9/19/16

Regime Shift in the Bond Market - Japanese Bond Market

Chicken Little is scared of his own shadow. In this post, however, Chicken Little makes the reckless prediction that the bull market in Japanese bonds is over. 

Betting against the Japanese bond market is known as the 'widowmaker' trade because it has bankrupted so many famous investors. Has Chicken Little found a bit of courage or gone insane?


Chicken Little takes a path that has destroyed many others 

This post has 4 parts. 
1. Chicken Little calls the end of the bull market in Japanese bonds.
2. The implications for investors outside of Japan. 
3. Has Japan been helped by declining interest rates? 
4. Where do we go next?

1. The End of the Bull Market in Japanese bonds. 

"The Bull Market in Japanese Bonds is over." - Chicken Little, September 19, 2016. 

On July 16, 2016 the  interest rate on the Japanese 10 year bond in history was negative 0.30%. 


In 1990, the yield on a Japanese 10-year bond was over 8%. Since then, interest rates have decreased about 1% every 3 years. Chicken Little believes this era of declining Japanese interest rates is over. Japanese interest rates will stop going down, and at some point will rise. 

Why is the Bull Market in Japanese bonds ending? Chicken Little believes the end is here for two reasons. 

First, Japan is a fiscal basket case. It is heavily indebted, has a declining population, and an enormous budget deficit. It is the poster child for a risky investment. 

Japan will default on its debt. This may be an actual default where they restructure the debt and pay less than par value. Or it may be an inflationary default where they repay the debt with sharply devalued Yen. 

In any quasi-normal market environment, investors would require Japan to pay high interest rates to compensate for the risk. Central bank policies have moved us a long way from normal market conditions, so Japan is in the strange position of being an incredibly risky investment that pays less than nothing.  

While Keynes was right to say that markets can stay irrational longer than investors can stay solvent, Japanese bonds will eventually reflect their high risk.

Low interest rates spur Japanese consumers to buy safes

Second, there is a limit to negative interest rates. The Bank of Japan claims that low rates encourage consumer shopping. Unfortunately for the bureaucrats, the Japanese response has been to shop for home safes, and to store cash. Some Japanese entities are forced to buy bonds with negative interest rates, but there are powerful incentives to avoid such bonds. People will find a way to avoid owning bonds with extremely negative interest rates. 

2. The implications for investors outside of Japan.

If the Japanese bull market in bonds is over, what are the implications for people outside of Japan?

Uncertainty. 

Central Banks have two main tools to loosen monetary policy. One is lower interest rates, and the second is to buy assets with freshly minted money. 

If Japanese interest rates cannot be pushed lower, the Bank of Japan has lost one of its two tools. What will it do next? My answer is that they will increase the use of printing money. (See my longer article on the coming monetary bubbles.) 


The Bank of Japan is buying stocks, is rice next? 

The Bank of Japan is already printing money around the clock. In a world of loose money, Japan is arguably the loosest. The Bank of Japan uses the freshly printed money to buy both bonds and stocks. In the brave new world of super quantitative easing, they will buy more assets in quantity, and more different types of assets. Why not buy real estate, foreign stocks, emerging market equities?  

If printing a lot of money is good, isn't printing even more better? The logic, or lack thereof, of Central Banking loose money leads to more and more and more.  For example, Japan is always looking to help its rice farmers. Why not print some yen, buy the rice and burn it? 

If Japan does go on a printing spree will that be good or bad for non-Japanese investors? 

The net effect of monetary shenanigans is to make the world poorer. People spend time worrying about the impact of monetary meddling instead of making something. While the losers always outnumber the winners, bureaucratic manipulations distort prices and create winners. 

Perhaps Japanese exporters will gain if the Yen goes down in value.  Perhaps rice farmers will get richer if the Bank of Japan buys and burns rice. The people who know the winners are the people with superior information coming from the bureaucrats. The rest of us are likely to lose. 

3. Has Japan been helped by declining interest rates?

Central bankers use theoretical models to justify their policies. For example, Federal Reserve Chair Janet Yellen predicted in 2011 that quantitative easing would create 3 million additional jobs (link to her speech). 

Central Bank Economic Models are Fiction














How does Chairman Yellen derive the 3 million additional jobs figure? The answer is that she uses a mathematical model that compares two alternate worlds. One world with loose money, and one world with different policy. By comparing these two worlds, Chairman Yellen says 3 million.

When economists use mathematical models, at least one of the two world is imaginary. What is the real impact of loose money? Unfortunately, no one knows and many people think exactly the opposite of Chair Yellen. For example, famous Stanford Professor John Taylor writes, "Fed Policy is a drag on the economy.

Chairman Janet Yellen relies on theoretical economic models to justify US monetary policy. Those models were created by the same people who did not see the housing crises. In 2007, Federal Reserve economic models lead Ben Bernanke to his infamous statement that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

If your doctor cannot treat a cold are you going to expect a good outcome for your brain surgery? If your modelers cannot see the biggest economic crisis in nearly century, do you believe their theoretical calculation of an alternate world with different monetary policy? 

No sane person would believe in these economic models. 

Not to be outdone by the US, the Bank of Japan has teams of economic modelers. These models conclude that Japan has been helped by loose monetary policy. 

Reality suggests that Japanese monetary policy has hurt Japan. In the late 1980s, Japan was a global powerhouse. Since then it has endured a lost quarter century. 

The decades of Japanese decline and decay coincide with loose money policies of the Bank of Japan. While we cannot be sure that Japan has been harmed by printing money, we sure can wonder. Is it possible the outcome could have been even more dismal for Japan with different monetary policy? Yes. However, I think most Japanese people would love to return to 1989 and try the experiment over. 

Japan has suffered terribly during the bull market in its bonds

4. Where do we go next?

Japan and the rest of the world have been trapped in Central Bank fantasy land for decades. The core of this insanity is the idea that a country can become rich by printing money. 

Try this out tonight. Go to your copier, and copy some monopoly currency. Has the world become richer?

Copying monopoly money will not make the world richer. The same is true for the impact of the Bank of Japan or the US Federal Reserve cranking out some trillions of dollars worth of new currency. Loose monetary policy makes the world poorer, and enables powerful people with connections to take some of your wealth. 

We are at an important economic crossroad. One of the most powerful Central Banks in the world has run out of the ability to manipulate interest rates lower. Unfortunately, the next step is likely to be worse as The Bank of Japan, and other central bankers, try even more extreme manipulations. 






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