Sean Maher's  Instablog

· The Japanese have a history of proving inventive faced with desperate circumstances, and in fact rarely move forward without their backs to the wall, given inherent cultural inertia. The exceptional factors which have allowed endless deficits, notably the recycling of corporate retained earnings into JGBs to offset falling household savings, and a surprisingly resilient current account surplus despite a long-term deterioration in the country's comparative advantage in manufacturing, are now coming to an end. Near term, the BOJ slashed its economic growth forecast for fiscal year 2012-13 to 1.5% from 2.2% and decided to raise its asset buying and lending program. It was the first time since 2003 that the conservative BOJ has eased policy for two months in a row.

· In another radical shift, the central bank issued a joint statement with the government pledging their combined efforts to pull Japan out of deflation. In an unorthodox move (although not dissimilar to a recent BOE bank lending initiative), the BOJ also unveiled a plan to supply banks with unlimited amount of cheap, long-term funds under a new scheme initially set at around 15 trillion yen.Markets reacted with a sense of déjà vu to the latest asset buying plans but this has the potential to be far more significant both in its direct impact on the yen and in the combined determination of the bank and government to stave off another deflationary episode than the consensus thinks. The yen carry trade is back on, backstopped by the BOJ balance sheet…

· While Japan directly paid only $26m for the three Senkaku islands, the indirect economic costs of the resultant escalation of a simmering territorial dispute with China have already amounted to many billions. I covered Japan in a client note on the 9th November, concluding that: '…there have been only three occasions in the past 13 years when investors been more underweight than the current reading of -1.4 standard deviations. On each occasion, Japan has outperformed the MSCI World Index over the following quarter, by an average of 7%. Japan is now about as unfashionable among investors as European assets were back In June, when global investors dismissed the possibility of a radical policy breakthrough. In typically ambiguous Japanese fashion, we're probably seeing one…' While it's early days, the prospect of the LDP returning to power and imposing a hard inflation target on the BOJ has seen local equities show a rare burst of outperformance, despite real GDP contracting by 0.9% in Q3 at an annualized rate, driven by collapsing exports as well as weakening private domestic demand.

· With Japan currently overtaking China as the biggest foreign holder of US Treasuries, the rapidly weakening current account has global implications when the Fed finally stands down its QE program. In fact, as I've highlighted in many notes, from Indonesia to Russia EM official reserve growth is slowing markedly and many capital exporters are moving into chronic current account deficit - a key structural theme is that the clearing price of capital is heading upward through mid-decade on these trends and as China's demographic dividend reverses.

· There is little doubt after the latest trade data that Japan is back in technical recession, with about a half point contraction likely in Q4. Even if we see a very rapid settlement with Beijing post-election (and Noda's exit offers China the opportunity for a face saving deal), a sharp inventory adjustment will be sustained into Q1, adversely impacting corporate profits, but a weaker yen trend as well as extremely bearish investor positioning remain key supports for local equities. Despite outgoing Governor Shirakawa's latest assertion of sacrosanct bank independence, the BOJ is likely to add further stimulus at its next meeting on Dec. 20th, four days after the election, as its forecasts come gradually in line with far weaker private sector inflation and growth expectations.

· For investors, a continued re-rating of Japanese exporters in line with what will increasingly be seen as a secular turning point for the 'safe haven' yen is a good bet, alongside a steady rise in JGB 10-year yields toward 2% by end 2013 from a current level just above 70bps. Japanese equities now yield over three times more than bonds, so not only is foreign portfolio positioning unusually bearish, but there is scope for domestic retail reallocation as well. While Japan has been a classic value trap over the past couple of decades (with its economy caught in a liquidity one), increasing desperation from policymakers running out of options offers a window of opportunity to profit…

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Sometimes a bizarre event seems to capture the madness of the times, and this news  from Bloomberg fits the bill. A couple of Asians carrying Japanese passports have been arrested by Italian border police with a trunk load of non-negotiable US bearer bonds to the value of $134bn. It's not as crazy as it sounds. The Fed did actually issue bearer bonds up to the value of $500m each until the late 1960's (when electronic record keeping superseded them), and these look on initial examination like the genuine article. If they are real, they could only have come from a handful of countries with sufficient dollar reserves to have accumulated such a huge sum, notably China and Japan. In the much more likely event they are fakes, it would be the biggest such operation in history, and would almost certainly imply state involvement, with North Korea the prime suspect. Either way, even in the context of the trillions we have become accustomed to seeing tossed around in bailout plans, we're talking serious money. The presentation of huge sums in US bearer bonds isn't unprecedented in fact, even if it is in scale. In 2008, two bearer bonds to the value of $1bn were presented in Singapore, and upon authentification the receipt from the Federal Reserve was signed by Ben Bernanke himself.

The significance of this story is that it highlights the very topical importance of retaining investor faith in a fiat currency; if the supply of money is suddenly perceived to be vastly higher than believed, whether as a result of policy or widespread fraud, confidence can be badly shaken. If this was another crazy North Korean forgery scheme, it gets close to a casus belli on top of the relentless provocation of the US in recent months. If, in the less likely but possible case that an Asian country were genuinely but secretly attempting to dump dollar paper for other assets, the implications are very disturbing for international markets.

One final possibility for the conspiracy theorists. During WW2 several countries printed and put in circulation perfectly counterfeit enemy money (Hitler had a whole program dedicated to faking Sterling which he planned to smuggle into Britain to cause economic chaos). But it is also historically established that some central banks during the war like the Bank of Italy, issued the same securities twice ( ie identical registered number and code). This way they could print more money with legal tender than they officially declared. Surely that couldn't happen today, could it?  I suspect that this will prove a story worth following.