Global Debt Crisis: Greece -> Portugal -> Europe -> Japan?
From my previous article: Greece and Portugal are stuck in a very vicious cycle. Greek and Portuguese sovereign bond yields have risen substantially making it nearly impossible for these nations to roll over the debt with yields they can pay. For Greece, rising yields have brought it to the edge of default several times. To prevent a Greek default, the Troika (European Commission, International Monetary Fund, European Central Bank) has been sending large tranches of money to Greece to keep Greek bonds afloat and the Greek government solvent. Last year Portugal became the third EU country to ask for aid from the EU and IMF. In June, Portugal will need to rollover 10 Billion Euros of debt and it is a dubious notion that Portugal can do this without paying extremely high yields, unless the troika again becomes the lender of last resort. When Greece went this route two years ago, massive amounts of money were needed in aid and bond buying to keep its country from default. When I see headlines fearing the end of the world for Greek bond owners and possibly Portuguese Bond owners, I have to think, "Whose head will roll next?" In my previous article examining the future of Japan's equities, I came to the conclusion that Japanese debt is not a safe haven, but is sailing into a tsunami. In this article, I hope to develop an even stronger argument for why Japan's sovereign debt is an unsafe investment and why I suspect Japanese sovereign debt will soon be bludgeoned by a tide of rising yields, which we have seen wreak havoc on both Greek and Portugal bond prices, their economies and political stability.
The key to profiting in the future on JGBs will be understanding the rapid social mood changes that occur when a tipping point is reached. A tipping point is the critical threshold where a slight change can greatly change the environment of the system. This curvilinear change in social mood and thought, often occurs in the popping of bubbles like the millennium dot com bubble in US equities. Often because of the innate human bias to view the world in a linear fashion, tipping points are unforeseen by the masses because of their non-linear elements and complex form.
Japan's tipping point will need to be catalyzed by a trigger which could be a psychological contagion effect from a global credit event, a JGB downgrade, or others I will examine later in this post. Triggers will cause an increase in yields, which we have seen force Greece to nearly default on its bonds. For example, a big enough credit event originating in Europe will trigger a tipping point in the world's sovereign bond market. Bonds that are at risk like Japan's will experience a leap in yields because the market's opinions have rapidly changed. Investors will desire much higher risk premiums (yields) after being burned by the risk associated with sovereign bonds like Greece's. Japan has been kicking the can down the road for some time and a rise in yields will be the tipping point for JGBs.
My top indicators that Japan Government Bonds (JGBS) are over-valued and could be reaching a tipping point are:
- The Japanese sovereign Debt to GDP ratio is creeping close to 230%. In comparison to Greece's sovereign Debt to GDP ratio of 150% and Portugal's sovereign Debt to GDP ratio of 180%, Japan's 230% is more than worrying. In US dollars, each Japanese citizen (child, worker, and retiree) owes about $86,200 each to Japanese Sovereign bondholders. (Source: the Economist).
You can see how Japan has earned the nickname, "land of the rising debt." Right now, Japan has the world's highest sovereign Debt to GDP ratio at 230%, even though Japan also is the world's third largest economy!
- Japan's sovereign debt maturity timeline is very frontloaded and has an average maturity of about 6 years which is shorter than Italy, France, Greece, Ireland, Spain, and Portugal. A short average maturity means that more debt will become due earlier, putting more rollover risk on JGBs, if interest rates increase even slightly. The graph below should scare investors.
During the next five years more than 60% of current JGBs will need to be rolled over. This is a scary prospect given what could happen if borrowing costs rise. If at any point bond market investors no longer believe Japanese debt is as safe as it once was, a vicious cycle of ever increasing interest payments will begin just like in Greece and Portugal. This is the tipping point that is reality for Japanese debt.
- In April of 2012, the Japanese government expects to market another $566 Billion US or (44.2 Trillion Yen) to simply pay for the budgetary spending in 2012 that they can't fund with tax revenue. This bond outlay will raise Japan's budgetary dependence on debt to nearly 50%; in comparison the US in 2012 only has a 29.6% dependence.
I believe Japan's debt dependence sends a very strong signal to the bond markets that this debt might not be as AA3 rated (according to Moody's) as many investors believe.
Another way to perceive this problem is by calculating the percentage of the Japanese Government's revenue required to pay only the debt service on its debt, (just in case Japan suddenly cannot borrow more debt to pay its current debt's interest at current extraordinary low yields)
As you can see from this graph, 42.5 % of all of Japan's tax revenue would have to be spent paying its debt service (bond coupon payments). If the slightest thing goes wrong for Japan, the scale of the crisis that ensues will be almost unmanageable. As you can also see from this graph, total debt service payments are steadily growing (blue line) and government revenues are steadily decreasing (red line), for two decades
- Japan's population is rapidly aging.
Over the next 50 years Japan's total population will dwindle while the productive age population will also become a smaller and smaller part of the total population. An aging population will put stress on the welfare system that Japan has in place and will contribute more stress to the Japanese bonds in the future.
- Other key money managers are starting to suspect something is amiss in the JGB market as well. Kyle Bass, who made a fortune on the housing bubble crash and manages Hayman Capital, recently compared Japanese Bonds to the Madoff Ponzi scheme. The Madoff Ponzi scheme was profitable and viable up to the point when more money was going out than in. With the aging population in Japan and its elderly citizens no longer buying lots of bonds, it is starting to feel like there are more bond sellers than there are bond buyers in Japan. When the Japanese government is forced to go to the global fixed-income markets to sell bonds, the status quo of extremely low stable yields might be reaching a tipping point.
I have shown all of the important pieces are in position to set JGBs up for a tipping point, but it is also useful to understand at what point investors can no longer deny Japan is in trouble. Currently, Japan's cost of debt is only .97% on 10 yr bonds and 0.12% on 1 yr bonds. So the Japanese government is managing to float by paying extraordinary low interest rates and manageable interest payments. Now imagine what these interest payments would look like if the interest rate was 1.92% like 10 yr US bonds or 1.86% on 10 yr German bonds. To put these low rates in context, Portuguese 10 yr bond yields hit a new high today at 15.22%. The graph below shows the point at which these interest payments would outstrip the revenue the Japanese Government could rake in via taxes based on 2011 figures.
Currently interest rates are about 1%. If yields rise even a percent or two, the interest payments on JGBs would become massive, and the Japanese government would have a lot of difficulty in rolling over the debt, much less adding to it like they plan to in 2012. At the point when interest payments exceed the revenues the Japanese Government can take in via taxes, it is safe for investors to say "Japanese debt is more risky and worth less."
Keep in mind that Portugal has a cost of debt of 15% on its 10 yr bonds. As soon as the tipping point is reached, Japanese yields will be in for a very long ride up, which will cause enormous disruption in Japan.
However a tipping point for JGBs won't naturally occur on its own and the panic will need to be triggered. The next set of triggers I believe will start the flee from Japanese debt and facilitate the rise in yields and the vicious cycle.
- A global credit event would trigger a contagion effect and rise in JGB yields. The looming Greek default makes a credit event originating in Europe highly likely. When banks have to admit that many bonds in Europe are not worth what they are currently priced, they will have to mark to market their bond holdings. As a result, many banks will fail. Investors will look at Japan with uncertainty and yields will rise for JGBs. The IMF has already stated that the largest risk to JGB yields is a global spillover of credit stress. A correlation of JGB yields with other advanced countries can show how inter-related global credit stress and JGB yields are.
Graphic Source: IMF
After the first large-scale credit event in recent years, Lehman brother's collapse in September of 2008, the yields correlation among advanced countries has become stronger. In 2011, the trend continued and the correlation between JGB yields and yields in Germany, France, and the US became even stronger. I believe this shows the dramatic contagion risk to JGB yields.
- Another possible trigger would be a change of sentiment in bond markets. If global investors become frustrated with the increasing risk and decreasing yield in JGBs then we could see a rise in yields due to a reduction in the demand of buyers for JGBs. The Japanese government's rate of borrowing is increasing and investors could begin to demand larger yields, creating a tipping point themselves. I believe a good bond sentiment indicator is the CDS rate and in comparison to potential catastrophe countries and advanced countries. Japan's JGBs have a very low CDS rate compared to total amount of sovereign debt, but is very abnormal.
Graphic Source: IMF (same as above)
Japan is located way to the bottom right on the graph where no other country has been able to sustain high sovereign debt and low CDS rates. Japan may be the exception, but this obviously shows investors are very trusting right now in Japan and only a slight change in that sentiment is needed to set the system on its head. A regression to the mean will cause depression, desolation and default. Personally, when I look at this graph, I cannot imagine how JGBs are not mispriced especially given the difficulty Japan will have paying its debts back if yields rise 1% percent. At some point the markets are going to realize this is folly and investors betting against JGBs are going to profit from it.
- An aging population will lead to an increase in social security payments and a decreasing number of investors the Japanese government can market its bonds to. As they enter the "dis-saving stage of life," one can see how important these coming changes in demographics are when Japanese citizens, banks, and funds own more than 94% of JGBs.
Graphic Source: IMF (same as above)
Compared to other western developed economies in the world, Japan stands alone in funding almost all of its debt through itself and its citizens.
As a consequence of a rapidly aging population, pension funds are selling large amounts of JGBs to pay for the increasing number of pensioners. Pension funds typically buy "risk free" government bonds to obtain the maturities needed to match their payments as workers retire. Unfortunately for the Japanese government, pension funds have already purchased as many government bonds as they are ever going to.
Graphic Source: Zero Hedge
Pension funds including the National Pension Fund that owns 10% of all JGBs have become net sellers of JGBs, which means that any new bonds the Japanese government plans to market are going to be even harder to sell. In the right panel, you can see the Japanese government increasingly relying on short-term bills to fund its debt, which is not a healthy sign.
Unfortunately, debt service will not be the only thing the Japanese government has to pay for in the future. The graph below shows how much non-discretionary expenditures Japan can be currently paid for with tax revenue. Non-discretionary expenditures include debt service, education and the quickly growing social security payments.
- A decrease in the amount of money saved by Japanese households and invested in JGBs could trigger the tipping point as well. While there are fewer young people to invest in bonds, the household saving rate has been steadily decreasing over the past twenty years. Japanese citizens are not looking like they will be picking up any future slack in outlays of JGBs.
The most popular saving vehicle for Japanese households has been JGBs since the stock market peak in 1990, but if households are saving less and less, that doesn't bode well for future outlays for JGBs.
For twenty years and until recently, equities were one of the most volatile and poor investments in Japan. Thus JGBs didn't have to compete with equities for investors, but now the dividend yield of Japanese equities more than doubles the 10 yr Bond yield. It is becoming harder and harder for Japanese (banks and citizens) to justify investing in bonds when stock and dividend yield appear to have broken the disastrous 20-year downtrend.
The divergence of dividend yields and bond yields hurts the future marketability of JGBs to Japanese citizens. If enough JGB bondholders begin to sell JGBs and buy equities, it could trigger the tipping point for JGBs as well. In disclosure I am long both JOF and JEQ which are closed end mutual funds that specifically own both large and small cap Japanese equities as well as mutual funds with equity exposure to the Japanese/Asian region.
- A downgrade would trigger a drastic rise in yields like we saw in Greece and in Portugal recently when Portugal's bond rating was downgraded to "Junk." Portugal now is in the same junky category as Greece, and as expected, the market reacted and yields on Portuguese debt dramatically rose after the downgrade. It seems very likely that the vicious cycle of rising yields and rising debt riskiness has triggered the end game for Portugal.
The same effect of a downgrade would be expected for JGBs. Even though Japan sovereign debt was not as poorly rated as Portugal's to begin with, we have seen how slight of a change in interest rates can start the avalanche. A downgrade seems more and more likely especially given Standard and Poor's director of sovereign ratings, Ogawa, admitting that it "might be right in saying that we're closer to a downgrade." Keep in mind this is not the first time the ratings agencies have warned of a downgrade and then followed through causing extreme repercussions.
- Any spending increases in areas other than debt servicing would increase the amount of borrowing needed to fund Japan's expenditures and debt rollover. Increased borrowing would increase the risk of JGBs and increase the risk of rising yields.
In 2010 Japan spent roughly 1% of its GDP on its national defense (4.8 trillion yen). This is small in comparison to other developed countries like the US which spent roughly 4.8%(yes, the US was at war at the time), Germany which spent 1.4%, and China which spent 2% reportedly (very likely 2-3 times that estimate is actually spent). At 1% of GDP, defense spending in Japan measures at about ¼ of all debt service spending. If defense spending were to rise in future years this would put a lot of pressure on the debt service spending and increase the riskiness of JGBs significantly.
I think it is reasonable to expect Japanese defense spending to rise in the coming years because of the recent increase of territorial conflicts between Japan and its fast growing neighbor, China. China has been pushing the bounds of military relations with Japan by frequently using waters near Japan for military exercises. North Korea tensions in the region have also been rising as North Korea's nuclear program is gaining strength. It is not impossible that defense spending in Japan will need to rise in the coming years and this would put more stress on future Japanese government borrowing and JGBs.
2011 also marked the first trade deficit Japan has had in 30 years. This is important because the main driver of this sudden change was the 33% increase in oil imports due to a decrease in nuclear energy being produced in Japan. While the decrease in nuclear energy resulted in the wake of the Fukushima nuclear disaster, it seems reasonable to expect Japanese oil imports to increase in the coming years. It seems a full-scale disaster in the Fukushima nuclear complex was closely averted, but recent checks of other nuclear facilities were found to be insufficient, which could easily lead to a more thorough examination of the nuclear power plant facilities in Japan and stoppages in nuclear power production. The question still remains, whether the trade deficit signals a new trend or if the Japanese trade surplus can bounce back despite an increased dependence on oil imports. If trade deficits are really the new trend then it can easily be extrapolated that JGBs will be undergoing more stress as borrowing increases to pay for more oil imports.
- Japan knows it is kicking the can down the road and officials are getting desperate. In desperation to reel in expenditures and decrease reliance on debt, the Japanese Prime Minister recently announced intentions to hike the consumption tax from 5% currently to 10% by 2015 and maybe to 25% in future years. Bank of Japan Governor Masaaki Shirakawa also admitted that a 100% raise in taxes might be the solution in his January LSE lecture. While at first this seems like a positive direction change and a sound way to bring the sovereign debt total down to more manageable levels for Japan, I believe this is going to decrease confidence in the Japanese government and JGBs. When citizens are hit by 100% tax increase and its commensurate expected "austerity economic contraction," I don't think they are immediately going to save more to give to their beloved government for debt service purposes. I also wonder how long these changes are going to stay in place, because as we know Japan is on its sixth prime minister in five years, which leads into one of my favorite quotes,
"You don't hold office in this town. You run it because people think you do. They stop thinking it, you stop running it."
-Millers Crossing (1990)
Japan's key to keeping the sovereign debt sustainable will be keeping confidence high and stable. As soon as confidence slips, the torrent of selling will snowball into an avalanche. Investors' crowd psychology will take over once the slightest doubt about default has been raised and yields will inevitably rise.
After all this doom and gloom, the remaining question is how to take advantage of the situation? I am currently picking entrance points in (JGBS) Inverse Japanese Government Bond Futures ETN and (JGBD) 3x Inverse Japanese Government Bond Futures ETN. One thing I am keeping in the back of my mind is the possibility of a flight to safety after a credit event in Europe, which may temporarily cause an inflow of capital into supposedly "safe" bonds like JGBs. I don't wish to experience the pain of failing to understand the basic rule of a short, "markets can remain irrational longer than you are solvent." But after this small capital inflow, I expect the sea of capital to recede in preparation for the imminent tsunami of panic.
As history showed in both the Greek and Portuguese downgrades, the market action period when the biggest profits on these shorts are made is limited, thus investors have to be ready when the panic starts. Only when confidence has become its strongest will reality set in.
Japan has leveraged its economy substantially enjoying extremely low yields on its sovereign debt and unwavering public confidence in its ability to pay the debt back. As soon as the tipping point is reached, Japanese yields will be in for a very long ride up.
Graphic Source: IMF (same as above)
"The greatest trick the devil ever pulled was convincing the world he did not exist"
- Charles Baudelaire
Investors may be convinced Japan will pay back all its debts with non-inflated money for now, but I am not convinced and am positioning myself accordingly for Revelations.
Click here to see my original article and other related articles.
Additional disclosure: It is very likely I will initiate a long position in JGBS and JGBD as well as add to my current positions in JOF and JEQ