Attention Government Bond Buyers: Japan Has Changed the Rules of the Game

by: Brian Kelly

When the Bank of Japan announced its new Zero Interest Rate Policy and suggested it will buy assets other than Japaneses Government Bonds (JGB’s) it changed the face of global economics. The game changer was the de facto elimination of the so-called “banknote rule”. This rule prohibited the BoJ from buying more debt than banknotes in circulation, thus preventing the BoJ from monetizing the country’s enormous debt. Once the BoJ announced that the new QE fund would not be subject to the banknote rule, it is effectively allowing debt monetization.

Further, overnight, the Japanese government has said it is now considering a sovereign wealth fund which will not only buy domestic assets, but also buy resources across the globe. The given rationale for this move is a desire to reduce Japan’s reliance on China for rare earth elements. However, the implications are much more complex.

Since the BoJ can now monetize Japanese debt, the size of the new SWF is theoretically infinite. The counter-argument is that the SWF will be limited by the ability of Japan to borrow from the public markets – however here is where a giant game of chicken is being played.

The BoJ, and the U.S. Fed, are making the wager that the buyers and holders of their debt must continue to buy or risk multiple asset class collapse. Typical sovereign debt buyers are pension funds, insurance companies and other sovereign nations – all have a vested interest in keeping asset prices high. For example, under the current policy of government support of asset prices, a pension fund must continue to buy sovereign debt if it wants its stock portfolio to remain elevated. In fact, it is not really a choice – in order to meet obligations, pension funds need positive stock returns. Therefore, in a perverted way, pension funds must hold their nose and buy sovereign debt so the government can turn around and prop up asset prices.

This policy, and subsequent incestuous relationship, is the economic equivalent of Mutually Assured Destruction (MAD). The BoJ has played the nuclear card and has forced the hand of all markets participants. The further governments become entrenched in asset markets the bigger the game of chicken. Governments are betting that they hold all the cards and debt will continue to be bought…because it must be bought.

Disclosures: Accounts managed by Kanundrum Capital are long U.S. equities, GLD, TIP.