Japan's 'Reflation' Policy - Upsetting Global Market Balance?

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Includes: EWJ
by: Acting Man

The BoJ "Disappoints"

At its June meeting, the Bank of Japan decided to leave its inflationary policy "as is". This was greeted with disappointment by the markets, as some market participants had apparently been hoping that the BoJ would announce fresh measures to 'soften volatility in the JGB market" – read: keep that market from imploding. At least that is what the financial media have reported.

Ironically, this actually lends support to JGBs, as they are bought almost reflexively whenever the Nikkei declines and the yen strengthens. However, it no longer happens to the same degree as before, and in spite of briefly spiking above the lateral resistance at 143 which we have mentioned a few times, the 10 year JGB future has quickly retreated back below it.


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A 30 minute chart of the June JGB future shows the brief spike above resistance and the subsequent return back below it.


On a weekly continuous chart of the 10 year JGB future, the recent volatility is even more strikingly evident. It seems to us that such a vast increase of volatility near an all time high cannot portend anything good for the market.


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JGB, continuous futures chart, weekly candlesticks. Note the huge increase in short term volatility since the BoJ's new "reflation" policy under Kuroda has begun.


Since the BoJ "disappointed" the markets by not announcing any additional measures at its June meeting, the Nikkei's decline has resumed with some gusto (it has just lost another 613 points overnight) and the yen has begun to unexpectedly strengthen rather swiftly. Reportedly, a number of newly adopted yen carry trades have been forced to be unwound, as stop points are tripped by the suddenly resurgent yen.


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The Nikkei, daily. At 12,500, it has now reached the 50% retracement level of its rally from the November 2012 low. The close on Wednesday was the lowest since the decline began.


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After a relentless decline that began once it became clear that Shinzo Abe would win the election, the yen is suddenly changing course again rather swiftly. It is now almost back to the level it inhabited when the BoJ's new policy was first announced in early April. However, it is possible that Abe has actually less to do with it than it appears.


Shades of 1997?

We believe it is noteworthy that market volatility has increased globally ever since the BoJ's extra-inflationary program has begun. First of all, a declining yen invites carry trades, but this conversely raises the risk of an unwinding of such trades every time the yen rallies. Consider the fact that the recent severe rout in emerging market currencies and bonds happened to coincide with the yen's rally. There is probably a feedback loop informing these moves.

It should however also be pointed out that the yen's weakness has not only been a result of the perception that Japan's policymakers want the yen to weaken. After all, they have intervened against yen strength before and often to no avail. Moreover, as we have tirelessly pointed out, even with the recent inflationary efforts, Japan's money supply growth rate remains the lowest among the major developed nations. So it is a good bet that the secondary or maybe even the main motive behind the yen's decline is the "pricing out of tail risk" that began with the ECB's LTROs in late 2011 and has then intensified after its "OMT" announcement. Gold and the Swiss Franc have both been pressured by this loss of a 'tail risk premium" as well. In short, the moves in the yen may owe more to the ECB than the BoJ.

However, in spite of the rebound, the yen is still down quite a bit from its 2011 high. A weekly chart puts the recent rally in perspective:


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The yen, weekly. In spite of the recent rebound, the yen remains down quite a bit from its 2011 high.


Several things are worth noting here. For one thing, a rising yen is likely a sign that 'tail risk" is once again thought to be rising. It is not merely "disappointment with the BoJ" as the headlines claim. Rather, there is a flight from "peripheral risk", and this pushes the yen up.

The second thing worth pointing out is that the last time the yen suffered a bout of extended weakness, namely after its 1995 spike high, it very likely helped to trigger the Asian crisis (incidentally, China also devalued the yuan sharply in 1994). A number of Asian countries had pegged their currencies to the US dollar, and so the Greenspan boom was replicated in them. However, as the yen weakened and their currencies remained firm, their current account and trade deficits widened ever further, requiring more and more inflows of money from abroad. When foreign investors became suspicious of the sustainability of the boom, they fled and the Asian crisis was the result.

Something along similar lines may well happen again, and note that this time it is China stands out as the country with one of the strongest currencies in Asia.

Japan's reflation policy is quite possibly helping to undermine boom conditions elsewhere, as there can be no doubt that the weak yen has sizable effects both on portfolio flows and real economic activity across Asia.

One thing is certain: recent market moves indicate strongly that there is a "disturbance in the force". As will be seen in the next post, there are also a few slightly alarming moves in credit markets in the euro area and neighboring countries observable.

Addendum: Related Charts

  1. JGB trendline support and MACD/Price divergence

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As can be seen here, apart from the break of lateral support, the JGB is also close to violating an important long term trendline. Note the very large long term price/MACD divergence.


  1. CDS on debt of commodity producers

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5 year CDS on the senior debt of four major commodity producers [ Vale (NYSE:VALE) , Rio Tinto (NYSE:RIO), Xstrata (OTC:XSRAF) and BHP Billiton (NYSE:BHP)]; Vale and Rio both stand out lately, but these four are always directionally linked. Vale is probable held to be especially vulnerable due to its iron ore focus and the resultant dependence on China's steel industry.


  1. CDS on the debt of Australian Banks

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5 year CDS on the senior debt of Australia's "big four" banks – as Mish recently pointed out, the Australian dollar's slump has intensified following some bad news on mortgage credit growth and a surge in insolvencies. Australia's housing bubble is closely linked to the China/commodities boom, so the rise in these CDS can be seen as an indirect warning sign regarding China.


  1. CDS on JGBs

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5 year CDS on JGBs (the white line) and the sovereign debt of France, Belgium and Ireland. CDS on JGBs continue their recent "decoupling" and while 82 basis points are not yet a catastrophic level, it is quite a lot considering their low yield.


Charts by: Bloomberg, Investing.com, BarCharts, BigCharts