Japan's Markets - Moving Toward a Decision Point

by: Acting Man

Triangles Running Out of Real Estate

Both the Japanese yen and the Nikkei have spent several months building large triangle formations, which are creeping ever closer to their respective apexes. Let us first look at a daily chart of the yen (in inverse notation, i.e., down means a weaker yen):

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The triangle in the yen is tightening ever more.

Given the size of this triangle, a very strong move must be expected once prices break out from it. The direction of the move is fairly uncertain in the case of a symmetrical triangle, except to say that normally, the probability is somewhat higher that it will turn into a continuation formation – which would indicate that a sharp weakening of the yen probably lies ahead. What argues against this view is that in spite of heavy monetary pumping by the BoJ, money supply growth in Japan remains subdued relative to US money supply growth. However, there is one reason why a sharp move downward move in the yen could occur anyway: a crisis.

In Japan, we see the potential for either a fiscal crisis, or a crisis due to the legacy of the March 2011 tsunami: the softly glowing Fukushima nuclear plant. As we have previously discussed, the removal of spent fuel rods from the upper floors of the tilting building that houses reactor number four is potentially quite dangerous and if this daunting task proves to be accident-prone, a catastrophic worsening of the situation cannot be ruled out (from "maximum credible accident" to "sauve qui peut"). For details on this fuel rod removal problem see “Fukushima – Still Getting Out of Hand”.

Ironically, a crisis – depending on its nature – could also lead to a sharp upward revaluation of the yen, if it leads to repatriation flows. If we were to guess, then a fiscal crisis would be yen negative, whereas any other type of crisis could actually be yen positive, at least in the short term. This is really hard to gauge in advance.

On the weekly chart of the yen, we can see even more clearly how large the triangle really is (its beginning must actually be dated with March) and how tight the triangle formation is becoming now (this time in the "normal" notation, i.e., higher values denote a weaker yen):

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Yen weekly.

Naturally, the Bollinger bands are recently contracting sharply as well, as yen volatility gradually subsides – which in turn is also a sign that a sharp move is imminent.

The Nikkei sports a triangle as well, which is a mirror image of the triangle in the yen (the Nikkei tends to move up whenever the yen moves down and vice versa, and it is actually hard to tell which is regarded as "cause" and which as "effect" by traders).

The main difference is that the Nikkei's triangle is slightly tilting toward being an ascending rather than a symmetrical triangle, as the July, September and October peaks all occurred at roughly the same level, while the lows in June, August and October have been at progressively higher levels. Normally we would conclude that this is bullish. On the other hand, a rising Nikkei cannot be reconciled with the idea of "crisis", so we have a bit of a dilemma here.

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Nikkei, daily – a triangle that is a mirror image of the yen's and coming ever closer to a resolution as well.

Looking at a weekly continuation chart of the Nikkei future, one is also inclined to regard the triangle as an interruption of an ongoing uptrend, given that such a large base has been built prior to the beginning of the 2012-2013 rally.

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Nikkei futures contract, weekly.

On the other hand, Japan's stock market is a past master at delivering false dawns. Many a promising looking advance was eventually given back again. It is open to question whether the inflationary "Abenomics" policy will suffice to alter this well-ingrained pattern.

Money Supply and the JGB Market

Looking at a chart of Japan's monetary base, one could be forgiven to think that one is perhaps seeing a data series from the Weimar Republic.

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Japan's monetary base: going vertical.

There is a noteworthy bump in this chart, when Japan's central bank briefly tried to roll back "QE" in 2006 and lowered the amount of base money by nearly 25% overnight. What happened subsequently is precisely what we expect to happen if the Federal Reserve ever decides to 'pull back'. By the way, we believe it may not be a coincidence that the BoJ's attempt to tighten happened to almost precisely coincide with the peak in US real estate prices. One thing the reduction in free bank reserves seemed to have a dampening effect on was the yen carry trade that was all the rage at the time. Of course one must keep in mind that money supply growth was slowing down markedly in all the major currency areas concurrently at the time.

Anyway, the huge advance in Japan's monetary base has not had a very big effect on money supply growth so far. Below is a chart showing the annualized growth rate of M2, which actually happens to track Japanese money TMS quite closely. Note the enormous difference in money supply growth prior to the bursting of the 1980s bubble and thereafter.

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Japanese money supply M2 – annualized growth rate.

The huge decline in money supply growth in post-bubble Japan has been due to the reduction in outstanding bank credit, which so to speak "sabotaged" the BoJ's "reflation" attempts. However, recently money supply growth has reached the upper boundary of its post bubble range at nearly 4% (money TMS growth is slightly higher at 4.7% annualized, but recently slowing again).

How to explain this stark discrepancy between base money growth and money supply growth? In our opinion it has to do with how the BoJ operates. Apparently the beneficiaries of the bulk of its bond buying are commercial banks, so that excess bank reserves are growing. On the other hand, the BoJ also buys REITS in the stock market, so there is also a bit of money leaking out to non-banks, which helps grow extant deposit money to a small extent. However, in order for the easing to actually lead to stronger money supply growth, banks would need to greatly step up their inflationary lending. Private banks have steadfastly refused to do that thus far.

They are however lately stocking up on JGBs again, in other words, they are actively helping to monetize the government's growing debtberg. As a result, JGBs have regained their strength (see also our recent discussion of the "Kuroda Put" in “Buried by Abenomics” – Japanese banks are fearless buyers of JGBs because they are relying on the BoJ keeping this market under control).

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Japan's growing public debtberg.

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10 year JGB, weekly continuation of nearest futures contract.

In fact, JGBs are trading close to their all time highs again – so there is definitely no sense of 'crisis' in this market, at least not yet. Market participants also seem unwilling to discount even the remotest possibility of the BoJ achieving its "inflation" target, in spite of the fact that current 10 year yields are already well below the most recently reported annualized increases in CPI (which in turn are largely a function of rising energy prices and rising import prices more generally due to the weaker yen).

However, we have a nagging feeling that once the breakout move in yen and Nikkei comes, we will see a big move in the JGB market as well. There is a rising wedge on the chart (beginning with the 2013 low) that looks decidedly bearish to us. Initially it won't be possible to tell whether a decline in JGBs merely reflects rising inflation expectations (and associated 'growth' expectations), or something more sinister. However, rising interest rates would soon pose a major problem for Japan's government, which even with 10-year rates at less than 0.6% uses a full quarter of its tax revenues merely to service interest on its debt.


As we always say when discussing Japan, the clock is ticking. Or as the Japanese would say: カチカチ (tic-toc, kachikachi)

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