For around 20 years now, shorting Japanese government bonds has been the ultimate “widowmaker” trade.
Year after year, punters reckoned it was time Tokyo’s unsustainable debt load, dismal demographics and negligible growth would collide to panic markets, send yields soaring and stampede invstors.
And year after year, naysayers came up short, profit-wise.
Might 2020 be the year the market finally cracks? There are several reasons to worry that the world’s second-biggest debt arena is heading into a year of turbulence.
One, tax revenues aren’t rebounding.
Since December 2012, Prime Minister Shinzo Abe’s stimulus efforts managed to produce the longest expansion since the 1980s. To offset the jump in borrowing needed to finance countless fiscal-spending packages, Abe’s government has hiked sales taxes twice.
The first in 2014 boosted consumption levies to 8% from 5%. It triggered an immediate recession, necessitating even greater bond issuance. At the start of 2014, Japan’s debt-to-gross-domestic product ratio was 232.5%. By the end of 2019, it’s seen topping 240% – on the way to 250%.
That’s even before considering the fallout from another sales tax hike in October – that one to 10%. On December 5, Abe’s Cabinet announced a new stimulus jolt to offset the damage, a replay of 2014. It telegraphed a sizable shortfall in tax collections and larger bond auctions. As such, observes Fitch Ratings, “Japan’s fiscal health is unlikely to improve.”
This fits with recent rumblings from the International Monetary Fund. Its economists worry a fast-aging and shrinking population is stymying Tokyo’s efforts to service a worsening debt burden. In 2018, Japan saw the lowest number of births since 1899.
“Demographic trends will increase age-related government spending, particularly mandatory social security expenditures, heightening fiscal sustainability concerns and potentially triggering bond market stress,” the IMF argues in a recent report. “Higher risk premia could increase debt service costs and refinancing risks for the sovereign – with adverse feedback effects to the financial system and the real economy.”
Granted, the coming borrowing binge might not seem daunting for a $5 trillion economy; the headline figure amounts to about US$239 billion.
At some point, though, bond investors will object to being party to the cycle in which Japan Inc. is trapped. Each pledge or effort to curb overall debt ends up falling short, only to be subsumed by the next one.
Another worry is what happens when the market’s biggest investor – the Bank of Japan – slims down. At the start of each year, traders bet this will be in one in which the BOJ “tapers” or goes even further, reducing its titanic balance sheet.
Since 2013, BOJ Governor Haruhiko Kuroda’s team has hoarded more than half of all outstanding government securities. It has also cornered the stock market by snapping up more than 75% of exchange-traded funds.
By the end of 2018, the BOJ’s balance sheet exceeded the size of Japan’s entire economy. (Yes, you read that right.) And by April 2019, the BOJ became a top-10 shareholder in half of all Tokyo-listed companies. That means the BOJ is a bigger stockholder than even Japan’s Government Pension Investment Fund, the world’s largest.
At the time, analysts at Zero Hedge quipped: “Somewhere, Brezhnev is spinning in his grave.”
Yet something notable is happening as 2020 approaches: the BOJ is resisting adding more liquidity. Even as the Federal Reserve slashed rates and the trade war slammed exports, Kuroda & Co. resisted pressure to act, most recently on Dec. 19.
Exports fell 7.9% in November from a year earlier, the 12th straight monthly drop. Business confidence is cratering, while the 4.2% drop in industrial production in October was the biggest in nearly two years. Inflation rose just 0.5% in November, a long way from the 2% target. And that mild increase, mind you, was exaggerated by the October sales-tax hike.
In part, Kuroda’s team is worried about the banking sector in 2020. Ultra-low rates, coupled with its negative bond yield policy, make it hard for banks to, say, borrow cheaply via short-dated securities and charge more for long-term loans. The BOJ’s unprecedented stimulus has deadened bond trading.
On certain days, not one single bond changes hands.
For markets used to the monetary equivalent of a pyramid scheme, there’s no telling how punters might react when they realize the BOJ is unwilling to refill the proverbial punchbowl.
This gets us to the last worry: investors voting with their feet.
As investors conclude that tax collection and BOJ largess has stalled, Japan’s safe-haven status is in jeopardy. Tokyo financial circles got a whiff of how that may play out on Oct. 1, the same day the latest sales tax hike when into effect.
That day, the Ministry of Finance sold US$20 billion worth of 10-year bonds. MOF officials figured demand would be robust given that Team Abe was reaffirming its commitment to fiscal consolidation.
In fact, the auction met the opposite fate. Demand, as gauged by the ratio of bids to the number of securities on offer, was the weakest since at least 2016. The result shook markets as far away as New York.
The BOJ doesn’t have the firepower, or global clout, to tame every flareup in debt next year, particularly as Tokyo’s finances deteriorate. At the moment, 10-year bond yields are just 0.01%.
Ultimate safe asset…?
Still, Japan has two unique features going for it.
One, nearly 90% of Japanese bonds are held domestically, reducing the odds of a global run on yen assets. Two, they’re the core financial asset held by virtually every sector of the economy. If yields suddenly surge, local governments, banks, companies, pensions, insurers, endowments, universities and fast-growing ranks of retirees all get hurt.
This makes for a mutually-assured-destruction dynamic. It disincentivizes massive sales and incentivizes the BOJ to work closely with the Ministry of Finance to keep the peace in bond land.
Yet these unique features confront the secular trends mentioned earlier. Those are what Tokyo needs to address if it’s going to keep yields from skyrocketing in 2020.
Abe’s government, for example, needs to demonstrate it can at least cap Tokyo’s runaway debt. It must prove it can reign in demographic risks – be it by via increased immigration or higher productivity. It must hasten growth organically – via structural reforms, not increased borrowing.
Changing any one of these narratives is hard enough in the best of times, never mind amid a trade war and slowing global growth. Given the low odds Abe can flip the script convincingly, Japan’s bond market is heading into a rocky 2020 – and taking a fragile world economy along for the ride.