Monday, January 23, 2012

Economic Commentary: Shorting Japan - Ari

Investors,

First I'll offer a quick update on the global markets and economy and then zero in on my next big bet: shorting Japanese Yen and government bonds.

The last two months have been relatively quiet for the global markets despite plenty of scary headlines. Iran threatened to close the strait of Hormuz and crude oil rallied moderately. US equities started strong on the back of better than expected employment and consumption data and were then further buoyed by good news out of Europe - Spain and Italy were more successful in their debt auctions then expected and Greece may be nearing a resolution with debt-holders for an orderly restructuring. The Euro has gradually sold off and I covered almost all of my short Euro position. I'm generally too early in covering my winning bets, but with record short interest in the Euro, the downtrend may have run its course for a while. A good line about the Euro comes from Jim Rogers; Rogers has been bearish on the Eurozone for a decade but is long the Euro at the moment because he believes that while the Eurozone will eventually collapse, it won't be this year or next.

I've talked before about Japan's coming crisis, but was reluctant to pull the trigger on a major bet because I didn't feel like I understood the timing well enough. I still don't have a clear picture of how the crisis will unfold but I believe I can structure a bet with excellent reward for the risk despite the uncertainty. I'm shorting both Japanese Yen and Japanese government bonds.
Why short Japan? First the basics - Japanese debt to GDP is around 230%, far higher than any country has ever been able to sustain in the history of the world. Social security alone accounts for 52% of the government budget. Japan has gotten away with this debt load primarily because almost all their debt is owned domestically (about 95%); the Japanese people keep buying debt that yields almost 0% for cultural reasons and because the government requires them to do so (many institutions are required to have huge holdings of government bonds). The demographic situation in Japan is rapidly worsening. The percentage of elderly Japanese is rising from 17.4% in 2000 to 25% in 2014 (versus 12.8% in the USA.) Now throw in stagnant growth in tax revenues and the fact that 25%* of tax revenues go to pay interest on the debt. This is debt that yields close to 0%! It's easy to see that if Japanese debt sells off even moderately and yields climb just slightly, the country will almost immediately have to choose between defaulting and monetizing its debt.

What could trigger yields to rise? While Japan's fundamentals have been worsening for a decade, their bonds were supported by increases in savings. The rate of savings has been gradually falling but nominal savings were increasing. The savings rate has is now on track to hit 0% and turn negative in the next few years. Another specific catalyst is that the latest data from the Japanese government suggests that Japan just experienced its first trade gap since 1963! As Japan's current account surplus vanishes, that means there's less excess capital to buy Yen denominated bonds.
So how does this crisis play out? A lot of the demand for Japanese bonds exists because the Japanese have had more than a decade of deflation. A 0.5% yield is tolerable under these conditions. Once yields start ticking higher and headlines of "Monetize or default?" start flooding Japan, at least some of the bond holders will start to sell. With every tick up in yields, the situation becomes exponentially more vicious. Even a 1% increase in long-term yields would produce an immediate cash flow crisis. Most likely, the central bank will start to purchase the bonds to keep yields down. This monetization will produce the threat of inflation, causing more bond selling, forcing more central bank purchases leading to a rapid and large devaluation of the Yen. The Japanese government would likely sell holdings of US securities to partially finance these purchases so we might see brief but sharp upward pressure on the Yen for this repatriation of government assets. Any scenario I try to envision of Japanese bond yields rising seems farfetched to me because it would be suicidal for Japan, but I'll be shorting Japanese bonds in case they choose not to monetize. In case I'm completely wrong and Japan starts to finally experience growth, this may also lead to higher bond yields so the short JGB helps to reduce the risk exposure with, I believe, a positive expectancy hedge. With long-term yields near 0, I'm getting a very cheap option on higher yields.

I should also note that a crisis in Japan will surprise many investors with its contagion effect. We rarely think of Japan as a key driver of the global economy, but Japan is the third largest economy in the world (just slightly behind China) and represents almost 9% of global GDP. Japan is also the second largest holder of US treasuries and US dollars in the world. In a crisis, they will likely become aggressive sellers to raise money.

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