Playing with Fire

We have recently written about what we have termed “the world's strangest market”, namely the JGB market. For a long time, it made sense for Japanese institutional investors to invest in JGBs. Even with extremely low nominal yields, they produced an acceptable return in view of stable and sometimes mildly declining prices in Japan. Obviously, today these investments don't make much sense anymore. With Japan's central bank hell-bent on debasing the money it issues, there can no longer be any hope of achieving an acceptable return with JGBs. Moreover, the market has basically died – there is almost no trading in JGBs anymore, except for the incessant and massive buying by the BoJ. Trading volume in JGB futures has also collapsed since 2012:

 

 

JGB, weeklyTrading volume both in cash JGBs and JGB futures has collapsed over the past few years. Recently it has practically dwindled to nothing – click to enlarge.

 

Apparently this is exactly what Shinzo Abe wants though – he wishes Japan's pension funds to 'move out' of JGBs and invest into 'higher yielding assets' instead. The problem with such assets is of course that that they are risky – although by now an argument could well be made that JGBs are even riskier than e.g. equities. Reuters reports:

 

“Prime Minister Shinzo Abe is moving to shake up oversight of the world's largest pension fund, expanding the board and giving it new power to steer a shift out of Japanese government bonds and into higher-yielding assets, according to two people with direct knowledge of the matter.

Officials are considering a proposal to add two or three dedicated professional advisors to the committee that oversees investment at the $1.26 trillion Government Pension Investment Fund (GPIF). They would play a key role in reforming a fund that's bigger than the economic output of Mexico with the power to influence markets as Abe presses policies to spur growth.

The beefed-up GPIF committee could be given new, broader powers that would make it the final arbiter for how the Japanese pension fund invests its money, according to the people, who asked not to be named because the policy measures remain under discussion.

The existing investment committee comprises academics and economists, with a representative from Japan's trade union federation and one from the main business lobby. Its current role is restricted to advising the fund's president.

The proposed reforms would help shift GPIF towards riskier investments like stocks and away from low-yielding Japanese government bonds. Supporters of the reform say targeting higher returns would benefit future pension recipients in Japan's ageing population and drive economic growth.

[…]

GPIF currently holds 60 percent of its assets in Japanese government bonds, but the Bank of Japan now buys up most new debt issued by Japan's government as part of an aggressive monetary easing.

"Debate is already proceeding and we've indicated a direction for GPIF in moving out of JGBs and into risk assets like stocks, REITs and infrastructure funds," Japan Vice Minister Yasutoshi Nishimura told Reuters

 

(emphasis added)

Leaving aside for the moment whether 'investment by committee' is a good idea, especially a committee such as the one described above, it is probably not a bad idea in principle for the pension fund to get out of JGB Dodge. The question is though, if the biggest Japanese pension fund sets an example by selling its JGB holdings and other pension funds follow suit, what will happen to the prices and yields of JGBs?

On the one hand, the BoJ has succeeded in suppressing JGB yields with its massive buying, but on the other hand it has also 'succeeded' in turning their yield deeply negative in real terms. If JGBs were to properly reflect the loss of the yen's purchasing power, the government would face an enormous funding problem. At a 0.6% yield-to-maturity, 25% of its entire tax revenue is spent on servicing just the interest payments on its existing debt. If yields were to increase substantially, the government's continued solvency would soon come under doubt. This in turn would likely lead to even more debt monetization by the BoJ. In the end, the government may well end up owing its entire debt to itself. It is a good bet that if that were indeed to happen, the currency would become worthless and cease to function as a viable medium of exchange.

 

The Goal is to Drive up Faltering Share Prices

The Nikkei index is perilously close to breaking down from a descending triangle as the daily chart shows:

 

 

Nikkei, dailyThe Nikkei, daily: a descending triangle that seems close to breaking down – click to enlarge.

 

Shinzo Abe is probably worried by the fact that Japanese stocks are no longer rising. The Nikkei's performance is the means by which the media measure the performance of 'Abenomics', regardless of whether this is actually justified.  Weakness in the Nikkei is invariably accompanied by bad press about Abe's 'reflation' program.

The market meanwhile exhibits grave doubts with respect to what we wrote about the yen's possible future above – and rightly so.

The reason for this is that while the BoJ has been engaging in massive 'QE', it has actually failed to spur a commensurate increase in the rate of growth of Japan's money supply. To be sure, 5% annualized money supply growth is actually a lot for Japan, but it is very little compared to the US. Hence there is little reason for the yen to decline much relative to the dollar at present.

The yen's decline was partly justified as the 'risk premium' embedded in it was  priced out when the euro area debt crisis abated, but it was at least in part also an overreaction to the announcement of the BoJ's 'QE' policy. The market has probably initially overestimated the policy's effect on money supply growth, and lately seems in the process of correcting this overreaction:

 

 

Yen

The yen is a mirror image of the Nikkei – and it sure looks like it wants to go higher – click to enlarge.

 

So the market does not really believe that 'Abenomics' is going to succeed in achieving its inflationary goals in the long run. Of course, this will actually depend on how determined the BoJ turns out to be: it could e.g. alter its modus operandi in such a way as to achieve much faster money supply growth than hitherto. If that happens, all bets are off, or rather, will have to be reassessed.

If the policy on the other hand is not here to stay and fails to achieve its goals, then it will probably be a very bad idea for Japanese pension funds to move into stocks and other risk assets. In fact, by the time a government-directed agency jumps on a trend, the trend is often close to reversing anyway. In that sense, Abe's latest initiative is quite possibly a contrarian warning sign for risk assets.

 

 

Charts by: BarCharts, BigCharts

 

 

 

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One Response to “Abe Wants Japan’s Pension Funds to Make ‘Riskier Bets’”

  • Keith Weiner:

    There is an eery similarity to what Janet Yellen was saying before she was appointed as Fed Chair. She said the Fed should push down the interest rate and keep it down, and then increase its “supervision” of pension fund and other asset managers.

    Ignoring the moral problems with government taking over private investment decisions, magic is impossible. If you want to “euthanize the rentier” as Keynes put it, then no one can earn a yield. Whether they are taken over by the government or not.

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