The Breadth Of Shortage

by: Alhambra Investment Partners

By Jeffrey P. Snider

The yield on the Japanese government's 10-year paper traded negative yesterday for the 17th straight session. When Haruhiko Kuroda first announced his negative rate experimentation, the 10-year JGB was low but still safely positive, yielding 22.9 bps on January 28. It would be negative for the first time on February 9 right as the rest of the world started to perk back up, and then fall below zero on an apparently durable basis February 24. At the lowest point, the bond's yield was -10.3 bps on March 8.

That raises the question as to who in their right mind is buying 10-year bonds at -10 bps? And why are they continuing to do so?

Part of the answer can be found in NIRP itself, as even the BoJ's three-tiered system only penalizes "idle" bank reserves and only so far. Rolling out of the equivalent of the Japanese deposit account and into a government bond escapes that monetary "tax." The fact that such an effort is pushing up to 10 years in maturity demonstrates serious distortion (as of March 17, the 15-year JGB is safely positive at 15.7 bps but that yield, too, is pushing lower).

To roll into such long maturity negative yields, however, defies somewhat the point of holding even inert bank "reserves" in the first place. It adds elements of risk into the mix that go beyond trying to find the least costly monetary nothingness. That suggests something else working in concert to Japan's banks.

Trading in Japan for today (meaning March 18 on that side of the dateline) shows that "something" else. The Japanese bond market saw what Bloomberg describes as "panic buying."

Investors at home and abroad can't get enough 10-year Japanese government bonds, driving the yield to an unprecedented minus 0.135 percent.

Yields sank across the curve Friday after the Bank of Japan's operation to buy long-term debt met the lowest investor participation on record, spurring what Bank of America Merrill Lynch strategist Shuichi Ohsaki called "panic buying."

As the article correctly points out, trading pushed the yields on so many bonds below the -10 bps NIRP threshold, meaning that this is far more than Kuroda's deepening mistake. The answer is the huge discount to "borrow yen", meaning cross currency basis swaps. The negative premium was again at a record high in this trading, which means that investors only need a safe haven to park their "borrowed yen" while they pocket a huge spread on the swap. Who is making out in all this? Anyone with spare "dollars."

The negative yen basis swap acts like leverage where even yields on the interim "investment" are negative. Any speculator or bank with spare "dollars" could lend them in a yen basis swap meaning an exchange into yen. Because you end up with yen you are forced into some really bad investment choices such as slightly negative 5-year government bonds, but that is just part of the cost of keeping risk on your yen side low. Instead, the real money is made in the basis swap itself since it now trades so highly negative. The very fact of that basis swap spread means a huge premium on spare dollars; which is another way of saying there is a "dollar" shortage. Because of the shortage and its premium, you can swap into yen and invest in negative yielding JGBs in size and still make out handsomely. There has been, in fact, a rush of foreign "money" into Japan to take advantage of this dollar shortage; the fact that there has been such enthusiasm and it still has not alleviated the imbalance proves scale and intractability. [emphasis added]

It's not just yen, either. Euro basis swaps are negative (though not anywhere near, yet, 2011) as are sterling. It makes quite the coincidence of indications, including negative swap spreads, to which we can now add repo collateral holders. The most advantageous financial position in all the world right now is anyone with spare "dollars."

The whole world is offering huge premiums in all sorts of formats, methods and expressions of "dollars" and yet "somehow" nobody wishes to offer them. If the US$ system were truly fine, then what a time to be a dollar owner. It seems to be, at the moment, the most valuable commodity around even when its form can be as disparate as a hugely negative basis swap to a loan to a cash-starved Egyptian company at 10 pounds to the dollar (funded at around 8). The world is the dollar's opportunity, so where are they all? This is exactly what the "rising dollar" means, where something in increasingly short supply leads not just to higher prices but actually increasing demand, too. In other words, a "short squeeze."

Individual banks have practically declared themselves uninterested anymore in "investment banking." In isolation or ceteris paribus that is terrific news, as the global economy needs less IB squishiness and financialism in favor of more and actual intermediation. However, going from A to B without something already in place is a drastic gamble, as there is no ceteris paribus in the real world. Bank balance sheets are "dollars"; they don't want to provide them; QED "dollar shortage." The fact that stocks, junk bonds and oil are all back in the sun doesn't change that fundamental backdrop; indeed, it forgets that over this "rising dollar" squeeze or "run" that sunshine on these markets has been far more the exception. Nothing goes in a straight line.

What's most concerning about the yen avenue here in currency basis swaps is that they are on the "other" side of all this, also short the dollar as funding or borrowing costs skyrocket. If I am correct about Japanese banks being a major conduit for China's "dollar short", then this will only enflame that retreat. Like negative swap spreads, the fact that these huge premiums are not being massively arb-ed by banks anywhere and everywhere only suggests internal-driven constraint. Though there has been a rush of speculation in yen, thus the JGBs, the negative basis persists meaning any new lending in "dollars" doesn't even replace whatever retreat from Japanese banks formerly providing them further down the eurodollar system.

When the PBOC was first forced into "devaluation" by so many unseen "dollar" problems last August, I wrote:

The connection Reuters failed to make is clear in this "dollar" context; 6-year low in oil plus turmoil in China funding equals bad "dollar" pitching even lower. There is no currency war save one: the "dollar" is in a total war with itself, meaning everything will be a casualty at some point. The list of central banks falling victim grows bigger.

Nothing has really changed since then except that more indications suggest the same and to even greater magnitudes - including that list of central banks which has since added the ECB's past QE and once more the Bank of Japan and its new NIRP. There really is only one currency war and everyone is involved whether they want to see it or not (most do not). I don't know how many more blaring, immense warnings it will take, but it all adds up in only that direction.