JGBs Weaken Again

Overnight the JGB market once again weakened slightly, to 141.875 points. To be sure, this wasn't a very big move, but the fact is that JGBs continue to consolidate below the lateral support line provided by the interim highs made in the 2010-1012 period. Moreover, an uptrend line that has been in force for several years has been violated.

There is an even more important lateral support zone visible on the weekly chart at the 140 to 141 level. Since this support zone is not very far away from current prices, it is certainly conceivable that it might break fairly soon. If so, we believe the selling will probably intensify. As we remarked to a friend in a recent e-mail exchange:


“For more than two decades anyone trying to short the JGB market got burned. It has become an entrenched truism that the JGB market cannot decline because only Japanese domestic investors hold the bonds. Kyle Bass believes Japanese government bonds will eventually plunge because of Japan's high public debt, but it seems actually more likely that it could do so because Kuroda loses control of the effects of his policies. Japan's public debt is huge, but the government also holds valuable assets one must deduct from the gross figure (the result is still a very large number, both in absolute and relative terms, but it is only about half of the reported gross figure). The problem is a different one: banks, insurers, pension funds, all hold JGBs because they think it is impossible for inflation to flare up. Once just one of the bigger investors gets scared and concludes that this may no longer be true, there will be a snowball effect.”


The Dangers of a Breakdown

In order to appreciate just how dangerous a breakdown in the JGB market could turn out to be, consider that Japanese banks reportedly hold JGBs worth 900% of their tier one capital. Obviously that is a rather humongous degree of leverage, especially in terms of exposure to a single type of asset. Similar to banks elsewhere, Japanese banks don't have to reserve against holdings of domestic government bonds, which is inter alia what has made these bonds so attractive to them, especially in an environment of mildly declining consumer prices (which increases real returns), in an era of negative private sector credit growth to boot.

Even  bigger problems may however be faced by Japan's pension funds. They do after all have large long term liabilities that practically require a firm JGB market, simply because their holdings are so large. While higher yields would increase the nominal income from government bonds in the longer term – as long as the government remains solvent in the face of rising interest rates that is – there would be very large capital losses on their holdings in the short to medium term. Let us just say, Japan's pension fund, insurance and bank managers are probably slightly worried about the policies of the Abe/Kuroda team at this stage, even though the decline in the yen has produced a windfall profit for them due to the increase in the value of their foreign securities holdings (as an aside: so far Japan's institution seem to have mainly used the decline in the yen to cash some of those profits in and repatriate the funds instead of going out and buying more foreign assets as was widely expected).



JGB weekly-annot

10 year JGB, weekly chart with the uptrend line and two lateral support/resistance levels penciled in. Today's closing level was the lowest close for the move thus far. If the second support zone at the 140 to 141 level should give way, the selling will probably intensify – click to enlarge.



We also wanted to briefly look at the inverse of the bond price chart, namely its yield. As can be seen, yields have recently broken out above a shorter term downtrend line:



JGB Yield

JGB, 10 year yield. The short term downtrend from the 2011 high has been violated – click to enlarge.



The Lone Ray of Hope for JGB Holders

The yen has been bouncing up and down in a very tight range in recent days, but the downtrend as such has certainly not been broken yet. Any further weakening of the yen could contribute to a more forceful change in Japanese inflation expectations –  that obviously represents a grave danger for JGBs.

The decline of the yen has lost a bit of its previous momentum though and there is still no evidence of a marked rise in Japan's money supply. Until such evidence emerges, the recent moves in the yen as well as the JGB market will continue to be based on nothing but expectations. These expectations may well continue to be proven wrong. This is in fact the best hope holders of JGBs have at this point in time.




The yen's decline is ongoing, but is lately losing some of its previous momentum. There is however no evidence yet of a significant change in the growth rate of Japan's money supply – click to enlarge.




If Japan's money supply continues to stagnate, JGB holders can go back to worrying solely about the lack of sustainability of Japan's public debt and the government's solvency instead of having to worry about a possible increase in inflation expectations and an eventual rise in consumer prices as well.

We believe that Haruhiko Kuroda's policies can only hasten the arrival of the long awaited debt crisis. However, should his attempt to inflate prove as ineffective as previous attempts, some additional time could be gained before the crisis threshold is crossed. Since the one thing that no Japanese government has as of yet seriously considered is stopping or even reversing the growth of the public debt mountain, a crisis seems unavoidable – it  mainly appears to be a question of timing. Such a crisis would have global implications, due to the size of Japan's economy, the size and reach of its financial system and its role as the world's biggest external investor and creditor. The repercussions would likely be quite staggering.



Charts by: BarCharts, Bloomberg




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