of Japanese government bonds (NYSEARCA:JGBL) (NYSEARCA:JGBT) is unlikely to change much. Increased BOJ purchases will be offset by some investors leaving that market, leaving bonds roughly the same or slightly higher. For the reasons given above I think a bond crash is highly unlikely. Shorts on government bonds (NYSEARCA:JGBS) (NYSEARCA:JGBD) are likely to be sorely disappointed. The volatility in the Japanese government bond market just after the easing announcement appears to be due to either one large seller or uncertainty about the the details, which was quickly resolved (see below). I don't see this market having much profit opportunity whether Japan gets inflation or not.

Japanese stocks (NYSEARCA:EWJ) of course have been rocketing upwards. If you believe that Abenomics will finally solve Japan's economic malaise over the long term - and that inflation will take hold - a return to boom times is possible. Additionally, it usually pays to be on the same side as the central bank - in this case buying. A better way to take advantage of re-emerging inflation and economic growth would be a currency hedged investment (NYSEARCA:DXJ). As I discuss next, a return to inflation is likely to mean a drop in currency value, so hedging is a good idea. On the other hand, the Nikkei has had a habit of rocketing up only to fall back to Earth. So if you don't think Abe will fix the economy...

Lastly, talk of money printing and desiring inflation will always affect exchange rates. This suggests inflation is expected over the longer term - and that Friday's deflation report caused a 1.5% correction supports the view that yen trades (NYSEARCA:FXY) (NYSEARCA:YCS) are looking for future inflation. Further in the long run we may expect Japanese insurers to move capital out of Japan - though in the short term they are bringing profits back to Japan. The profit taken may account for the yen strengthening every time it gets close to the 100 mark.

It is tempting to think that the yen's drop over the last few months is spectacular and unlikely to continue. But a longer-term view gives a different perspective:

The U.S. dollar dropped compared with the yen over the course of the great recession. This could be attributed to QE or a Japan-like recession in the U.S. The weak US economy ironically made Japan look stable and produced an appreciating currency. Now that BOJ and Abe are attempting to outdo the Fed- and easily outdoing congress - the yen is likely to lose its image of stability. As the U.S. economy gradually recovers and Japan gradually gets inflation, optimistically I see the yen returning to pre-crisis levels around 115.

Disclosure: I am short yen. 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.