Japan Foreshadows Next Global Crisis

Asia Confidential's picture

Japan is the only game in town right now and for good reason. First, it was the yen's +20% move in less than six months and now there's the extraordinary volatility in Japanese stock and bond markets. What's behind the recent action? Nobel laureate Paul Krugman points to false alarm over rising bond yields which is actually reflective of increased optimism in a Japanese economic recovery. One can only assume Krugman wrote this with a straight face, all the while ignoring the real reasons for Japan's dysfunctional bond market: 1) investors bailing due to 10-year government bonds yielding just 0.85% when the central bank is targeting 2% inflation 2) And that snowballing into liquidity concerns as the central bank increasingly crowds out other players in the bond market, leading to increased yield volatility.

These first signs of investors' losing of faith in Japan's bond market not only spell trouble for the world's third largest economy. They're also likely to prove a prelude to what will later happen in other developed markets, including Europe and America. Namely, the unprecedented economic measures of the developed world will reach their limits when investors no longer view government bond markets as safe havens and yields spike on supply concerns. The jig will then be up and it'll have huge spill-over effects for the world's currencies, including the reserve currency, as well as stock markets. Hang onto your seatbelts; it's going to make for a wild ride.

Paul Krugman can't be serious

I played tennis at a high level as a teenager and one of my then heroes was the irrepressible John McEnroe. During one of his famous temper tantrums, McEnroe was so furious with an umpire at the Wimbledon championships that he uttered the immortal line, "you cannot be serious", before treating the centre court crowd to a more colourful diatribe.

I couldn't help but think of the McEnroe line when reading Paul Krugman's latest take on Japan. In the column in The New York Times, Krugman lauds Japan's unprecedented stimulus efforts:

"A short term boost to growth won't cure all of Japan's ills but, if it can be achieved, it can be the first step to a much brighter future."

This isn't a surprise given that Krugman, like the majority of the economics profession, believes that during an economic downturn, government stimulus and reduced interest rates can help to boost GDP growth as reduce unemployment (the Keynesian school of thought in crude terms). I won't debate that here, but as noted in many prior newsletters, there's little historical evidence that it actually works.

Krugman then goes to suggest that the stimulus efforts in Japan are starting to bear fruit:

"The good news starts with the surprisingly rapid Japanese economic growth in the first quarter of this year - actually, substantially faster growth than that in the United States, while Europe's economy continues to shrink. You never want to make much of one quarter's numbers, but that's the kind of thing that we want to see."

Here Krugman is on shakier ground for he knows (or should) that GDP growth isn't reflective of economic health (didn't we learn that from the 2008 financial crisis?). And he conveniently ignores the latest inflation statistics which show Japan remains mired in deflation.

Then we get to the more interesting part of the column. Krugman notes other positives in Japan including a steep rise in the stock market (prior to when the column appeared on May 23) and a sharp fall in the yen, aiding the country's exporters. Of the bond market volatility, he writes:

"Some observers have raised the alarm over rising Japanese long-term interest rates, even though those rates are still less than 1 percent. But the combination of rising stock prices and rising interest rates suggest that both reflect an increase in optimism, not worries about Japan's solvency."

Let's put aside the skewed logic that rising stock markets are a sign that Japan's economy is getting back on track (supposedly paper wealth via stock markets will trickle down into economic spending).

Let's instead focus on Krugman's claim that rising bond yields in Japan are sign of increased optimism. By the way, this is a view shared by most of his Keynesian brethren too.

If this claim leaves you scratching your head, you're not alone. Apparently we're supposed to believe that after 23 years of economic stagnation, bond investors (94% of them domestic at last count) now see better times ahead. That 10-year government bond (JGB) yields spiking from 0.35% to 1% in around 7 weeks is a sign of a healthy market. And that the bond market being halted on numerous occasions due to unprecedented volatility is a further sign of a healthy market.



Better reasons for a dysfunctional market 

There are other, more plausible reasons why Japan's bond market has become dysfunctional - and I don't think that's too strong a word for its current state. The first reason is that there are some investors who are clearly unhappy with getting paltry returns of 0.85% from 10-year JGBs. Why own them when the government is intent on producing 2% inflation, implying a -1.15% real return? Particularly when the bonds are denominated in yen, whose further decline seems assured given the central bank's extraordinary actions.

The second reason is that these extraordinary actions, involving the Bank of Japan (BoJ) printing money to buy JGBs, mean the central bank is becoming the dominant player in the JGB market, crowding out other investors. This crowding out effect reduces liquidity and heightens volatility. An illiquid market means that banks can't quickly find counterparties with which to trade large volumes of bonds.

The situation is likely to worsen as the BoJ intervenes more heavily in the bond market going forward. And it may have little choice, just to prevent a more substantial crash in the market.

There's also the possibility that the volatility in the JGB market will lead to rising yields in other developed world bond markets as investors look for better returns for the risks that they're taking on. This in turn could put further upward pressure on JGB yields.

The significance of the tumultuous action in Japan's bond market can't be understated. As I've said on many occasions, the interest of Japanese government debt already takes up 25% of government revenues. If yields were to rise to just 2.8%, that figures becomes 100%. A bond market crash would happen well before it got to that point though.

The more immediate concern is with Japanese banks which hold massive JGB portfolios. According to the BoJ, a 100 basis point increase across all bond maturities would lead to mark-to-market losses of 10% of tier 1 capital for the major banks. Reduced capital means banks wouldn't be able to lend as much. This in turn would blunt the impact of Japan's quantitative easing (QE) policies.

A template for what's to come

Few investors realise it yet, but the action in Japanese markets is likely a prelude to what will happen in other developed countries, including the U.S.

To understand why let's briefly take a step back. The 2008 financial crisis resulted in governments in many developed markets taking over the enormous debts accumulated in the private sector. Whether this was right or wrong has been endlessly debated and we won't do that here - it's done.

Cutting these enormous debts would probably have sent the world into depression. Instead, governments chose to try to inflate these debts away. That's where QE came into play. QE involved printing money to buy bonds off financial institutions. Theoretically, these institutions would use this money to lend more, thereby stimulating the economy. This would also produce inflation, thereby reducing government debts in local currency terms. Cutting interest rates at the same time would amplify the stimulus.

The problem is that banks haven't lent the money out to the extent that central banks would like. That's because consumers have been busy paying off debt and they've been frightened to take on more again. They've learned their lesson, in other words.

Because stimulus has failed to kick-start economies, government debt in developed markets has continued to skyrocket, and total debt remains on an uptrend too. In fact, total debt to developed market GDP is 270%, 21 basis points higher than it was in 2008!

Developed market total debt - May 2013

Not to be deterred, governments in these developed markets don't view QE as a failed experiment. They believe that it's prevented a sharper economic downturn. And that more QE will help their economies recover faster. That means governments and their central banks everywhere are ramping up stimulus. It's a coordinated effort that's not been seen in modern history, not even during the Great Depression.


Therefore, it's highly likely that QE will be incrementally increased so long as economies don't recover to the satisfaction of central bankers. That's why you shouldn't expect any imminent cut to stimulus in the U.S. either.

In may respects, Japan is the template for what's to come in other developed markets. After an enormous credit bubble which burst in 1990, Japan has refused to restructure its economy in order for it to grow in a sustainable manner. Instead, it's chosen the less painful route of printing money to try to revive the economy and reduce debts in yen terms.

It's been unsuccessful at previous attempts at QE, including in the early 1990s and 2001-2006. Now it's got to the point where the debt load is so large at 245% of GDP, and the interest burden so excessive, that there are no good choices left. So Japan has chosen to print even more money, at the not-so-subtle urging of developed countries, particularly the U.S.

The trouble with this is that there comes a point where bond investors lose confidence in the ability of the government to repay the money. These investors then refuse to rollover government debt at low rates. When bond markets dry up, they normally do so quickly. The current wobbles in the Japanese bond market can be seen as a prelude to this endgame.

Though Japan has escaped its day of reckoning for a long time, other developed markets are unlikely to be as lucky, given the extent of their indebtedness and continued commitment to flawed policies.

This post was originally published at Asia Confidential: http://asiaconf.com/2013/06/01/japan-foreshadows-next-crisis/

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bugs_'s picture

watch for them to close their bond market

mendigo's picture

Clearly the was selling of bonds an buying of stocks - why would this lead any sentient being to conclude that the economy is improving. If the economy is improving there would be evididence of such to trigger the buying of stocks and selling of bonds.
Krugman throws-up one of his increasing weak and frantic attempts at reason and this guy goes for it with a long winded critique.
I smell a rat.
It like the con where they create a disturbance and pick your pocket while you are distracted. Common technique among con artists, congress and the ny times.

boeing747's picture

Do you guys know at the peak of Japan housing bubble there were many 100-year-mortgages which need 3 generations to pay off? Now you know why Japan's debts to gdp is over 250%. Every country goes thru housing bubble will enter prolong recession thereafter. QE is to recapitalize big banks which lost everything in housing bubbles.

Ham-bone's picture

CB's print money to buy T's, MBS, and securities (ETF's). Result is lower yields for debt (T's, mortgages, loans) and thus higher housing prices, higher stock markets with cheaper government financing of it all. Lets also assume they manipulate PM's, Libor, PCI, GDP, etc..  The real suprise of this has been the coordination of all major nations to simultaneously devalue their currencies so no serious FX implications come to any nation whilst they dilute the money supply.

And that really seems to be the question - can they dilute their money supplies ad infinitum? Seems the wind has been at their back due to a global economic slowdown since the reflationary policies from '09 to '11 ran out...and since '11 to now the worlds economies, global trade, global need for commodities are all slowing. This is great news in one sense for the money printers as this slowdown helps offset the devaluation of currencies (wondrous low inflation). So no oil or copper or timber or nat gas booms. All are suffering due to slowing cap-ex spending worldwide, slowing construction in China and elsewhere, coupled with oversupply.

However, the fact that global trade and economies and global GDP is slowing only means that greater devaluation and dilution of the existing money supply will be needed...etc etc etc. More bond buying to push interest costs of debt lower for nations now deeper in debt, lower mortgage rates to push home prices higher for those in developed nations whose incomes don't appreciate, more money to be deployed to push equities higher.

So, seems we all know this is not a sustainable or durable way to run a national or global economy...however how a Ponzi plays out when "new investors" can be printed ad infinitum is a good question...particularly when all nations agree to do this in concert...so if bond yields can be pushed ever lower, if this has little impact on FX crosses...if global demand continues to wane then no inflationary monsters are found.

Alas, I will posit that it comes down to Japan who now will break the stalemate. Japan's situation of massive debt at nearly zero interest rates while attempting to create a stock bubble...means JGB holders ($10T worth) will sell...which means the BOJ or other CB's or entities on their behalf must buy and sustain the losses of doing so. This neccessary acceleration in printing to double or quadruple Yen creation (or dollar swaps if Fed determines to help Japan try to sop up JGB's)...this is a pig in the python moment...or more correctly an elephant in the python moment.

What happens with all the money traded for JGB's? Where does it go? Implications? I guess we'll have to tune in next week for the next chapter of "As the printing whirrs".

pauhana's picture

"What happens with all the money traded for JGB's? Where does it go?"  Kyle Bass gets quite a bit richer.

Non Passaran's picture

What's happened to Fed's losses on US bond losses?
Nothing. It's just paper and some digits inside of a computer. Japan will do the same. The CB can stop paying dividends for 50 years, pull the lame 1tn. coin trick or whatever (meaning: it doesn't eve have to make any sense!).
I'm buying PMs, but I am not inclined to think TPTB will lose control over such triviality as CBs' loses. It's just digits and paper.

ebworthen's picture

Krugman is like the Mom whose little boy can do no wrong, even though he's 23, shooting heroin, and mugging people.

Can an individual or household recover from debt by increasing their debt?  No. 

Can they improve their situation by borrowing more and spending more?  No.

End of story and argument.

Accounting101's picture

While I appreciate the point you are trying to make, and I certainly agree excessive debt is problematic, your comparison between individuals and governments is economically illiterate. It leads us to continually get our economic asses kicked by the Oligarchs.

When the argument is about big government debt and the government is just like a family, the middle class is being separated from its money.

ebworthen's picture

When simple truths are supplanted by complex schemes and verbiage you can be certain it's a con job.

In other words, if it sounds too good to be true it probably is.

bank guy in Brussels's picture

James Gruber of Asia Confidential, like in most such articles about Japan, recites the more obvious facts, while not mentioning the absolutely essential deeper thoughts and conclusions that some others have already expressed, highly relevant and indeed crucial to the Japanese situation.

As for example with Gruber not addressing the essential ideas of Japan's great economist Richard Koo of Nomura, who long ago expounded the key notion of the 'balance sheet recession', a topic precisely addressing the solution to the problem which Gruber describes above in these words:

« The problem is that banks haven't lent the money out to the extent that central banks would like. That's because consumers have been busy paying off debt and they've been frightened to take on more again. They've learned their lesson, in other words. »

Yeah, old ancient story ... Richard Koo addressed this years ago, how this is normal human behaviour in balance sheet recessions, and argues quite credibly that the ONLY solution is government fiscal borrowing quite up to the level of the domestic savings pool (which can be combined with monetary expansion QE etc for other reasons). And that in these long-term balance-sheet recessions over many years, the private sector credit collapse is the reason why the public debt load is far less menacing than it might seem ... what Reinhart and Rogoff seem to have missed as well.

Koo's framework needs to be digested and addressed whenever this 'bank lending transmission' issue is cited. For example as well in how the euro currency area is totally, disastrously dysfunctional, because of its allowing for capital flight in the same currency, exactly sabotaging the fix that is needed in Southern Europe.


James Gruber also raises the hoary 'bond vigilante' argument - yields are going up and can destroy everything - while at the same time admitting the somewhat contradictory fact that Japan's central bank is buying, and ready to buy more

There are indeed some delicate and thorny issues about what happens when the central bank becomes the entire government bond market, but it is not illuminating to just claim rates are going up when ...

As others have put it, digesting the issue a bit further:

« You cannot predict higher interest rates if you also predict QE to infinity. QE is the non-economic purchase of government and other debt securities. Therefore as long as QE expands to meet the size of bond offering, the bond market will stay bullish and interest rates will not rise significantly. »

- Jim Sinclair, JS Mineset

or more recently

« The Bank of Japan must crush all resistance, and will do so »

- Ambrose Evans-Pritchard



Japan is at the front lines, and we are in a new area of economic space, in a complex programme that might work or might explode, no one really knows. But the uncertainties about the future, need to be confronted in a deeper way, building on some profounder insights into what is at play here.

css1971's picture

They don't get to have their cake and eat it too.

If the BOJ crushes yields and I fully accept they could. Then they are going to destroy the Yen and the Japanese financial sector as they wander off down the path of becoming the sole holder of all Japanese debt.

I mentioned previously... They can save the government, and keep a bid under JGBs, but they can't save the corporations. Who's going to buy corporate debt at 1.5% when inflation's officially at 2%? Who's going to issue mortgages?

Or lets say they do, they take the nuclear option, kill off the private banks entirelly, buy all the corporate debt they can get their hands on and mortgages and unsecured loans too. Well I guess I set myself up as a corporation and start issuing bonds.

This all gets reflected in the Yen. Again, they don't get to have their cake once they've eaten it.

Urban Redneck's picture

The Yen is the practical limit to the BOJ's ability expand its balance sheet and absorb government issuance.  They need to import energy in order to export manufactured goods or provide the domestic bread & circuses.  Interest rate volatility is only a symptom, regardless of the many faces of the bond vigilantes, it is not the underlying disease- the threat is if interest rate volatility ressurects counterparty fear among major market participants that this leads to increased collateral calls and certain market particpants deciding that their wothless derivates might actually be worth some moar paper (as opposed to the paper they are printed on), at which point the BOJ might face an immediate problem it can't print its way out of.  

disabledvet's picture

while i'm all on board (kicking and screaming--as in "you will go on that Titanic or i'll make you" kiddo kind of thing) "Central Banks rule the world" humbuggery the idea that somehow interest rate risk...if not risk period...has been banished from the earth is a wee bit of a stretch. this is a very good piece i think in the middle to end parts...but also I think Paul Krugman has some valid points if oil and natural gas prices really correct in here (ala the 1980's.) that obviously would be Japan and East Asia in general positive..."at the margin." of course these prices need to correct first...collapse even. this is why US consumer demand is so critical to global growth. i agree...probably a temporary thing...at some point other consumers will pick up the slack and industry and business will regain pricing power ala the 80's, 90's and 2000's...but i'm really coming around to the view that we won't see that for a LONG time. instead this blip in Treasuries is temporary due to the fact that it is a diversified global asset unlike JGB's and German Bunds...i'm really unclear how it works in London actually although i'm sure they'd prefer the American model. simply put i still believe default risk is at an all time high in the West, the USA and Japan still...the Governments are doing all in their power to masquerade this risk...that Japan is yet another attack on this facade (Greece and Southern Europe to the bond vigilantes, Germany to the Government types, Cyprus appears to have been a sacrificial lamb to the BV's, now Japan) so we'll just have to see. http://www.youtube.com/watch?v=u9bk2MrMGaA

OpenThePodBayDoorHAL's picture

"...the elastic retreat brings the close of play..."