Authored by Grant Williams via Mauldin Economics,
“To sum up what is most crucial in Japanese political culture: the Japanese have never been encouraged to think that the force of an idea could measure up to the physical forces of a government. The key to understanding Japanese power relations is that they are unregulated by transcendental concepts. The public has no intellectual means to a consistent judgment of the political aspects of life. The weaker, ideologically inspired political groups or individuals have no leverage of any kind over the status quo other than the little material pressure they are sometimes able to muster. In short, Japanese political practice is a matter of ‘might is right’ disguised by assurances and tokens of ‘benevolence.’”
– Karel Van Wolferen, The Enigma of Japanese Power: People and Politics in a Stateless Nation
“Living in a world such as this is like dancing on a live volcano.”
– Kentetsu Takamori
Last week, appropriately enough on Halloween, the Bank of Japan did something truly scary.
As shocks go, this one — though it had been fairly well-telegraphed to the markets that something wicked this way might be coming — was in a league of its own.
I’m sure that by now you’re well aware of what Kuroda-san (the Governor of the Bank of Japan) announced to the world; but in case you’re not, here’s a little recap:
(Japan Times): The bank will “enter a new phase of monetary easing in terms of quantity and quality,” Kuroda said.... “This is coming from a different level in both quality and quantity,” Kuroda told reporters after the two-day Policy Board meeting. “We have put forward everything there is to do at this point,” he said....
The former chief of the Asian Development Bank said the BOJ will aim to expand the amount of outstanding JGBs by hiking purchases to an annual pace of ¥50 trillion.
Increasing the amount outstanding of the bank’s JGBs at an annual pace of ¥50 trillion will bring the current balance of ¥89 trillion to about ... ¥190 trillion by the end of 2014.
It also will target longer-term debt, including JGBs with maturities as long as 40 years, as well as ETFs and real estate investment trusts, it said....
Kuroda said he’d allow this monetary experiment to run until the inflation target is met.
He also said the main target of the BOJ’s operations would switch from the uncollateralized overnight call rate to the monetary base, which will be fattened via money market operations to the tune of about ¥60 trillion to ¥70 trillion a year.
Kuroda also pledged that the BoJ:
Will invest ¥1 trillion in exchange-traded funds and ¥30 billion in real-estate investment trusts annually.
Vows to continue quantitative and qualitative monetary easing until 2 percent inflation is achieved in a stable manner.
Will conduct monetary market operations so Japan’s monetary base expands at an annual pace of about ¥60 trillion to ¥70 trillion per year. The monetary base is cash in circulation and the balance of current-account deposits held by financial institutions at the BOJ.
Shocking? Unprecedented? Foolhardy?
All of the above... except...
That was the announcement Kuroda made in April of 2013 as the first of Abenomics’ Three Arrows was fired.
Last week, barely 19 months after the world digested the news that Japan was going all-in, Kuroda pointed over the shoulders of all the other players at the table, said “Look! Behind you! An Austrian economist!” And in the ensuing panic, he slipped a bunch of freshly minted chips from a secret pocket in his jacket onto the table and, once calm had returned, went all-in again.
This time, apparently, he was serious.
The Bank of Japan, said Kuroda, would first be increasing its purchases of JGBs to ¥80 trillion a year from the previous range of ¥60-70 trillion.
What does this mean in real(ish) money? Well that’s about $720 billion. Sounds OK, right? After all, TARP was $787 billion, and that hasn’t done any damage whatsoever, has it?
However, there’s this age-old problem with comparing apples to oranges; and so, once we get our citrus fruits straight and convert the BOJ’s stimulus to a number proportionate to the larger economy of the USA, we find ourselves staring at the equivalent of the BoJ’s splashing out almost $3 trillion. Each year.
JP Morgan swiftly pointed out that this means the BoJ will be buying more than double the amount of new JGBs issued by the government.
Yes. You read that right. Double the total new government issuance. The Fed are lightweights compared to this mob.
We’ll get back to why they’re doing this a little later.
But this is just the beginning.
The BoJ will also triple its purchases of ETFs and J-REITs (yes, direct intervention by a Central Bank into the stock market is now not something to be afraid of, but rather embraced) which will make the BoJ the largest buyer of Japanese equities.
Do you smell anything wrong with this, Dear Reader?
Well, by way of a change, a few mainstream commentators are also beginning to question the logic of Kuroda-san’s latest incursion into monetary madness:
(Gavyn Davies, FT): [The BoJ’s] gigantic increase in QE activities... [is] ...of first order global importance… ensuring that the total central bank injection of liquidity into the global economy in 2015 will be much larger than it has been in the last year....
The Japanese injection... relative to the size of the economy, is far larger than anything attempted by the other central banks.
[Japan is now conducting] a laboratory experiment... [and] Governor Kuroda’s monetary experiment has in effect morphed into a strategy of devaluation plus financial repression.
But Davies isn’t alone in highlighting the sheer madness of Kuroda’s latest move:
(Richard Katz, The Oriental Economist): In the face of growing loss of faith in the Bank of Japan’s ability to either achieve its 2% inflation target in the foreseeable future or to help boost real growth, Kuroda has doubled down his strategy of lots of confident talk and even more money-creation.... (I)t is well known that Prime Minister Shinzo Abe, who keeps a stock monitor in his offices, sees rising stock prices as critical to voter confidence in Abenomics and hence his own approval ratings.... Moves to lower the yen and raise stock prices are key to the BoJ’s own strategy and tactics; Kuroda is an Abe ally, not a puppet.
However, leave it to David Stockman — one of the shoutiest sane people you’ll ever come across — to dispense with journalistic niceties.
In a piece entitled The BOJ Jumps the Monetary Shark — Now the Machines, Madmen and Morons Are Raging, Stockman takes Kuroda and the BoJ to task as only he can:
This is just plain sick. Hardly a day after the greatest central bank fraudster of all time, Maestro Greenspan, confessed that QE has not helped the main street economy and jobs, the lunatics at the BOJ flat-out jumped the monetary shark. Even then, the madman Kuroda pulled off his incendiary maneuver by a bare 5-4 vote. Apparently the dissenters — Messrs. Morimoto, Ishida, Sato and Kiuchi — are only semi-mad.
Never mind that the BOJ ... balance sheet which had previously exploded to nearly 50% of Japan’s national income or more than double the already mind-boggling US ratio of 25%.
In fact, this was just the beginning of a Ponzi scheme so vast that in a matter of seconds it ignited the Japanese stock averages by 5%. And here’s the reason: Japan Inc. is fixing to inject a massive bid into the stock market based on a monumental emission of central bank credit created out of thin air. So doing, it has generated the greatest frontrunning frenzy ever recorded.
The scheme is so insane that the surge of markets around the world in response to the BOJ’s announcement is proof positive that the mother of all central bank bubbles now envelopes the entire globe.
The “surge of markets” to which Stockman refers illustrates the madness that has consumed both equity and bond markets in the wake of the 2008 ceding of custody of formerly free markets to the world’s central banks.
These are the two charts that people care about when discussing the Bank of Japan’s moves.
Firstly, the Nikkei 225:
As you can see, stocks have exploded in Japan since the beginning of Abenomics, rising 41.6% in just 19 months — but it wasn’t a straight line. Initially, after a 30% surge, the doubts set in and the Nikkei retraced most of its gains before beginning a long grind higher as investors reluctantly bought into the idea that Abenomics might just work raise the Nikkei 225.
Taking a step back, we get to see just how poorly stocks have behaved since the bursting of the twin Japanese bubbles in real estate and equities back in the late 1980s, as well as the clear breakout, retest, and break higher from the 25-year downward trendline:
The second chart that folks care about in the wake of the BoJ’s moves is this one, the yen:
Again, as you can clearly see, QE10 and now QE11 jumpstarted the yen. (Are you paying attention, Janet? Do you think for a second that when the BoJ announced QE1, it was as the first installment of a cunning 11-part plan to be implemented over a couple of decades?)
However, jumpstarted tends to imply a positive effect, as does a chart that travels from bottom-left to top-right. In the chart above, I have inverted the yen to better reflect the damage being done to it by the BoJ rather than the kinda-cool-looking chart where it explodes “higher."
Of course, thanks to the wisdom of guys like Kyle Bass (whose Rational Investor Paradox warned of a plummeting yen and a skyrocketing Nikkei) and Dylan Grice (whose 63,000,000 call for the Nikkei by 2025 is occasioning fewer chuckles by the day), everybody is riding both these horses — hard. However, the fact that everybody got “long the Nikkei” and everybody got “short the yen” when Abenomics’ first arrow was fired is the wrong reason to be cheering Kuroda’s interference in the natural forces that used to drive markets.
Now, “long the Nikkei and short the yen” is undoubtedly a great trade and has much further to go — something my friend Jared Dillian pointed out in his excellent Daily Dirtnap recently. Pointedly, the piece was entitled “Unlimited Upside”:
(The Daily Dirtnap): I am starting to wonder if nobody understands why this trade works and why it will continue to work, and why, in November 2012, I called it “THE GREATEST TRADE EVER.” The reason it is the greatest trade ever is because you literally have unlimited upside. JPY can infinitely weaken. The stock market can go infinitely high....
So USDJPY is going to get to 120 in a hurry, then what? You’ve seen the chart. If it gets through that trendline, the sky is the limit. Where could the Nikkei go? Beats the heck out of me. But that is the great and interesting thing about this trade, is that if Japan really does find itself in trouble, they can’t default — well, I suppose they could, and that actually would be the smart thing to do, but no, they will print their way out.
No arguments from me there, Jared, BUT... the charts that people need to be looking at to try to understand the dire state Japan is in (as well as the ultimate futility of the Keynesian free lunch) are charts of things that can’t be directly influenced by the BoJ but which are instead supposed to be indirect beneficiaries of Abenomics and to generate the organic growth needed to revive Japan’s moribund economy.
Charts like... oh, I dunno, Japanese industrial production:
Orrrr... perhaps that relatively unimportant macroeconomic datapoint, GDP:
Then there are the places my friend Paul Mylchreest of ADM ISI looked at this week in an excellent piece that landed in my inbox — places like real Japanese household incomes:
(Paul Mylchreest): You only know with hindsight, but there’s a good chance that Japan’s economy has just moved into the terminal ward of mismanagement and decline.
Kuroda went nuclear just as Mr and Mrs Watonabe… never mind the rest of the world… had begun to realise that “Abenomics” wasn’t working.
Real household incomes in Japan are running 6.0% lower year-on-year, which is close to the worst they’ve been in a decade… and most of the bad data points have followed the implementation of Abenomics.
And then of course there are the twin charts from my presentation at the Strategic Investment Conference back in May: Japan’s trade balance and current account (updated here to show the improvement in the data):
In his most recent Global Macro Investor, my friend and colleague Raoul Pal pointed out a couple more problems with the Japanese economy that no amount of prestidigitation can hope to cure, beginning with the reaction to Abe’s recent sales tax hike and moving swiftly along to exports (ordinarily the natural beneficiary of a plummeting currency for an exporter like Japan):
(Global Macro Investor): Japan’s economy has reacted as it always has with regards to the tax hike — it got flushed down the toilet…. It puts to rest any stupid notions that you can falsely raise inflation and see it stick. It also shows that QE does not help the economy in any way.
We can also see that massive Japanese QE has not helped its industrial production base…. And exports are just not picking up with a cheaper currency…. And even after a massive currency move versus the RMB, it is still not able to export its way out of trouble… demand is just not there, regardless of price….
Ahem!
So the simple truth is this:
Japan’s only solution to its crippling debt burden and seemingly unbreakable deflationary spiral is to weaken its currency.
Period.
Yes, there is plenty of talk of reform, though given Japan’s corporate culture that is far harder to achieve and much farther in the distance than most outside observers could possibly imagine; but were the narrative presented to the world simply as “we are going to destroy our currency,” even the market monkeys who continue to see no evil would be forced to take drastic action.
By maintaining the pretense that weakening the yen is actually part of a broader strategy which will ultimately be successful, the Bank of Japan is engaged in simply that: pretense.
Now don’t get me wrong: I’m not saying the necessary reforms CAN’T be achieved in Japan — just that they won’t. Not in time to save the country from disaster at the hands of Abe, Kuroda, and the rest of the Crazy Gang, anyway.
Those stagnant exports are a huge, flashing-red warning sign in the face of what can only be described as a resounding success in beginning the complete destruction of weakening the yen.
Let’s face it, if you are Japan and a chart like the one below doesn’t have a significant positive effect on your exports, something is structurally wrong — and structural change is not something the Japanese like (or do):
Now, after 18 months of a one-sided assault on the Asian currency markets, several countries are nearing a line in the sand. Raoul again:
(Global Macro Investor): This all leads me to another important topic for discussion, and that is Japan and China. There is a war going on and we need to understand it... with a chart of the Chinese Yuan versus the Japanese Yen. This is going to become increasingly important in understanding what is likely to develop.
The JPY has just wiped out 21 years of Yuan weakness.
This is an aggressive competitive devaluation against Japan’s largest competitor — China. This is a big deal…. But in the case of Japan it is not all about dollar strength; something much more troubling is going on, and that is a currency war with its competitors. The JPY/KRW cross is also getting close to some very key levels…. The JPY/TWD cross is equally troubling….
Think the Bank of Korea or the Central Bank of the Republic of China (Taiwan to you and me) are about to sit idly by and watch their exporters get put out of business by Japan Inc.? Me either... and that spells T-R-O-U-B-L-E, as Raoul ominously points out:
(Global Macro Investor): The issue here is the mercantile trade policies of Asia in a highly-indebted, imbalanced, low-demand world — the only answer is currency war and trade war.
Thus, I think it will not have escaped the notice of the other Asian countries that Japan is trying to steal an advantage from them in a desperate bid to counterbalance the gigantic debts within Japan itself.
Their response will be the only answer they can make — allowing their own currencies to fall sharply (I think the charts in the previous section show that).
In a currency war in Asia, four possible risk events could occur:
1. Someone loses control of their currency, and economic collapse and de facto defaults occur (devaluation or hyperinflation).
2. The dollar absolutely skyrockets (almost a certainty).
3. The Yuan is forced to devalue sharply.
4. War.
So it appears that Japan is playing some high-risk games, both with its own markets and with its mercantile neighbours….
Scary stuff — perfect for Halloween.
But what of the bond market? Well, fortunately for Japan, the profile of those poor unfortunate souls who own JGBs looks like this (left):
As you can see, only 4% of JGBs are owned by overseas investors, which helps keep this little problem in-house for a while longer, and ‘in-house’ is something Japan needs, because the Japanese ability (and willingness) to take pain for the greater good is beyond the comprehension of most market watchers.
That’s the good news.
The bad news brings us back to what we were discussing earlier — the reason why the BoJ is ramping up its bond buying to levels which have left madness in the dust.
As I wrote in Things That Make You Go Hmmm... back in 2011 when Japan’s Government Pension Investment Fund (GPIF) first announced that they would be turning seller of JGBs to fund retirees demands for cash, that shift, when it occurred, was going to cause significant problems for the BoJ. Well, right around the time Kuroda was scaring the kids with his latest news conference, the GPIF made an announcement of their own quite coincidentally and in no way coordinated with Kuroda’s:
(Bloomberg): GPIF, which manages 127.3 trillion yen, revealed plans to reduce domestic bonds, while setting allocation targets of 25% each for Japanese and overseas equities, up from 12% each.
Under the new plan, GPIF would need to cut about 23.4 trillion yen of its domestic bond holdings to achieve the 35% target, according to data compiled by Bloomberg based on the plan. The fund’s new target allows for a 10% deviation. GPIF held 67.9 trillion yen of local debt, which accounted for about 53% of its portfolio as of the end of June.
The announcement of the BOJ’s added stimulus on the same day GPIF revealed its new investment plan was no coincidence, according to Takatoshi Ito, who led a government pension advisory panel last year.
“Everybody involved was on the same wavelength,” Ito said in a telephone interview from Bangkok. “It is quite a coordinated action, whether consciously or unconsciously. It was beautifully timed, and I would call it a Halloween treat.”
“A Halloween treat”? Really?
REALLY?
William Pesek of Bloomberg took a rather dimmer view:
(Bloomberg): In announcing that it will boost purchases of government bonds to a record annual pace of $709 billion, the central bank has just added further fuel to the most obvious bond bubble in modern history — and helped create a fresh one on stocks. Once the laws of finance, and gravity, reassert themselves, Japan’s debt market could crash in ways that make the 2008 collapse of Lehman Brothers look like a warm-up. Worse, because Japan’s interest-rate environment is so warped, investors won’t have the usual warning signs of market distress.
Even before Friday’s bond-buying move, Japan had lost its last honest tool of price discovery. When a nation that needs 16 digits in yen terms to express its national debt (it reached 1,000,000,000,000,000 yen in August 2013) sees benchmark yields falling, you’ve entered the financial Twilight Zone. Good luck fairly pricing corporate, asset-backed or mortgage-backed securities....
Kuroda’s latest move means Japan’s QE scheme could last forever. The BOJ has willingly become the Ministry of Finance’s ATM; reversing the arrangement will be no small task.
Pesek continued, taking aim at the GPIF:
All this liquidity has made for surreal events in Tokyo. Take the news that Japan’s $1.2 trillion Government Pension Investment Fund will dramatically rebalance its portfolio away from bonds. Japan has enormous public debt and a fast-aging population, and now the world’s biggest pension pool is shifting to stocks. Yet somehow, 10-year yields are just 0.43 percent. The explanation, of course, is that the parts of the market the BOJ doesn’t already own are sedated by its overwhelming liquidity. The BOJ is now on a financial treadmill that’s bound to accelerate, demanding ever more multi-trillion-dollar infusions to keep the market in line.
And what of Japan’s households — the people who have been promised that the value of any cash holdings will be systematically destroyed by the men entrusted to steward the country successfully across the river of deflation to the safety of inflation waiting on the other side in the sunlit uplands? What of them?
Well, if the most recent flow of funds report, released by the BoJ in September, is anything to go by, poor old Mrs. Watanabe is about to get what is known in the West as the shaft:
Yep... the BoJ has made the Japanese people a promise. They will continue trashing 53.1% of their assets (having already knocked roughly 20% off them since the beginning of Abenomics); BUT, not to worry, because they will simultaneously inflate the value of the 9% of their assets held in equity portfolios by an as yet unspecified amount.
Now, rudimentary math would suggest that the Nikkei would have to double to compensate them for the confiscation of 20-odd percent of their cash — and that is assuming no further erosion — but a promise is a promise.
Pesek finished his piece on a high, taking aim squarely at Kuroda:
(Bloomberg): Kuroda is turning the BOJ into the world’s biggest asset-management company. The BOJ won’t admit it, but it’s monetizing Japan’s debt on a massive scale, and probably even retiring large blocks of it — just as the government did in the 1930s. What happens when the BOJ decides Japan needs a credible and functioning bond market in the years ahead? Kuroda’s successors face terrible odds disengaging from a market he’s effectively nationalized.
erhaps history will vindicate Kuroda’s genius. That depends on whether Abe musters the courage to attack structural impediments to growth in employment, industry, trade and energy. More likely, Kuroda is demonstrating that it’s one thing to go long on a market, and quite another if you have to stick with that bet forever. To avoid being remembered as a madman, Kuroda had better devise an exit strategy from history’s most audacious bond trade.
I feel certain that when we finally emerge from this dystopian Keynesian nightmare and the books are written about this sorry period in monetary history, the day Kuroda finally went Colonel Kurtz on the world will be seen as the beginning of the end.
Back in 2010, my friend Dylan Grice wrote these words:
Despite the Japanese government paying a mere 1.5% on its bonds, interest payments amount to a hair-raising 27% of tax revenues. Including rolled government bills (which Japan’s MoF defines as debt service) takes the share to an eyebrow-singeing 57%.
Any meaningful repricing of Japanese sovereign risk would push yields to a level the government would be unable to pay. Moreover, since the domestic financial system is loaded up to the eyeballs with JGBs, a crisis of confidence there would soon transmit itself beyond the public sector.
The BoJ is now paying even less on its bonds — such is the temporary miracle of faith in a central bank’s ability to control the unintended consequences of its actions no matter the level of sheer lunacy involved — but, as Dylan pointed out, the BoJ’s course of action was set in stone four years ago.
Kuroda’s move was inevitable; and that, sadly, also applies to the end game. Back to Dylan:
So the path of least political resistance will presumably be to keep yields at levels which the Japanese government can afford to pay, and to stabilise JGBs at levels which won’t blow up the financial system. This will involve the BoJ buying any/all bonds the market can no longer absorb, probably under the intellectual camouflage of “a quantitative easing program” aimed at breaking Japan’s deflationary psychology. Economists might applaud such a step as finally showing the BoJ was getting serious about Japan’s problems. In fact, it will be the opening chapter of a long period of inflation instability.
Is Dylan a psychic? No. He’s just a very smart, incredibly astute observer of both market psychology and, perhaps more importantly, history.
The die is already cast, and all we can do now is wait for the inevitable to happen and Japan’s bond market and currency to be destroyed — and the Nikkei to head in the direction of Dylan’s 63,000,000 target.
In his always-brilliant Epsilon Theory this week, Ben Hunt looked at the BoJ move through the prism of Game Theory, threw in a lesson learned the hard way from getting schooled by his Grandmother’s bridge partners, and reached his own conclusions — conclusions that echo the fears of Raoul, Dylan, and myself. (Incidentally, I sat down with Ben in New York recently for a chat with my RealVision hat on, and what he had to say was fascinating:)
(Epsilon Theory): For five and a half years the BOJ has had a clear field to take whatever actions they wished without fear of some other, stronger central bank smacking them in the mouth. There has been a coordination of central bank purpose and effort that hasn’t been seen since… the 1985 Plaza Accords? Bretton Woods? Whatever your reference point might be from an economic history perspective, it’s been a very long time since we’ve seen such a very long period of such a non-strategic, we’re-all-in-this-together decision-making backdrop for second tier central banks like the BOJ or the BOE. So it really doesn’t surprise me at all that the BOJ did what it did last Friday. Like you and me and market participants everywhere, the BOJ Governors have been very well trained to expect that the Fed has got their back, that they can act according to their own narrow and immediate self-interests without concern or fear that their actions will result in someone smacking them in the mouth.
Unfortunately for the BOJ, I think that this happy state of coordinated policy bliss ended about six months ago. I think that they have redoubled this particular contract as if they were playing bridge with doting grandparents rather than chain-smoking, penny-pinching old crones. I think that there is a clear and growing divergence between the US and the rest of the world when it comes to balance sheet expansion and monetary policy intentions, and I think that for China in particular this latest BOJ action is perceived as an aggressive provocation that must be responded to forcefully.
So what’s next? I’m waiting for China’s response. I have no idea whether the response will be (to use the political science terminology) symmetric or asymmetric in scale and delivery. That is, the response could be larger or smaller than the perceived provocation, and it may or may not be a response delivered through monetary policy. I have no idea exactly when the response will occur. But I have zero doubt that a forceful response is coming. I have zero doubt that Japan is about to get smacked in the mouth. And when that happens, the monetary policy calculus in Japan … and the UK … and even the EU will take on a very different shape.
Kuroda has fired the shot that looks likely to trigger the next phase of the crazy monetary experiment we’ve all been living in for the last five years. Unfortunately, the next phase is where things start to get nasty. Just because equity markets cheered the latest sugar rush he guaranteed them should not make smart investors lower their guard — quite the opposite, in fact.
Colonel Kuroda has gone up-country into the Heart of Darkness, and all we can do is await the Apocalypse now.
* * *
Download Grant Williams full letter here (PDF).