"For 20 long years of deflation, Japan suffered a deep loss of confidence. It is now time to become an engine of economic growth."
Those are the words of Shinzo Abe, the Prime Minister of Japan.
But Mr. Abe failed to heed the words of another prime minister, Winston Churchill:
"There is no worse course in leadership than to hold out false hopes soon to be swept away."
Now Japan is an engine not of growth, but pain…
Mr. Abe promised to fix Japan's problems, and fix them quickly, through a shock and awe program of currency devaluation, inflation creation, outright market intervention, and structural reform. Most of this was supposed to happen through the implementation of super-QE (quantitative easing on steroids). But now it has become apparent that 1) structural reform was always going to be the hardest part, and 2) all Mr. Abe may have succeeded in doing was to get a bunch of money managers excited.
The Nikkei started rising late last year, when Mr. Abe started talking about major change in his political platform. This captured the imagination of Japan observers, who have long envisioned a monetary policy blast-off that would unlock the value of Japanese equities.
You can see this in the chart of WisdomTree Japan (NYSEARCA:DXJ), the main U.S. vehicle for non-specialists to play Japan:
We can't help quoting a favored market observation here -- paraphrased from the great George Soros:
Volatility is greatest at turning points, diminishing as a new trend becomes established.
To wit, price action speaks… and when a market pukes up a lung, it is telling you something.
It is your job as trader, investor or speculator to figure out what that something is exactly… but when volatility goes blammo, you can rest assured that something is being said.
Japanese equity markets plummeted in response to Abe's latest speech -- major thumbs down -- and, via Sober Look, we can see that Japanese volatility is at its highest since the Fukushima Disaster:
We see a plausible multi-pronged explanation for what is going on here:
Buy the rumor, sell the news. It was the anticipation of major reform, on monetary and structural fronts, that led to the big bull run in Japanese equities. "Buy the rumor" kicked in as Abenomics went on tour. But once the easy part was over -- making fiat changes in central bank leadership and policy -- only the massively hard part was left. Hence, "sell the news" of super-QE being carried out.
The JGB Sword of Damocles. Japan has amassed gargantuan amounts of debt (in terms of debt to GDP). This in turn has created massive service costs for that mountain of debt. As it turns out, when the Prime Minister and Central Bank Chief promise inflation "no matter what," bonds respond by selling off, thus threatening the recovery with spiking rates. Who'da thunk it?
Carnage at the hedge fund hotel. Lots of money managers (and not just hedgies) piled into Japan in size, looking as hard as they can for the closest thing to a new AAPL in this low yield, low returns environment. Japan seemed to fit the bill perfectly, and everyone got uber-long -- just in time for the trap to spring shut. Now you have the negative feedback loop possibility of Japanese equity sell-offs fueling U.S. equity sell-offs, and vice versa, via the "portfolio contagion" paradigm of linked money manager portfolios.
The brick wall of structural reform. As mentioned, talking about policy was the easy part. Changing out the head of the BOJ (Bank of Japan) was the easy part. Making huge promises of hope and change (sound familiar?) was the easy part. Actually doing something about the deadly serious structural issues keeping Japan in the muck? Brick wall. Good luck breaking through.
Deja Vu All Over Again. Via Todd Harrison/Cullen Roche: "This time is different for Japan, right? Well, maybe. Since the Nikkei stock market bubble burst on New Year's Day 1990 -- at a level of almost 40,000 -- we've see rally attempts of 22%, 37%, 50%, 36%, 60%, 62%, 138% and most recently, from November of last year until late May this year, 84%." Investors have seen this movie before, and the ending has always sucked.
All Aboard the Pain Train
Japan's plunge is spreading plenty of pain, as the WSJ recently reported:
Hedge funds and other overseas buyers pumped more than $25 billion into Tokyo's stock market in the seven months before the Las Vegas conference, according to EPFR Global, which tracks such flows. They were lured by a new government's plans for radical action to boost Japan's economy after two decades of stagnant growth and falling prices known as deflation.
The bet paid off big, at first: The benchmark Nikkei 225 index soared 83% over the seven months to late May. Foreigners fell in love again with a market they had long ago left for dead.
Then, the rally turned with a vengeance. The Nikkei sank 7.3% on Thursday, May 23. It fell 3.2% the next Monday, 5.2% the following Thursday and then 3.7% on Monday of this week. It has fallen 15% in just eight trading days. Mr. Novogratz didn't return phone calls seeking to determine what he has done with his investments.
Ordinarily, this kind of heart-thumping decline is spurred by a crisis, such as Japan's March 2011 earthquake. But this time, no crisis was evident; analysts had trouble explaining why stocks were down.
D'oh! But it is not just caught-out money managers feeling the pain. "Abenomics" is also inherently deflationary -- and potentially painful -- for the rest of the world…
Consider the following:
Abe wants Japan to become an "engine of economic growth."
But a large part of the plan to make this happen is devaluing the currency… bringing about a weaker Japanese yen.
A weaker Japanese yen means more competitive Japanese exports… which means lower profits and wages for major export competitors. This is partly why Ford shuttered its Australia plant after 86 years -- it could no longer compete with Japanese imports (which are at a record) into the Australian market.
South Korea will have no choice but to match, or at least mitigate, Japan's yen devaluation efforts to keep its own export flow competitive. Germany, the world's second largest exporter, is under the same pressure. Not only will currencies get devalued (the old arms race), profit margins will be squeezed. Wages will be frozen or cut.
And thus, via the land of the rising sun, deflation is exported…
The Horror, The Horror (of Rising JGB Yields)
Another serious problem Japan faces is the threat of rising Japanese Government Bond yields.
- As JGBs sell off, interest rates go up.
- If rates rise too much, Japan's economic recovery is crushed.
- If rates rise high enough, Japan can no longer make debt service payments.
Some observers, like Kyle Bass, see the JGB markets as primed for a spectacular crash. But JGBs do not have to "crash" to block Japan's recovery. They simply have to act as a frustration ceiling…
Can the Bank of Japan support the JGB market in a pinch? Yes, most likely.
As with the United States Federal Reserve, the BOJ is "unconstrained." It can buy unlimited quantities of bonds with printed yen… and Abenomics already has a vested interest in seeing the yen fall (which, as we described above, increases Japanese competitiveness by exporting deflation to the rest of the world).
But the ability to buy JGBs will not keep rates from occasionally spiking. It is only a last-ditch means of heading off catastrophe.
And so, in result, you potentially get a really nasty feedback loop:
- JGBs sell off as economic optimism improves.
- This is a function of capital rotating out of JGBs/back into the economy.
- Yields spike on the sell-off.
- Everyone gets freaked out by the spiking yields.
- Rising rates put a damper on the recovery.
- The BOJ intervenes to support the JGB market.
- Wash, rinse, repeat.
- Every time the recovery approaches critical mass, yields spike.
- JGBs thus act as an impenetrable "frustration ceiling."
- The full-blown recovery doesn't happen.
No Easy, Just Hard
From a rational economic perspective, Japan's quandary -- and the looming failure of Abenomics -- makes perfect sense.
No matter how they might wish it to be so, cosmetic changes to monetary policy do not actually facilitate change. Bad monetary policy can make a problem a lot worse, certainly. But actually fix it? No.
That would be like a doctor treating your burst appendix with topical ointment. It just doesn't work.
To truly facilitate change, Japan has to figure out what to do about its rapidly aging population… its marginalization of women in the workforce… its hide-bound, anti-innovative corporate culture… its tendency for Japanese youth to seek bureaucratic "jobs for life" rather then entrepreneurial dynamism… its isolationist (and vaguely racist) attitudes toward immigrant assimilation and cultural engagement with the rest of the world… and a number of other "hard" (extremely hard) problems.
You don't fix any of that stuff with boom-boom monetary policy. Especially not when there is a massive, massive debt overhang acting as a frustration ceiling, causing yields to rise and punch your recovery in the face every time "inflation," even positive inflation, tries to gain traction.
(That is another paradox the Japan bulls never addressed. How does one pull off an aggressive pro-inflation stance -- making inflation happen "no matter what" as Abe and Kuroda promised -- while yet dealing with the Sword of Damocles that is JGB yields? Again, you don't need a crash to make 'em deadly… just a ceiling…)
More Than Just a Gut Check
If our take on Japan is right, then the head-spinning volatility in Japanese equities is more than just a gut check within a bull move. It does not necessarily prelude a "crash" -- a financial Armageddon scenario for Japan -- but it could well suggest that the "buy the rumor, sell the news" portion of the Japan move is over and done, and that the money managers who piled in to "buy the rumor" will now contribute to ongoing reversal as the reality of the "structural reform brick wall" hits home.
Of course, Japanese equities could well crash again too… it wouldn't take a whole lot for long-suffering Japan-watchers to get depressed, much like fans of the Chicago Cubs, who have seen this movie a zillion times.
But the key point is, you don't need a Kyle Bass "crash" of any kind -- just plain old disappointment -- in order for Japan's problems to kill the "risk on" rally that heretofore dominated in 2013.
When the Nikkei was going straight up, Japan was a massive tailwind for risk assets globally.
Now Japan is becoming a massive headwind as sentiment turns south, ugly realities abound (about the challenge of structural reform), and portfolio contagion risks abound.
Our trading take on this:
- Clear out of risk assets for now
- Buckle down and brace for more "risk off" pain
- Go long U.S. Treasuries (for a trade)
If Japan goes tapioca, the biggest benefactor could be U.S. Treasuries (which we bought on June 5th). That is where a large portion of the wounded money will flow. (Another benefactor will be the U.S. dollar, on which we remain bullish.)
The following also helps the UST case -- via the Financial Times:
Some of the world's biggest quant hedge funds have suffered steep losses in the past two weeks following the sell-off in global bond markets.
So-called "CTAs", which use computer models to automatically spot and ride market trends, were caught out as investors anticipated an end to the Federal Reserve's measures to stimulate the US economy, triggering a global rout in fixed income investments.
Bond yields have risen sharply from some of their lowest levels in decades in the past fortnight, leaving funds with large holdings badly hit. Many quant funds have been major buyers of bonds over the past few years as their algorithms have followed yields lower.
"Since mid-May it has been a perfect storm of some of the biggest trends in markets reversing all at once," said a senior manager at one large quant fund. "It has been particularly brutal."
AHL, the $16.4bn flagship fund of Man Group, the world's second-largest hedge fund by assets, lost more than 11 per cent of its net asset value in the past two weeks alone as a result of its huge bond holdings, according to an investor…
Why is the above bullish, not bearish, for USTs? A couple reasons.
First, the sell-off in USTs was predicated on the idea that things were going well -- they aren't -- and that the Fed would soon begin "tapering" aggressively -- they may well not. It was a massive juke… a headfake/wrong-direction.
Second, the serious pain inflicted on various bondholders means that the "weak hands," along with some not-so-weak hands, have experienced a major bloodletting. U.S. Treasuries have experienced a major "wash and rinse" in their violent move to the downside, which has again made them a value proposition.
And last but not least, USTs may be "cheap" again -- good value -- relative to their medium term prospects after their sell-off, and as "risk on" evaporates in the wake of Abenomics disappointment.
On the relative cheapness of Treasuries -- in the context of this particular environment, not historically -- consider the following (via AGF Investments):
…A third major crisis took place in the United States in the 1870s. In both prior American instances, long-term bond yields persisted in a sub-3% range for approximately 20 to 30 years, far more than the four years we have experienced so far, or the seven years that the consensus is expecting. In fact, these are the only periods in the last 200 years during which yields have been below 3%, so the yields we are experiencing are indicative of an abnormal period of prolonged disinflationary economic activity following a financial crisis.
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.