Waiting for the yen to drop

Mar 14, 2013·Chris Marcus

Japanese Prime Minister Shinzo Abe has only been in power for a few months. But in that time he is made it clear that his campaign platform of unprecedented monetary stimulus was no empty promise.

Despite a pledge by the G20 nations to avoid currency wars, Abe doesn't seem interested in playing ball with the rest of the gang. He continues to talk about revising the Bank of Japan’s charter while he assembles his team of easy money compatriots.

Recently Government Pension Investment Fund president Takahiro Mitani made some comments in an interview that point out the type of market dynamics that politicians never seem to grasp. The fund manages $1.16 trillion worth of assets of with about 67% currently allocated to Japanese government bonds (JGBs):

"JGBs were how we made money over the past 10 years. If the economy gets better, then long-term interest rates like a 10-year yield at less than 1 percent are unlikely. If we think about the future and if interest rates go up, then 67 percent in bonds does look harsh."

It’s pretty stunning that the yield on Japanese 10 year debt is only 66 basis points while the Prime Minister is attempting to implement a 2% inflation target. That’s not a very attractive investment profile. If Abe’s goal is to continue to suppress bond yields, then this can be done – in the short to medium term at least – by the Bank of Japan’s printing press. The cost of doing this, however, will be borne by ordinary Japanese consumers and savers in the form of higher inflation.

Since Abe’s election victory became apparent to the markets towards the end of last year, both the Nikkei and the yen have reacted strongly. Mitani also pointed out how one of the main reasons for owning bonds no longer exists; over the past 30 years as central banks were suppressing interest rates that meant that the price of the bonds continued to rise. But with yields already seemingly as close to 0% as they can go, investors can no longer buy bonds with the hope of capital appreciation.

How much upside is their in owning a bond that yields just 0.66%? Maybe another five or 10 basis points? Of course the downside is that the bonds will either experience an outright default, or an implicit default, where investors do get paid back – but in worthless currency.

It was also interesting that Mitani mentioned that he might reallocate into emerging markets stocks and other alternative asset classes. This is another example of how central-bank stimulus leads to speculation that causes asset bubbles. During the housing bubble investors were forced out of so-called “safe haven” government Treasuries and into riskier mortgage bonds because fixed income savers needed to find yield. Now we are seeing the same thing happening again. This could actually work out well for precious metal holders, as an exit from the Japanese markets due to currency debasement would tend to support the bulls’ case for these metals.

The Abe government appears determined. They have not only promised but are now also acting on their pledge to unleash a tidal wave of QE.

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