Tuesday, March 15, 2011

Is is Time To Finally Short JGBs and Buy Equities?

JGBs or Japanese government bonds, have been in a bull market for years. Near zero percent interest rates leave bonds with no more room to advance and is in large part, blamed for much of the financial malaise that has gripped Japan for the past generation.

In response to the devastating earthquake, tsunami, and multiple nuclear fallouts, the Japanese government has unleashed a massive spending program on an order that would make Ben Bernanke proud. Trillions of yen are being printed to address the short term liquidity crunch, pay for much needed repairs, and to support equity markets. (Note - While I do not intend to downplay the human toll of recent events, this is a blog dedicated to financial speculation and its ripple effects. It is possible to be both humane while still sticking to the original mission statement).

But even before the recent catastrophe Japanese public finances were in a dismal state. With public debt to gdp approaching 230% the JGB bond market had attracted the attention of bond vigilantes eager to short. In comparison, the US debt level is closer to 95%-100% (depending on which source you rely on).

While these bond bears had initially arrived in the early to mid 1990s following the dramatic Japanese market corrections and property bubble, most had moved on to greener pastures, unwilling and/or unable to fight the firepower of the Japanese central bank. Other bears switched to the increasingly lucrative forex trade where they sold the low yielding yen to buy higher interest bearing currencies like the Aussie, Real, and Kiwi.

In the intervening years, Japan continued to wallow through deflation. Its ranks of elderly grew while the number of young people shrank. These members of the "lost generation" became disaffected by societal changes beyond their control. Many became "otakus" or socially ignorant shut-ins whose only refuge was the Internet. The complete lack of job security for young workers who can only find temporary employment has made life difficult for new families and caused the birth rate to be cut in half (job openings are restricted to care for the ranks of middle aged and elderly that were promised a cradle to grave existence by prior managements). Society became more insular and engrossed in domestic affairs.

Nowhere was this demonstrated more dramatically than last year when China overtook Japan as the world's 2nd biggest economy. But even this event was noted with weary resignation by a population already accustomed to a diminished role on the global stage.

So, will the recent turn of events cause them to return? The short answer is possibly. But not right away.

Rising bond yields are correlated with rising equity markets. Or are they? In the months following the Kobe earthquake of 1995 the Nikkei continued to slide. The Topix bottomed out in June 1995 (Japan's largest index after the Nikkei, similar to the rivalry between the DJIA and the S&P 500). Even the Nikkei failed to regain its pre-2008 highs. Japan's government has traditionally been able to rely on domestic consumption to finance most of its needs. This is a generalization but foreigners find it difficult to engage the non-Japanese investor. Companies and families are now faced w/the prospect of liquidating their assets (including JGBs) to pay for much needed supplies like food, water, and housing - not to mention the enormous debris clearance and reconstruction efforts. Some bears are beginning to awaken from their hibernation, entranced by the prospects of JGBs achieving junk status in the near future.

But the BOJ has never intervened on a scale like this before. Additionally, the worst effects of persistent deflation seem to have been priced out. Indeed, the effects of deflation are so strong that JGB yields are STILL implying zero inflation despite oil >$120/barrel and staple food prices advancing over 150-200% in a year!
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