Investors are slowly but surely adjusting to a world where markets are becoming more uncorrelated and (macro) risks are now local instead of global. We are now living in a bottom-up world and global macroeconomists with a Cassandra bent are becoming an endangered species. Or at least that's the refrain from the Street researchers that I am following.
Apart for some important qualifiers (see below), I tend to agree with this. I certainly never bought the recent misplaced worries about current account deficits in Brazil, India and Indonesia as the potential source of a new eurozone-type crisis. Current account deficits are perfectly normal for these EM economies, and indeed, welcome in a world where everyone wants to export their way to growth. As I argue below, investors have been focusing on the wrong deficits.
The notion of a less correlated world is an interesting narrative in itself because it is starting to emerge as a serious alternative to the Zero Hedge view of the world. In fact, it is worth pondering whether the recent 12 months’ impressive melt-up in developed market equity market isn’t, in part, a contrarian response to the growing faction of Armageddon Preppers that has infiltrated financial market commentary.
For investors, the transition to a world dominated more by bottom-up and local themes would constitute a more benign investment environment relative to a world where the future of financial markets rests on the whims of Greek bureaucrats’ dealings with the IMF. This is the good news. The bad news is that I don’t think investors can completely disregard global macro risks. Specifically, I see two “local” macro risks with the potential to become global; a capital outflows crisis in China and the growing CA deficit in Japan (and its consequences for the JPY and JGB).
In this post, I deal with the latter.
Japanese current account makes no economic sense
There are two reasons why the current account deficit in Japan should command investors’ attention. In the first instance, it is important because it points to further and strong JPY depreciation. Secondly, because it is a necessary, but not sufficient condition for the JGB market to blow up (yields to rise sharply in Japan).
Edward has already dealt with the challenges that Abenomics face over at AFOE. I agree with the main sentiment; especially this:
(…) it seems to me Japan’s problem set is overdetermined in that we always seem to be facing at least one more problem than we have remedies at hand.
Turning to my own narrative, the first point above may seem less controversial. Every serious and non-serious macro trader has been short the JPY in the past 12-18 months. I would suggest that trade will continue to perform nicely, but a negative current account suggests that the JPY could now be on the cusp of weakening with a speed and to a level that will garner serious attention from the other G7 economies and market participants. This is to say that so far, the short-JPY trade has been a lucrative idiosyncratic trade driven by a local macroeconomic experiment in Japan. A negative current account could be what makes a weakening JPY a systemic risk for the global economy through its impact on Japan’s economy. To put this in a language market participants can understand, so far, the short JPY has been a risk-on trade with the USDJPY being very correlated to the US 10-year yield and Nikkei 225. With a current account deficit, my contention is the JPY would weaken sharply even in an environment where stocks sold off and US 10-year notes rallied.
Remember that the rest of the world has so far accepted the experiment that is Abenomics, not only because Japan has been running a current account deficit (thus making it more reasonable for Japan to weaken its currency), but also because the depreciation has so far been orderly. With a growing negative current account, the wheels are now set in motion for a decidedly disorderly depreciation of the JPY, and one that could ultimately be life threatening for the Japanese economy.
In simple terms, Japan’s current account deficit is "perfectly" in line with a rapidly aging economy that is supposed to dissave. However, it is also the first example of its kind. We simply do not know how an economy with no discernible future investment yield and opportunities will react to the need to import foreign capital to pay for consumption and investment through, as is currently the case, a big and growing budget deficit. My guess is that all known theories of life cycle economics are about to run out of line as it becomes clear that negative current account dynamics do not make sense for a rapidly aging economy. Either the currency weakens up to the point at which the current account is closed (that is rapidly and violently!), or bond yields start to rise (in similar violent and rapid fashion). Neither scenario is going to be pretty.
The biggest push-back I continue to get here is that the BOJ will simply continue to buy all the JGBs, and thus, that bond yields will not be affected. This certainly looks like where we are going. A case in point has been the amazing statements from the Government’s Pension Investment Fund (GPIF) signalling their intent to sell bonds and buy more equity.
This puts an incredible onus on the BOJ. Not only is the Japanese pension industry now dissaving (i.e., structural net sellers of bonds to fund retirement redemptions), but if they also start to liquidate their stock of JGBs to rotate into stocks, who will pick up that flow? Remember here that Japan is currently running, by far, the biggest budget deficit in the world. There are only two constituents that can pick up this flow really; foreigners and the BOJ. This has customarily been the main reason for expecting ever more aggressive monetary easing and essentially that the BOJ would become the JGB market. This is certainly where we are going, but a negative current account changes dynamics significantly
In essence, the notion of the BOJ buying up all JGBs does not necessarily apply in the case of a current account deficit. More specifically, no matter the speed of the printing press in Japan, foreigners need to finance the current account per definition. If the deficit is structural, it is difficult to imagine this would not include buying JGBs (thus, presumably demanding a higher yield for their effort). The BOJ could, in theory, buy every single JGB, but this would then be done de-facto in order to shield the JGB market from foreign influence and higher yields.
The presence of a negative current account thus creates a veil between the BOJ and its objectives. It can still achieve its objectives, but it would require a drastic radicalization of its bond buying program, and thus, a likely very aggressive nominal target for JPY weakness. This would, in the first instance, call for accelerated JPY weakness, but investors should not automatically assume that the BOJ can control this process.
This brings us to the second point stated above. A negative current account deficit is thus the first step towards a rout in the JGB market. While it is true that Japan has its own currency and will likely use it aggressively as an adjustment mechanism, the key question is the speed with which such an adjustment will work. Investors should not take this lightly. If inverted yield curves in the eurozone periphery proved to be a significant global source of tail risk, a similar development in Japan would be equivalent to a global financial nuclear disaster.
Many commentators have noted here that as soon as Japan turns back to nuclear power, the current account will stabilize, but this is far from certain. And even if this was the case, the speed with which such a change materializes in the current account balance could easily be enough to upset the cart.
The investment implications are clear, in my view. Being short the JPY makes imminent sense, and investors should add to their positions. The traditional risk-on/risk-off dynamics would suggest that a market sell-off should be correlated with JPY appreciation. My view is that the negative current account changes that dynamic. I would also suggest buying OTM put options on the short end of the JGB curve. Being short JGBs has so far been a widow maker, but a negative current account deficit changes the risk/reward ratio drastically for such a trade. Investors should take note.