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Entries in Japan (118)


Negative current account in Japan makes a short JGB trade worth considering 

Investors are slowly but surely adjusting to a world where markets and becoming more uncorrelated and (macro)risks are now local instead of global. We are now living in a bottom-up world and global macroeconomists with a Cassandra bent are set to become an endangered species. Or so at least is the refrain from the Street researchers that I am following.

Apart for some important qualifiers (see below) I tend to agree with this. I certainly never bought the recent misplaced worries about current account deficits in Brazil, India and Indonesia as the potential source of a new Eurozone type crisis. Current account deficits are perfectly normal for these EM economies and indeed welcome in a world where everyone wants to export their way to growth. As I argue below, investors have been focusing on the wrong deficits.

The notion of a less correlated world is an interesting narrative in itself because it is starting to emerge as a serious alternative to the Zero Hedge view of the world. In fact, it is worth pondering whether the recent 12 months’ impressive melt-up in developed market equity market isn’t, in part, a contrarian response to the growing fraction of Armageddon Preppers  that has infiltrated financial market commentary.

For investors the transition to a world dominated more by bottom-up and local themes would constitute a more benign investment environment relative to a world where the future of financial markets rest on the whims of Greek bureaucrats’ dealings with the IMF. This is the good news, the bad news is that I don’t think investors can completely disregard global macro risks. Specifically, I see two “local” macro risks with the potential to global; a capital outflows crisis in China and the growing CA deficit in Japan (and its consequences for the JPY and JGB).

In this post I deal with the latter. 


Japanese current acount makes no economic sense

There are two reasons why the current account deficit in Japan should command investors’ attention. In the first instance, it is important because it points to further and strong JPY depreciation. Secondly, because it is a necessary but not sufficient condition for the JGB market to blow up (yields to rise sharply in Japan).

Edward has already dealt with the challenges that Abenomics face over at AFOE. I agree with the main sentiment; especially this.

(…) it seems to me Japan’s problem set is overdetermined in that we always seem to be facing at least one more problem than we have remedies at hand.

Turning to my own narrative, the first point above may seem less controversial. Every serious and non-serious macro trader has been short the JPY in the past 12-18 months. I would suggest that trade will continue to perform nicely, but a negative current account suggests that the JPY could now be on the cusp of weakening with a speed and to a level that will garner serious attention from the other G7 economies and market participants. This is to say that so far the short-JPY trade has been lucrative idiosyncratic trade driven by a local macroeconomic experiment in Japan. A negative current account could be what makes a weakening JPY a systemic risk for the global economy through its impact on Japan’s economy. To put this in a language market participants can understand, so far the short JPY has been a risk-on trade with the USDJPY being very correlated to the US 10y yield and Nikkei 225. With a current account deficit my contention is the JPY would weaken sharply even in an environment where stocks sold off and US 10y notes rallied.

Remember that the rest of the world has so far accepted the experiment that is Abenomics not only because Japan has been running a current account deficit (thus making it more reasonable for Japan to weaken its currency), but also because the depreciation has so far been orderly. With a growing negative current account, the wheels are now set in motion for a decidedly disorderly depreciation of the JPY and one that could ultimately be life threatening for the Japanese economy.

In simple terms, Japan’s current account deficit is "perfectly" in line with a rapidly ageing economy that is supposed to dissave. However, it is also the first example of its kind. We simply do not know how an economy with no discernible future investment yield and opportunities react to the need to import foreign capital to pay for consumption and investment through, as is currently the case, a big and growing budget deficit. My guess is that all known theories of life cycle economics are about to run out of line as it becomes clear that negative current account dynamics do not make sense for a rapidly ageing economy. Either the currency weakens up to the point at which the current account is closed (that is rapidly and violently!) or bond yields start to rise (in similar violent and rapid fashion). Neither scenario is going to be pretty.

The biggest push-back I continue to get here is that the BOJ will simply continue to buy all the JGBs and thus that bond yields will not be affected. This certainly looks like where we are going. A case in point has been the amazing statements from the Government’s Pension Investment Fund (GPIF) signalling their intent to sell bonds and buy more equity.

This puts an incredible onus on the BOJ. Not only is the Japanese pension industry now dissaving (i.e. structural net sellers of bonds to fund retirement redemptions), but if they also start to liquidate their stock of JGBs to rotate into stocks who will pick up that flow. Remember here that Japan is currently running, by far, the biggest budget deficit in the world. There are only two constituents that can pick up this flow really; foreigners and the BOJ. This has customarily been the main reason for expecting ever more aggressive monetary easing and essentially that the BOJ would become the JGB market. This is certainly where we are going but a negative current account changes dynamics significantly

In essence, the notion of the BOJ buying up all JGBs does not necessarily apply in the case of a current account deficit. More specifically, no matter the speed of the printing press in Japan foreigners need to finance the current account per definition and if the deficit is structural it is difficult to imagine this would not include buying JGBs (thus, presumably demanding a higher yield for their effort). The BOJ could, in theory, buy every single JGB but this would then de-facto be done in order to shield the JGB market from foreign influence and higher yields.

The presence of a negative current account thus creates a veil between the BOJ and its objectives. It can still achieve its objectives, but it would require a drastic radicalisation of its bond buying programme and thus a likely very aggressive nominal target for JPY weakness. This would, in the first instance, call for accelerated JPY weakness but investors should not automatically assume that the BOJ can control this process.

This brings us to the second point stated above. A negative current account deficit is thus the first step towards a rout in the JGB market. While it is true that Japan has its own currency and will likely use it aggressively as an adjustment mechanism the key question is the speed with which such an adjustment will work. Investors should not take this lightly. If inverted yield curves in the Eurozone periphery proved to be a significant global source of tail risk, a similar development in Japan would be equivalent to a global financial nuclear disaster.

Many commentators have noted here that as soon as Japan turns back nuclear power the current account will stabilise, but this is far from certain. And even if this was the case, the speed with which such a change materialises in the current account balance could easily be enough to upset the cart.

The investment implications are clear in my view. Being short the JPY makes imminent sense and investors should add to position. The traditional risk-on/risk-off dynamics would suggest that a market sell-off should be correlated with JPY appreciation. My view is that the negative current account changes that dynamic. I would also suggest buying OTM put options on the short end of the JGB curve. Being short JGBs has so far been a widow maker, but a negative current account deficit changes the risk/reward ratio drastically for such a trade. Investors should take note. 


Random Shots - Above Expectations

The market action of last week repeated a lesson that many a punter appeared to have forgotten. Never run a bearish book into a European summit and especially not one where expectations for a result are as lows as they were going into Friday's meeting. Risk assets went up like a rocket with especially oil releasing heavily oversold momentum and you really could not do much wrong if you were running even moderately net long. 


Above Expectations in Europe

Obviously, the market is buying the rumour and not the fact. In traditional summit fashion we got a lot of road maps and promises but very little concrete effort. Details were exceedingly sketchy and to talk about game changers is premature. We usually do not get game changers from the EU, but merely fudge cakes. Alpha.Sources would however like to remind investors that such fudge cakes may be enough to quell the market's sugar addiction for several weeks.  

Three points are worth making. 

Firstly, the ESM appears to get the ability recapitalise banks directly and the door has also been opened up for the ESM/EFSF to buy peripheral debt without implied seniority. This is a big step in breaking the link between banks and the sovereign. Ireland and Spain in particular will be the beneficiaries of this. Alpha.Sources remain skeptical that the broadcasted notion of no conditionality will hold, but at least in principle there is a now a negotiated result which seems to allow countries to get help for their banks with little or no conditionality on the sovereign and no addition to sovereign debt to GDP. This is a significant step towards risk mutualisation through a banking union and ultimately a fiscal union. Alpha.Sources would note however that without applying haircuts to bondholders of both sovereign and private debt, One link is broken but another one is created between core Europe and the entire European banking system. While such a link may be stronger through the effective backing of the whole eurozone balance the key question is how far Germany and the EU will go. This question is particularly relevant (and binding) as it will inevitably become clear that whatever initial amount of euros ceded to the ESM/EFSF to sprinkle over Europe's barren financial markets, it will almost surely be too low. 

Secondly, the electorate and political establishment in Greece have every right to be perplexed. Greece has thus spent the past 3 months under an effective threat of being kicked out of the eurozone only to watch Spain and Italy get away with what is essentially preferential treatment.  The fact that systemically important entities, sovereign as well as private, are given special treatment in this crisis is nothing new, but it remains a democratic problem in the EU. Like Portugal who remains the only country ever to get fined under the Stability and Growth Pact even as virtually every country violated the rules, Greece may rightfully feel a sense of injustice. 

Alpha.Sources would then venture the claim that a Greek exit is now out of the question in the short run (i.e. in 2012). Even as Germany may still move to extract its pound of flesh from Italy and Spain, there is now little chance that Germany and the EU can play hard ball against Greece in the coming negotiations with the Troika. Greece could obviously still become the whipping boy, but the continuing argument that Greece is special is now so worn that even European politicians must be able to see that they can't use it anymore. On this background, Alpha.Sources can't see the ECB shutting off Greece from the ELA while the ESM/EFSF is loading up on Spanish bank equity as well as non-senior Italian and Spanish sovereign debt.

Thirdly, the modest but clear movement towards official creditors not being considered senior could potentially go a long way to break the doomsday loop by which once a country enters bailout proceedings it will never access the market again. Alpha.Sources emphasizes potentially here however and for now, Alpha.Sources will stick to the main rule that whatever we might constitute normal market access the eurozone periphery is far from it, but there is another silver lining to this. Consequently, in Greece it will alleviate the pressure on the ECB, EU and the IMF as it is clear that the country will need a second write down of its debt which will inevitably involve its official sector creditors. 

As a general conclusion, the summit results implies a very large degree of risk mutualisation which it is unclear that Germany will ultimately go for, but multiple conclusions are not possible at the same time and so far the market and punditry seem to view this, rightly or wrongly, as victory for Hollande, Monti and Rajoy. This also means that the decoupling of Bunds from US treasuries and Gilts as well as the recent steady increase in German CDS is set to continue. This is also why Alpha.Sources believes that unlike the German national team who might have to wait two years and the World Cup to redeem itself, Merkel will get her shot much sooner.

One thing Germany will push for is the fiscal compact rules to be put in motion at a fast track pace and also, if the ESM is to take direct and equal ownership of European banks Alpha.Sources feels certain that this will come with extended EU supervision of the involved banks.


Unimpressed in Japan

Another seemingly important political result this week was the approval of the increase in Japan's consumption tax, an increase which has been debated consistently for 5 years in Japan. If the final tax bill is passed, the tax rate will increase from the current 5% to 10% in two steps from to 8% in 2014 and 10% in 2015. 

While the consumption tax has long been touted as the first step to put an end to the fiscal train wreck of Japan's public finances Alpha.Sources believes that the measure will ultimately be counter productive. Japan's fiscal problems consequently do not stem from a lack of revenue, but rather from too much spending. Trying to extract more revenues from a domestic economy where aggregate demand is already chronically weak due to an ageing population will only steal consumption from a future which is, in an almost literal sense, not there. 

In this piece written on a similar VAT hike in Germany, yours truly presented a relatively simple economic framework for what it means to increase indirect taxes in the context of a rapidly ageing economy. In a nutshell, the argument is that while there will be a pure statistical effect on inflation readings as a result of the tax hike as well as positive effect on consumption as the purchase of durables is pushed forward, the end result is likely going to be deflationary. 

The following quote, while requiring a little bit of basic microeconomic intuition, presents the argument, 

(...) students of applied microeconomics learn to distinguish between the point of impact and point of incidence of a tax. The former constitues the party who actually levies the tax towards the government whereas the latter denotes the party who actually supports the tax. In the case of a value-added tax (an indirect tax) the point of impact would then be the consumer who (through an intermediary; e.g. a retailer) levies the tax towards the government. However, it is much more interesting in this case to discuss the point of incidence of the tax that is who actually supports the tax. In order for us to do so we need to introduce yet another economic concept, namely supply and demand elasticities of the tax hike. Consequently, the party with the highest relative elasticity (i.e. flexibility) towards the tax will also avoid supporting the lion’s share of the tax increase. What this means in the concrete case of the German tax is of course very difficult to asses. Yet, since for example consumers’ demand elasticity in this case can be operationalized as the relative fraction of disposable income which is consumed and saved (i.e. the MPC and MPS) we might actually be able to sketch a framework which suggests why the VAT hike in fact should not have been expected to rapidly push up inflation in the first place. The point would then be that the consumers’ demand elasticity towards consumption and thus flexibility towards avoiding the tax relative to businesses would be positively correlated with the marginal propensity to save.

In a rapidly ageing society, the attempt to extract tax revenue through consumption taxes fundamentally misunderstands the consumption and saving dynamics in the context of population ageing. 

Still, we should expect higher consumption in Japan and also, ironically, that inflation may nudge its way up close to the 1% mark set as the target for the BOJ. It would be tragic if this prompted the central bank to lay down its guard because the end result would almost surely be more deflation and contraction. 

With that dear reader it seems that just as Italy spearheaded by the enigma that is Balotelli managed to exceed expectations against Germany (only to come crashing down in the final!), so did we also get a number of political results which, at a first glance at least, were above expectations. In Europe, Alpha.Sources harbours a scant hope that the seeds layn may provide a little calm in the coming months however fleeting this might be while in Japan, the sentiment here at this blog is decidedly unimpressed.