10-year JGB yields near 0.5%

The 10-yr government bond yield in Japan is now around 0.5%, following an almost linear decline that started in 2006. The only way to rationalize buying 10-yr JGBs at 0.5% is believing that Japan will have a deflationary environment over the next decade and/or the central bank will absorb (or even monetize) the bulk of new issue bonds.

Moreover, these record low yields will do some serious damage to the Government Pension Investment Fund, which invests two thirds of its assets into local bonds. A significant portion of the population will tap the pension fund in the next 10 years. There will also be pain for Japan’s insurance industry that now faces a nasty asset/liability mismatch.

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From our sponsor:

Monetizing QE bonds

Congratulations go to the Bank of Japan who is now the largest holder of the nation’s government bonds. But no worries. This week Lord Turner of Ecchinswell, a former chairman of the UK’s Financial Services Authority (FSA) suggested that the bonds the Bank of England purchased as part of QE should be “monetized”. The bonds would remain permanently on the central bank’s balance sheet without the government ever paying them off. Of course it’s unlikely to happen in the UK in the near future, but Japan looks like a perfect candidate for monetization.

h/t @jmanfreddi ________________________________________________________________________________

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The BoJ's balance sheet is about to go parabolic

The Bank of Japan's balance sheet continues to expand at a fairly constant pace. Relative to the size of the GDP, this is already the largest QE program in the world. Yet some analysts believe that the BoJ will accelerate securities purchases later this year.

Source: BoJ

Here is why. Credit Suisse for example projects that Japan's inflation rate has peaked and is about to begin declining. In fact CS researchers see a complete divergence between the BoJ's own projection of inflation and reality. A number of other researchers (for example Scotiabank) agree.

This potential decline in inflation dramatically raises the risk of Japan slipping back into deflation - something that the BoJ and the Abe administration have been desperately trying to avoid. As inflation begins to lag the BoJ's projections, the central bank will accelerate QE to new highs.

CS: - As long as it sticks to its original commitment to achieve +2% CPI inflation by summer 2015, the BoJ is likely to decide on additional monetary easing once underperformance of the actual CPI inflation rate against its projection becomes visible.

The reason many researchers believe Japan's inflation may have peaked has to do with the yen.

Chart shows dollar appreciating against the yen in 2013 (yen weakening)
source: Investing.com

As discussed earlier (see post), a great deal of the recent inflation improvements in Japan was the result of weaker yen, which declined sharply in 2013. But more recently the yen has been range-bound (and in fact strengthening against the euro), which will halt a great deal of the price increases we saw earlier. The inflation rate is therefore expected to begin declining.

But can inflation in Japan be sustained without further weakness in the currency? Such an outcome remains unlikely because there is no evidence that labor costs will begin increasing any time soon. It is difficult to sustain price increases without labor costs and wages rising as well.

CS: - We think policymakers are on the wrong track: we refuse to be optimistic about inflation being close to target at end-year given that unit labor costs fell by 2.5% over the last 12 months and seem set to be unchanged for the next year.

This tells us that at some point later this year, the BoJ will shift into an even higher gear. The central bank's already bloated balance sheet will go "parabolic" in order to get back on track with the much publicized inflation target of 2%. The success if Abenomics depends on it.

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3 key facts about Japan's deteriorating demographics

While there is a great deal of detailed discussion in the blogosphere about Japan's unsettling age demographics (see example), it's worth pointing out three key facts that add some urgency to the issue.

1. With zero immigration and falling birth rates, Japan's working-age population is declining sharply and is now at a level not seen in 30 years. The decline also seems to be accelerating.

Wells Fargo: - While the overall population has only recently begun getting smaller, the labor force has been shrinking for more than a decade. This has serious implications for both the size of Japan’s future workforce and for domestic demand. According to the IMF, the size of the working-age population is projected to fall from its peak of 87 million in 1995 to about 55 million in 2050. If realized that would roughly equal the size of the Japanese workforce at the end of World War II.

2. As a result, the percentage of Japanese who are over the age of 65 has risen above 25% for the first time (and the growth in that ratio also seems to be accelerating.) A quarter of Japan's population is now over 65. That compares to about 14% of Americans who are over 65 (see stats).

Source: Japan Statistics Bureau

Just to put this in perspective, the total sales of adult diapers in Japan is about to exceed that of baby diapers (see story). Also see this amazing story about "a program to promote the use of nursing care robots to meet expected increases in demand in the face of Japan’s rapidly aging population."

3. According to Wells Fargo this is creating some material distortions in Japan's domestic interest rates. In fact (and this is an amazing fact indeed), Japanese seniors are having a greater impact on bringing down JGB yields than BOJ's unprecedented QE effort (see post).

Wells Fargo: - In addition to reducing potential growth, the aging of the population in Japan is having a downward influence on interest rates [chart below]. According to the IMF, elderly households prefer to avoid risk and feel more comfortable with safe assets such as Japanese Government Bonds; so much so that the downward effect on rates from elderly purchases has a bigger impact than purchases by the Bank of Japan.

10y JGB yield (source: Tradingeconomics.com)

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From our sponsor:

BOJ's aggressive QE finally brought down JGB yields

The Bank of Japan was able to lower Japanese government bond yields after an unexpected spike earlier this year (see post). The 10yr JGB is now yielding around 70bp, corresponding to about minus one percent of real yield.

The central bank continues to control this market, accelerating bond purchases since the new governor took the helm. Sooner or later that forces yields lower.

The goal is to make cash and government bonds so unattractive (negative real yield) that investors do something else with their money - hopefully stimulating growth in the process. The effectiveness of this program however is yet to be demonstrated. The recent economic gains were mostly the result of a weaker yen instead of more spending and investment. And the type of inflation generated by BOJ's policy is hardly what the central bank had in mind (see post).

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From our sponsor:

JGB yields spike in spite of all the BOJ bond buying

Japanese government bonds experienced a spectacular sell-off in the past few days, with the 10-year JGB yield rising by a half of its value.

Source: Investing.com

This is taking place in spite of BOJ's pledge to keep on buying paper (see post). Anyone who doubts the central bank's resolve, need only look at its JGB holdings. The Bank of Japan is now buying over 70% of all new government bond issuance.

Source: BOJ

The spike in JGB yields - in spite of all the central bank buying - is quite troubling.  It is precisely the opposite of what the BOJ had intended. It means that liquidity in JGBs is disappearing, as the market is increasingly controlled by a single buyer. And with most speculative players positioned long, what started as a small sell-off, quickly became amplified - as bets are unwound.

WSJ: - On Monday, Japanese yields moved higher even as the BOJ scooped up ¥1.2 trillion of JGBs maturing in one to 10 years at three separate operations—exactly the opposite effect the BOJ had been hoping for, strategists said.

With liquidity deteriorating, "a risk-free investment has now become risky," said Manabu Tamaru, senior investment manager at Baring Asset Management (Japan). "Thus investors are demanding a risk premium under the BOJ's buying program."

As of 10:30 EST (5/14) the sell-off continued.

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From our sponsor:

Abe threatens to turn BOJ into an unlimited piggy bank for the govenment

The persistent slump in the Japanese economy has accelerated.

Reuters: - Sentiment among Japanese manufacturers fell for a fourth straight month, a Reuters poll showed, providing more evidence that the world's third-biggest economy is slipping into recession amid a global slowdown and tensions with China [ see discussion ].

The monthly poll, which closely correlates with the Bank of Japan's quarterly tankan survey, comes after data this week showed the economy shrank 0.9 percent in July-September, the first contraction in three quarters.

Sentiment among non-manufacturers including retailers and construction firms tumbled in November after holding steady this year, a sign that private consumption is losing momentum after a recovery led by rebuilding from last year's earthquake and tsunami.

A slew of weak data is likely to keep the central bank under pressure to ease monetary policy further after having boosted monetary stimulus for a second straight month in October as a strong yen and weak global demand threatened the export-reliant economy.

But politicians always come to the rescue. Except rather than focusing on structural issues plaguing Japan, Shinzo Abe, the likely next prime minister of the nation, wants to use BOJ as a direct lender to the government. Of course he is not the first politician in recent months to use a nation's central bank to solve structural problems (such as excessive government debt).

WSJ: - Japan's main opposition leader Shinzo Abe said Saturday he would consider having the Bank of Japan underwrite construction bonds, a type of Japanese government debt, once he returns to power, Kyodo News reported.

"Money will be forced to go out to the market by (the government) having the BOJ buy construction bonds directly if possible," Abe said regarding steps to overcome deflation during a speech in the southern Japanese city of Kumamoto, according to the report. Construction bonds are issued by the government to finance infrastructure projects.

This new effort may make the recent QE efforts by BOJ (chart below) seem small in comparison.

Japanese Government Securities held by BOJ (source: BOJ)

The strategy is working even before the election, as the yen, already weakened by Japan's fundamentals, is getting clobbered. In practice, this is as much about construction bonds as it is about a "currency war". The new prime minister may be looking to further weaken the yen in order to revive the export sector. Of course printed money going to Japan's construction firms (see discussion) would be a wonderful side effect.

Yen per one dollar (source: Forexpros)

GS: - Potential for unprecedented political pressure on BOJ from the December election:  ... In a scenario where LDP [Abe's party] regains its position as the party with the greatest number of seats, with Abe becoming prime minister, and with the economy visibly weakening, we expect the government would call on the BOJ for further easing based on the joint government-BOJ statement issued on October 30.

Another central bank is about to lose any semblance of independence to become a tool used to win elections and provide cheap money to the government.

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Not to worry - BOJ will buy the JGBs that girl bands and sumo wrestlers haven't sold

AFP: - Japan's cash-strapped government is turning to wildly popular music group AKB48 to help it sell government bonds, as interest in the low-yield paper wanes, reports said Friday.

The all-female pop group will headline a summer campaign for "reconstruction bonds" aimed at financing projects in regions hammered by last year's quake-tsunami disaster, the Wall Street Journal said, citing an unnamed source.

AKB48, one of the world's highest-grossing acts with more than $200 million in CD and DVD sales last year, are a phenomenon in Japan and across Asia, with members appearing in commercials for everything from chocolate to mobile phones.

The debt campaign will see AKB48 -- comprising about 90 performers, ranging in age from early teens to mid-20s -- joined by sumo wrestling's champion Hakuho and female football star Homare Sawa, Japan's Jiji press agency reported.

See a more "colorful" version of this story from the Telegraph.

Buying government paper is being portrayed as a patriotic thing to do. These types of campaigns to push JGBs to Japan's population have been common in recent years. But with some 95% of bonds owned domestically and a rapidly aging population, selling long-term paper at yields of 90bp will become increasingly difficult - no matter how many girl bands or sumo wrestlers the government hires.

Some would argue that the central bank (BoJ) with its unlimited supply of yen can always step in and buy the government's massive amounts of rolling and new debt. That is Japan's Debt to GDP ratio can grow indefinitely. The rating agencies have simply been wrong to sound the alarm. And because Japan has been in a deflationary environment, printing more yen will do the nation some good.

In fact BoJ has been doing just that. The central bank has been engaged in a "perpetual QE" since the 2008 financial crisis. And that program has been accelerated this year, keeping long-term rates low.

BoJ JGBs held (units = 100MM yen; excludes shot-term bills, source BoJ)

Apparently that's not enough, as the governmental needs to sell more paper - above and beyond what the central bank, insurance firms, banks, pensions, and corporations have been buying. Clearly there is the reconstruction effort, after which the needs to sell large amounts of JGBs should subside.

Or maybe not. Debt to GDP ratio is expected to continue climbing at its current pace, exceeding 250% within the next few years. And that's assuming no change in interest rates. Should rates increase, the ratio's growth will begin to accelerate because the government would need to cover ever larger interest expenses.

Source: BNP Paribas

But for now BoJ will simply buy whatever the amounts the girl band campaigns are unable to sell. Deflation will be tamed, the yen will be weakened, the debt to GDP ratio growth will be ignored, and all will be well...

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Japan's leverage on the rise

Worried about rising federal budget deficit? Concerned about government debt spiraling out of control? Thinking there may not be enough buyers for all the new debt? Well it turns out that one can go on a spending spree and just keep selling more debt - for years. Japan has been trying to spend their way out of a prolonged recession (and deflation) since the early 90s. They tried raising taxes, but all that got them was even slower growth and more debt. Investors continue to gobble up that debt - 40-year bonds are yielding under 2%! The chart below compares Japan's debt levels to the rest of the world (it's almost double the OECD average).



The country is now leveraged at nearly 2 x GDP. Japan effectively transferred the leverage that existed on tremendously overvalued real estate in the 80s from the banking sector onto the government's balance sheet. Sounds familiar?

So who is going to pay all this Japanese government debt back? Of course it's the next generation. There are going to be more young people cranking out a larger GDP - they should be able to handle all that debt, right? Not really. The chart below shows how skewed Japan's population will become.



The percentage of young people is dropping, leaving increasingly higher debt burden per working individual. And even small GDP declines will increase the country's overall leverage, making it harder to roll the debt. As the population ages, bonds held by individuals will be converted to cash, forcing the government to look externally for buyers. At some point the growing leverage will come back to haunt Japan's government and it's people.