Is It Finally Japan's Turn?

Japan is starting to heat up a little in terms of risk and we hope that Noda is watching carefully. While the strengthening trend in USDJPY and JGBs has been a long one, the last few days are starting to worry some traders and most notably, Bloomberg points out that not only are FX options the most USD bullish-biased (JPY-bearish) in seven years, swaptions have screamed to their highest in over seven months at 54bps. The growing concern that the European crisis will spread to Japan is evident in recent underperformance but these option bets support the view that the JPY strength and trade surplus arguments are much less support than they have been recently.

Swaption spreads are their highest in seven months - traders are paying more now to lock in cost of future JPY funds on the expectation of rising rates...

and at the same time, the difference in prices for puts and calls in the FX option market are the most bearishly biased in over seven years. The so-called risk-reversal is positive for the first time since 2004. The combination of the bet on JPY weakness and rates rising at the same time as ratings, fiscal sustainability, and trade surpluses come into question is rather notably concerning.

Charts: Bloomberg

Some notable sections from the Bloomberg report 'Swaption Surge Signals Euro Contagion in Yen Debt: Japan Credit' include:

Options traders are the most bearish on Japanese bonds in seven months, signaling concern that Europe’s debt crisis may spread to a market that’s been insulated by currency gains and a trade surplus.


The risk-reversal rate for one-month options on the dollar versus the yen advanced above zero for the first time in seven years, as more traders wanted the right to buy the greenback if it starts to rise.




There’s speculation that a bad gain in bond yields and yen weakness will happen simultaneously,” said Yunosuke Ikeda, head of Japan foreign-exchange research at Nomura Securities Co., the nation’s biggest brokerage. “Overseas investors may be thinking a bond slump should spread to Japan especially after it occurred in Germany.



Takahira Ogawa, Singapore-based director of sovereign ratings at S&P, said on Nov. 24 that Japan’s finances are “getting worse and worse.” S&P rates Japan at AA- with a negative outlook, compared with Germany’s AAA grade.


It “may be right in saying that we’re closer to a downgrade,” he said in an interview. “But the deterioration has been gradual so far.”




The International Monetary Fund said in a report on Nov. 23 that concerns about Japan’s fiscal sustainability may result in a “sudden spike” in bond yields.





The yen has outperformed all of its 16 major counterparts this year. The currency tends to strengthen during periods of financial stress because Japan’s export-reliant economy doesn’t need foreign capital to balance its current account.


The nation, which had the world’s second-largest current-account surplus last year after China, will see a 28 percent decrease its surplus through 2016, according to estimates from the IMF.


“There’s a possibility that bond yields will surge because of the worsening of Japan’s finances,” Hiramatsu, whose Tokyo-based company manages about $58 billion, said yesterday. “That day is coming closer, but not this year or next year.”


Following S&P's recent 'downgrade' chatter, the IMF's decidely negative perspective on fiscal sustainability, and the market action of the last week or so, it seems perhaps Noda was right to keep watching. Perhaps the sad inevitability of the real endgame of Richard Koo's balance sheet-recessionary view of Keynesianism is closer than many believe.