Gordon T Long

Gordon T Long

Global Macro Research | Macro-Technical Analysis 





My view of Japan over the last couple of decades has changed. During the era of what even Japan refers to as the “Lost Decades”, I have come to view Japan as a Bank! It operates like one and the Japanese economy runs like it is one!

I fully appreciate that Japan is a major global exporter of automobiles, trucks and electronics, which contributes significantly to the country’s trade balance and current account. However, it is its massive loans around the world that truly add to the coffers of Japan. It is what the world calls the “Japanese Carry Trade”!

With its phenomenal economic revival from the ashes of World War II, Japan was one of the first Asian countries to climb the value chain from cheap textiles to advanced manufacturing and services – which now account for the majority of Japan’s GDP and employment. However, it was the tremendous wealth it acquired during this period and what it did with that wealth, as part of its clever Mercantilism Strategy, that has allowed Japan to maintain being the third largest economy in the world, despite being the largest Debt-to-GDP holder in the world.

How does all this exactly work? What does it mean going forward?

  • The Japanese Carry Trade is back and it is supplying a needy world with cheap money and liquidity.
  • Inflation in Japan from rising import costs is suddenly pressuring Japan’s historically low interest rates, which underpins the Japanese Carry Trade.
  • The BOJ’s Monetary Policy of YCC (Yield Curve Control) is under assault to maintain the Japanese peg of the JGB 10Y at 0.25%. Protecting it is further devaluing the Yen and exasperating import costs paid for in Yen.
  • It is clear the BOJ will eventually have to move the peg higher – but when?
  • The world is dependent on the Japanese Carry Trade and any disruptions will cause problems. US Debt financing is currently dominated by Japan. A problem here is a huge problem for the US$ and Eurodollar!
The Japanese Carry Trade rests on the fact that Chinese lending rates are one of the lowest in the world, and the YEN is stable, highly liquid and has historically been a safe flight to safety destination during troubled economic times. As a result, it is very attractive for both foreigners and Japanese individuals and institutions to borrow in Yen, and then lend abroad in higher yielding instruments, pocketing the spread or what is referred to as the “Carry”. As long as the borrowing currency is stable, rising or can be affordably hedged, it is safe easy money – and it is massive!
  • At $1.3T, the Japanese were the largest holder of US debt at the beginning of 2022.
  • Japan’s stash of foreign assets at $3.5 trillion is the world’s largest international investment position.
  • Japan is the world’s largest creditor, holding more than $3 trillion in net assets in foreign currency reserves and direct investment abroad. How high can you go?
  • Japan has historically had and still maintains one of lowest borrowing rates in the world.
  • Japan has famously low inflation.
  • The yen’s decline has come even as it has maintained its domestic buying power better than any other currency on the planet.
  1. Japanese Debt is dominantly held by Japanese Individuals, institutions and the BOJ (not foreigners).
  2. Japanese Debt is held in Yen, (not foreign currencies), with the Yen being a highly liquid reserve currency holding.
    • As of 2022, the Japanese public debt is estimated to be approximately 12.2 trillion US Dollars (1.4 quadrillion yen), or 266% of GDP and is the highest of any developed nation. 
    • 45% of this debt is held by the Bank of Japan, part of the same government issuing the debt in the first place.
    • As of December, the BOJ owned 43% of total debt outstanding, though it draws a line from debt monetization and buys government bonds via the market. “Half of the (government) debt is purchased by the BOJ.
    • The public holds over $22 trillion of the national debt.
    • 3 Foreign governments hold a large portion of the public debt, while the rest is owned by U.S. banks and investors, the Federal Reserve, state and local governments, mutual funds, pensions funds, insurance companies and holders of savings bonds.
    • 90 percent of the debt is held by Japanese investors.
    • Japan, with its population of 127,185,332, has the highest national debt in the world at 234.18% of its GDP.
    • The consumer price index for Japan in May 2022 was 101.8 (2020=100), up 2.5% over the year before seasonal adjustment and up 0.2% from the previous month on a seasonally adjusted basis.
The Japanese Carry Trade was extremely popular in the years before the global financial crisis. (chart top right).” 
Increasingly in today’s environment the act of doing this involves selling the yen and putting downward pressure on the currency. So far this year, carry trades involving the Australian dollar (a currency whose central bank is proving far more hawk-like than investors expected at the turn of the year) and particularly the Brazilian Real, have yielded equity-like returns, while bonds and stocks have fallen.
The behavior of Japanese investors has helped yen depreciation to become self-perpetuating. Small retail investors (generally referred to as the mythical “Mrs. Watanabe”) have once again worked out that persistent yen weakness means they can get better returns by investing abroad. The act of putting money into stocks and bonds outside Japan further devalues the yen and thus helps the trade to succeed.
The chart below shows the performance, in yen terms, for FTSE’s index of global stocks excluding Japan, relative to the Tokyo Stock Exchange TOPIX index.
You can see why Mrs. Watanabe does it!
It’s a truism that someone always has to win in foreign exchange, which is essentially a series of zero-sum games.
The problem is it’s also true that someone has to lose!
The yen carry trade crashed in spectacular fashion ahead of the crisis in 2008, as risk appetite receded and international investors bought the yen. It’s easy to imagine that happening again — although this time the crucial decision could rest with the Bank of Japan. It’s YCC (yield curve control) and the continuing battle against deflation IS what is making it so safe to bet against the yen. What happens when the central bank finally throws in the towel? 
Surprise indexes confirm what might have been expected — other countries got blindsided by inflation, particularly in the Euro zone. But Japan has continued to be an exception. The data hasn’t to-date placed the BOJ under any great pressure to relent.
But the signs are that there is froth in the currency market. The yen tends to be driven by the spread between yields on Treasury bonds and Japanese government bonds. But the latest appreciation for the dollar suggests that speculation is going beyond even that, as illustrated in this chart from Bank of America Corp.
That increases the risk of a damaging “sudden stop” if and when the BOJ changes course. In effect, it would behave like the removal of a currency peg. This is true even though the BOJ is highly unlikely to intervene directly to shore up its currency. A weak yen helps to push up inflation, after all. The last time it made any attempt to sell dollars (and thus strengthen the yen) was as long ago, in 1998, as Deutsche Bank AG illustrates (chart to the right).
Even with the yen under great speculative pressure, there is still a high bar for the BOJ to intervene. And when it does so, it will be through the medium of relaxing its bond market intervention rather than by playing directly in foreign exchange.
To quote BofA:
“the ball is still firmly in the BOJ’s court as to when it might think inflation pressures are not transitory, and, when it may be an opportune to retreat from yield curve targeting. Therein resides the ongoing danger for yen bears, rather than specific USD/JPY levels.”
However, there is at least some risk that inflation will take off, even in Japan. Core inflation, excluding food and fuel, is nearly at 1%. Many other central banks would kill for that, but by Japanese standards it’s already getting high.
  1. The BOJ has been consumed for years with its fight against deflation and achieving a higher rate of inflation (to debase the costs of its rising debt) and as a consequence has a monetary policy exactly opposite to the rest of the world. While the rest of the world is tightening to fight inflation, the BOJ still has an extremely loose monetary policy.
  2. However, Inflation has recently started to rise in Japan due to rising import costs, which like the rest of the world had been primarily deflationary due to Globalization.
  3. A steadily falling Yen, which is attractive to the Carry Trade, is now exasperating the price of imports rendering them even more expensive.
  4. The BOJ has monetary policy of YCC which targets the 10Y JGB at 0.25%. This “peg” is becoming increasingly difficult to maintain. Japan recently spent $80B in a single overnight operation to maintain the peg which only resulted in further weakening the Yen and adding to import costs needing to be paid in a weaker currency.
  1. There seems little doubt the BOJ will soon be for forced to drop the YCC peg.
  2. The Yen can not be allowed to fall too much further as domestic imports highly dependent on import commodities and components are facing major margin squeezes.
The BOJ is likely to soon move its YCC targets higher, which will reduce the “Carry” profits.
The BOJ will have reason to move eventually. When might this happen? The Monex Group sees it as inevitable:
“Yes, eventually Japan will follow the US lead. The BoJ always does. The one time it did not and insisted on a de-coupling from US policy, Japan got its Bubble Economy. Nobody, least of all Prime Minister Kishida, wants to go through that again”.
The question then becomes how long will it take to persuade the Bank of Japan’s veteran governor Haruhiko Kuroda to do this, or whether it will be necessary to wait until next year, when whoever is prime minister by then can pick a new governor? The problem, for those who would like to see the yen strengthen again, is that Kuroda is like the captain who is about to catch the great white whale, or perhaps the dog who is about to catch the car. Deflation has stricken Japan for a generation. He wants to be the one to beat it, and it’s hard to blame him.
Mrs. Watanabe, with some friends in the big Japanese investment institutions, may actually decide the issue:
“Japanese investors hold the key to the fate of the Yen. Japan`s status as one of the major global creditors dictates as much. As long as Japanese institutional and retail investors refuse to invest in their own markets and instead continue to prefer global/US assets, the case for Yen appreciation will be hard to substantiate.
Here it is interesting to recall the history of the world’s single biggest asset manager, the Japan public pension fund. The GPIF manages US$1.7 trillion, of which approximately 26% are in global bonds and 24% in global stocks. In all the grandstanding about the merits or de-merits of Yen depreciation, it should not be forgotten that Japanese pensioners are thus a major beneficiary of Yen depreciation: a 10% depreciation should create a 2-3% upside performance windfall profit (obviously depending on hedge ratios and equity/bond markets performance). I am not a public pension actuary, but some friends who are suggest it is quite possible that at Y140-150/$ (and on current asset allocation), Japan`s public pension may actually become over-funded.
Importantly, the GPIF contributed greatly to forcing the last major inflection point in the Yen’s fortunes when it announced a major re-allocation out of domestic JGBs into global bonds and equities during the early years of the Abe administration.”
This is a very tenuous situation and any unexpected developments could easily spin matters into a crisis.
The world can not easily absorb a reduction if the Japanese Carry Trade as a major source of cheap money and readily available global liquidity.
Stay tuned and keep a close eye on Japan!
“Yen depreciation and higher global commodity prices have lifted inflation in Japan. As our rates strategy colleagues note, this has resulted in expectations for a change in monetary policy and significant dislocations in Yen rates markets. Over the past week Market News International reported that rising global rates and Yen weakness may be moving the BoJ towards a policy change, which could come in the form a language tweak at the July meeting (e.g., dropping reference to Covid outbreaks) which could then allow a modification of easy policy after the summer (e.g., at the September meeting).
We think investors should consider owning USD/JPY downside structures in options now, and look to go short USD/JPY in spot on clear weakness in the US labor market and/or signs of an imminent change in the BoJs policy stance”



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