A Japanese Tsunami Out Of US CLOs Is Coming

Authored by Shannon McConaghy of Horseman Capital

Japan is at the very centre of the global financial system. It has run current account surpluses for decades, building the world's largest net foreign investment surplus, or its accumulated national savings. Meanwhile, other nations, such as the US, have borrowed from nations like Japan to live beyond their own means, building net foreign investment deficits. We now have unprecedented levels of cross-national financing.

Much of Japan's private sector saving is placed in Yen with financial institutions who then invest overseas. These institutions currency hedged most of their foreign assets to reduce risk weighted asset charges and currency write down risks. The cost of hedging USD assets has however risen due to a flattening USD yield curve and dislocations in FX forwards. As shown below, their effective yield on a 10 year US Treasury (UST) hedged with a 3 month USDJPY FX forward has fallen to 0.17%. As this is below the roughly 1% yield many financial institutions require to generate profits they have been selling USTs, even as unhedged 10 year UST yields rise. The effective yield will fall dramatically for here if 3 month USD Libor rises in line with the Fed's "Dot Plot" forecast for short term rates, assuming other variables like 10 year UST yields remain constant.

As Japanese financial institutions sell US Treasuries, which are considered the safest foreign asset, they are shifting more into higher yielding and higher risk assets; foreign bonds excluding US treasuries as well as foreign equity and investment funds. This is a similar pattern to what we saw prior to the last global financial crisis. In essence, Japan's financial institutions are forced to take on more risk in search of yield to cover rising hedge costs as the USD yield curve flattens late in the cycle.

Critically as the world's largest net creditor they facilitate significant added liquidity for higher risk overseas borrowers late into the cycle.

I follow these flows closely. One area I think is rather interesting is US Collateralised Loan Obligations (CLOs) which Bloomberg reports "ballooned to a record last quarter thanks in large part to unusually high demand from Japanese investors". CLOs are essentially a basket of leveraged loans provided to generally lower rated companies with very little covenant protection. Alarmingly, some US borrowers have used this debt to purchase back so much of their own stock that their balance sheets now have negative net equity. A recent Fed discussion paper shows in the following chart that CLOs were the largest mechanism for the transfer of corporate credit risk out of undercapitalised banks in the US and into the shadow banking sector. Japanese financial institutions have been the underwriter of much of that risk in their search for yield.

There are many other risky areas where Japan has become a large buyer, including; Australian Residential Mortgage Backed Securities, Emerging Market Bonds, and Aircraft Leases. Japan's financial institutions have desperately sought the higher yields on offer not only to compensate for higher hedge costs but also their dire domestic earnings outlook as the Bank Of Japan (BOJ) suppresses domestic interest rates below the break-even rates that many of these institutions need to remain profitable. A former BOJ Board member Takahide Kiuchi warns "there is no doubt that as a side effect of monetary easing, financial institutions are taking excessive risk". (Japanese) Banks are investing in products that yield too little relative to the risks involved. You tell banks to stop it, and then they go elsewhere to find opportunities — it's whack-a-mole". Importantly, Japan's Financial Services Agency is now instructing regional banks, to not only stop adding foreign higher risk assets but also to aggressively sell existing positions as soon as they begin to turn sour.

Unfortunately, this doesn't resolve the problem as restricting financial institutions like regional banks from buying higher yielding foreign assets removes their ability to offset their deteriorating domestic businesses. The situation will likely worsen, as even the BOJ Governor Kuroda himself acknowledges that continuously supressed interest rates will increasingly deteriorate domestic banking earnings over time as old higher yielding assets continue to roll-over onto lower rates. There is limited prospect of the BOJ meaningfully lifting interest rates to slow that deterioration. All of the BOJ's measure of underlying inflation have deteriorated this year. In addition, as the chart below shows, currency effects, which had brought some limited inflationary pressures to Japan earlier in the year, are now set to bring deflationary pressures.

An unstated objective of the BOJs monetary policy has been to weaken the Yen. As suppressed domestic interest rates also creating carry trade outflows from some Japanese investors who are willing to take unhedged currency risk. The 2016 commitment to keep interest rates pegged below zero out to 10 years, via yield curve control, has again pushed the Yen to near extreme levels of devaluation against its long-term average real effective exchange rate. The Yen is currently 23% undervalued against its export partners.

We can use purchasing power parity to specifically measure the undervaluation of the Yen versus the USD. The current 30% undervaluation implies a fair value of USDJPY 77. Surveys of Japanese exporters estimate  that they only break-even on average at above USDJPY 100.5. It is clear that the BOJ would be desperate not to trigger a reversal of carry flows and push the Yen back up to fair value by raising interest rates.

The BOJ has to make a choice and there are no good options.

If the BOJ raises interest rates they risk triggering a tsunami of Japanese money flowing back home, strengthening the Yen and amplifying the coming deflationary pressures. In addition, much of that money is currently propping up higher risk overseas debt markets like US CLOs. If Japan, the world's largest creditor, brings its money back home that would bode extremely poorly for the global credit cycle, which Japanese financial institutions are now more than ever directly exposed to.

If the BOJ doesn't raise interest rates, which I think is the likely outcome, then some Japanese financial institutions  will simply not be able to survive as privately owned listed entities in their current form as their domestic earnings will fall increasingly negative and they are restricted from seeking overseas earnings.

Regional banks are the entities which are suffering most and conditions have continued to deteriorate further since I wrote earlier in the year of policies in place already that would allow these entities to be resolved into more viable formats. Essentially, the cost of continuing current policy would be to zero the shareholders in some of these banks, a cost Japan has proved willing to bear on a number of occasions in recent decades already. I can see this as being the most politically palatable choice, out of a range of bad choices and see continued appealing returns in Japanese regional bank shorts.