Any search for the world’s most dangerous asset bubbles will, at some point, come Tokyo’s way.
Even though Japan has the biggest debt burden in the developed world, a rapidly-aging population, a negligible birthrate and the same credit rating as Slovenia, 10-year yields are an impossibly low 0.04%. Deflationary pressures offer some explanation, but Japan’s US$10 trillion-plus government is a financial calamity waiting to happen.
Just something to keep in mind as Goldman Sachs warns of market chaos if 10-year US Treasury yields rise to 4.5% by, say, year-end (from about 2.83% now). Stocks would tumble, warns Goldman economist Daan Struyven. But what if Japanese yields rose in sync with US rates?
Where Japan is concerned, a far smaller spike could do even greater damage. Government bonds are the linchpin of Asia’s second-biggest economy, the main financial asset held by banks, companies, pension funds, insurers, endowments, universities, government institutions, the postal savings system and the growing ranks of retirees.
A Japanese bond crash might not pose the same systemic risk as that of US Treasuries. About 90% of Japanese government IOUs are held domestically, while the Bank of Japan has cornered the secondary market to the tune of more than 40%. That makes a run on Japan less of a global risk than a loss of faith in the dollar. It would surely hurt, though. Turmoil in the fourth-biggest trading nation, issuer of a top-three currency and home of some of the most active markets in the world would reverberate everywhere.
The good news is that BOJ and Ministry of Finance officials are on top of things. Both entities coordinate efforts to smooth out market dynamics and avoid major yield spikes. BOJ Governor Haruhiko Kuroda, meantime, just secured an incredibly rare second term, during which he’ll manage market moves. It’s good news, too, that Kuroda is being joined by dovish deputy governors Masayoshi Amamiya and Masazumi Wakatabe to keep the liquidity spigot open – and bond traders reassured.
Where Japan is concerned, a far smaller spike could do even greater damage
The so-called bond vigilantes could be a different story. The reference here is to the cast of characters who take matters into their own hands when they believe fiscal policymakers are getting things wrong. While the BOJ’s largesse has deadened volatility, risks abound.
Granted, shorting Japanese bonds has been the ultimate widowmaker trade in recent years. Just ask hedge fund gurus like Kyle Bass of Hayman Capital Management, who bet against Japanese debt earlier this decade.
But that’s the thing about debt shocks – they tend to come out of nowhere. By the time investors and governments realize what’s afoot, it’s often too late. Here’s one risk that’s rarely discussed: what if the BOJ’s effort to generate inflation actually works? Bond yields could surge, destabilizing Japan Inc. A jump in 10-year rates even to the 2% level could be devastating to Japan’s entire financial system.
Japan’s nationalists have long been irked at Tokyo having a lower credit rating from Fitch than developing China – A versus A+. It’s reality, though, that Japan’s debt trajectory is a national-security risk for a deflation-wracked economy. That’s true of the US, too, which just gratuitously added US$1.5 trillion to its debt burden to cheer plutocrats even as inequality grows.
Yet Japan’s daunting debt position gets pooh-poohed all too quickly by global investors. In 2014, Tokyo raised the national sales tax to 8% from 5% to pay down debt. Never mind that Nobel laureates Paul Krugman and Joseph Stiglitz implored Tokyo not to create fresh headwinds in a deflationary environment. Predictably, the recession caused by the hike necessitated greater borrowing to stabilize growth. To sum up, a tax meant to buttress Tokyo’s credit dynamics weakened them. Another sales tax hike is planned for 2019.
Two things can be true at the same time. Yes, short-sellers haven’t made much money betting against Tokyo. Hence the folks at Goldman Sachs mulling risks to US Treasuries instead. But BOJ and MOF officials risk losing control of a market harboring the most obvious, and least acknowledged, asset bubble.