Dancing While the Music Plays: “You Will Have No Choice But to Buy”
In mid April, Reuters reported that there hadn't been any trades in 10 year JGBs for a day and a half – shortly after the BoJs holdings of JGBs topped 200 trillion yen for the first time. There once used to be a limit to "QE" by the BoJ: it wasn't allowed to buy long term JGBs in excess of the amount of yen bank notes in circulation. This rule, which was introduced in 2001, was repealed "temporarily" with the beginning of Kuroda's massive "QE" operation, although it had already been broken almost a year earlier. Considering that Japan's bank notes in circulation amount to about 80 trillion yen, the limit has by now obviously been left completely in the dust. In fact, since 1999, the BoJ has gradually repealed all the "JGB purchase rules" that were put in place in 1967. Once it couldn't buy a government bond until one year after its issuance for instance, and only 20 issues of 10 and 20 year bonds were eligible. By now, all bonds are eligible, and the "one year rule" no longer applies. By the end of 2013, the BoJ's long term JGB holdings amounted to 1.5 times bank notes in circulation:
BoJ's long term JGB holdings vs. bank notes in circulation.
Here are a few excerpts from the Reuters article mentioned above. We find the comments about the paucity of choices allegedly faced by market participants especially interesting:
“The Bank of Japan's massive purchases of government debt hit a milestone this week, sucking liquidity out of the market to such an extent that the benchmark 10-year bond went untraded for more than a day, the first time in 13 years.
Data from the BOJ late on Monday showed its holding of Japanese government bonds topped 200 trillion yen ($1.96 trillion), or about 20 percent of outstanding issuance – up by more than half from 125 trillion yen about a year ago.
The fall in market liquidity looks set to intensify as the BOJ has vowed to continue its aggressive buying for at least another year, with market players expecting it to expand its easing some time later this year.
"Everybody thinks the market is not going to move for the time being because of the purchase by our dear customer, the BOJ," said a trader at a major Japanese brokerage.
The BOJ stepped up its bond buying last April when Haruhiko Kuroda became its governor, vowing to take radical easing steps to end deflation once and for all. The increasing dominance of the BOJ in the market, however, resulted in shortage of tradable bonds in the market, reducing trading flows between market players. Brokers are reluctant to go short, fearing that they cannot buy back when they want. On the other hand, few investors are willing to chase prices higher, when the 10-year bonds yield about 0.6 percent
The upshot was that the average daily trading band of 10-year JGB futures price so far this month is 0.15, compared to about 0.50 in the 10-year U.S. Treasury notes futures. The current 10-year cash bonds saw its first trade of the week on Tuesday afternoon, having gone untraded for more than a day and a half. Trade volume in the benchmark cash bonds so far this month dropped to less than one trillion yen, down about 70 percent from the same period last year.
"Everybody is holding off buying now only because they want to buy at a higher yield. But in the end, the only strategy you can take under an environment like this is buy more given the shortage of what you can buy," said Takeo Okuhara, fund manager at Daiwa SB Investments.
One reason many investors are cautious about buying despite tight market conditions is the trauma of sharp reversal in the market rally after the BOJ adopted the current policy last April. The 10-year JGB yield hit a record low of 0.315 percent on the following day after the BOJ's easing, only to jump back to 1.0 percent about a month later — a scenario market players think can be repeated, given the fall in liquidity.
"I know this could end badly. But if you are in this market, you will have no choice but to buy," Daiwa SB's Okuhara said.”
This sounds like a Japanese version of former Citigroup CEO Chuck Prince's famous saying “As long as the music is playing, you have to dance. We are still dancing”. He uttered this sometime in 2007 – about a year later, his institution was essentially insolvent from all its "dancing". It turned out that when the music stopped playing in this particular game of musical chairs, not enough chairs were left to seat even the largest and most respected "dancers".
We find the comments above especially interesting in view of what Kyle Bass has pointed out in a recent presentation that included remarks on Japan. A video of the presentation can be seen below, the part about Japan starts at the 6:50 mark. It's a presentation by Kyle Bass delivered on April 22.
Bass theorizes that the BoJ will eventually have to double its buying of JGBs in order to buy up all the JGBs Japanese institutional investors will presumably sell if the 2% CPI inflation target is actually reached or if it is widely expected that it will be reached (not to mention so as to avoid Japan becoming dependent on foreign funding due to its lately growing current account deficit). According to Bass, Japanese banks are already selling JGBs, and this is no doubt correct (they are selling to the BoJ). We found a chart showing the situation as of the end of Q2 2013, which depicts the JGB holdings of Japan's banks vs. BoJ holdings since 2000:
In mid 2013, the BoJ's JGB holdings exceeded those of banks for the first time in five years.
Bass noted that the BoJ's actions are bound to weaken the yen in the long term and will eventually entail a "loss of control" over the level of interest rates.
Most interesting though was his reply to the final question in the "Q&A" following the presentation. He was asked whether cultural proclivities would keep Japanese institutions from selling their JGBs. He notes that his fund surveyed 1,000 different investors in Japan asking them whether they would rather hold bonds out of a feeling of patriotic duty if interest rates were to rise, or if they would sell. Apparently only 8% would actually be prepared to lose money out of a sense of patriotic duty – the rest would "run, not walk".
A Huge Ponzi Scheme
We have frequently pointed out the contradictions inherent in the Abenomics plan in these pages, specifically the fact that "success" would mean that interest rates on JGBs must eventually rise considerably. However, in that event, even more debt monetization should be expected, as Japan's government already needs to spend 25% of its annual budget merely to service interest payments on its existing debt – n.b., with 10 year JGBs yielding a mere 0.6%. Meanwhile, a full 46% of the government's annual revenues stem from new debt issuance (see the chart below, detailing the 2013 budget). In essence, it is a Ponzi scheme and has been one for some time (note here that public debts in the modern-day regulatory democracies amount to Ponzi schemes everywhere, only Japan's is by far the most advanced. It is very likely beyond the point of no return).
Japan's 2013 general budget. Note that the Japanese treasury receives the BoJ's profits every year. This would change if interest rates were to rise, as then rising payments on excess reserves would soon eat up all the BoJ's "profits".
With the BoJ buying ever more debt, Japan's government debt has only become an even bigger Ponzi scheme and all indications are that this trend will accelerate. So one wonders, even if long term JGBs only trade rarely these days and the BoJ is a giant bidder distorting the market, how long can this picture of tranquility be maintained?
10 year JGB future, weekly – still trading close to its all time highs.
Due to the BoJ's modus operandi, the effect of "QE" on the money supply is actually not very pronounced – mainly it is increasing excess bank reserves, rendering the fraction of the country's money supply that consists of "covered" money substitutes ever bigger (since bank reserves deposited with the central bank essentially represent the banks" cash assets ex vault cash, and will be transformed into bank notes should depositors withdraw money from their demand accounts). Only to the extent that the BoJ buys assets from non-banks (such as when it e.g. buys REIT shares on the stock exchange), does deposit money immediately increase along with bank reserves.
As a result, money supply growth in Japan is not as large as one might think. The most recent year-on-year growth rate of narrow money TMS-1 (currency plus demand deposits) is at 5%, which is actually a lot for Japan, but considerably less than both US and euro area money supply growth. However, as the chart below reveals, money supply growth in Japan does definitely respond to QE or the lack thereof. When the BoJ reduced its monetary base by 25% in 2006, money supply growth collapsed into negative territory two years later:
Year-on-year growth rate of Japan's true money supply
However, the purchasing power of money not only depends on its supply, but also on the demand for money and influences from the goods side (the more goods and services are produced, the lower their prices should be). The factor that seems most important in assessing Japan's case is probably the demand for money (cash balances). If the public becomes convinced that the inflationary policy will "succeed" and that the BoJ will be increasingly forced to monetize government debt to keep the government afloat, there could be a sudden change in the demand for money. At the moment, the recent increase in consumer prices probably has the opposite effect. Real incomes are declining and people are therefore altering their spending patterns – more of their income is spent on non-discretionary items, so the prices of other goods will come under pressure. The demand for money may well temporarily rise in reaction to the decline in real incomes.
However, it seems quite likely that a continuation of the "QE" policy will eventually lead to a reassessment of the situation by a critical mass of yen holders – especially if Kyle Bass' prediction that the yen is bound to weaken considerably further comes to pass. Since not everyone can reduce their cash balances at the same time – someone must end up holding the cash – such a reassessment would likely lead to a rapid decline in the yen's purchasing power. In other words, the currency's purchasing power would "catch up" with the money supply inflation that has already occurred up to that point.
Kyle Bass is probably on to something: the day when the famous "widow maker" trade of trying to make money from shorting JGBs could become a very enticing proposition is probably a lot closer. Obviously, with the BoJ buying enormous amounts of JGBs at the moment, the day of reckoning has been postponed further. At the same time, this very policy is laying the foundation for an all the more spectacular denouement down the road.
Charts by barcharts, Japan Center for Economic Research, Bank of Japan, Kyodo Graphics