The Keynesians are rejoicing at the election of Shinzo Abe in Japan and his determination to build more bridges to nowhere with freshly printed dollars from the Bank of Japan.
It’s been nearly 25 years since Japan’s stock market collapsed. I can’t tell you how many times since then that I’ve read commentary pronouncing the end of the Japanese bear market. But after all of that time the Nikkei is still 75% below the levels it reached in 1989.
If you believed all of the talking heads in the media today you’d think that the rally over the last few months has been so big that it proves that the bear market is over and that it is time to buy the Japanese stock market.
To those talking heads, I say, not so fast…
Let’s step back a little bit and look at a chart of the Nikkei since 1990:
Click here to enlarge
That tiny little blip higher at the right end of the chart in the ellipse is the rally that everyone is making a big fuss over. So after nearly 25 years of having a 100% strike rate of false starts this rally is THE rally to buy?
Just a cursory analysis of the chart shows six rallies of between 40-50% in the last 20-odd years and one rally of about 120% from 2003-2007. Every one of those rallies eventually hit the skids.
The cause of most of the rallies in the past is the same as the cause of the current rally. Keynesian fiscal stimulus combined with Quantitative Easing from the Bank of Japan.
The Nikkei is now up about 33% since the middle of last year so we’re getting close to the 40-50% zone where past rallies have run out of puff. That still means we could see another leg up from here over the next few months, but you would want to be nimble if you were planning on getting long the Nikkei from here.
As Kyle Bass the founder of Hayman Capital Management said in a recent CNBC interview, people who are buying the Japanese stock market are picking up dimes in front of a bulldozer.
He also said something that I mentioned last week, which is that the actions of Shinzo Abe to pressure the Bank of Japan into adopting a 2% inflation rate will actually bring forward the final collapse of the Ponzi scheme known as the Japanese Government bond market.
The only reason institutions in Japan are happy to buy JGB’s at incredibly low yields is because of their acceptance of the pervasiveness of deflation. When inflation is negative even a zero per cent bond yield is positive.
If Shinzo Abe is successful in shifting investor perceptions of their future inflation expectations he may become the poster child for the expression ‘be careful what you wish for’.
debtJapanese government is now 24 times government tax revenue.
25% of Japanese government revenues are currently spent on interest payments. And every 1% rise in the cost of capital for Japan’s economy will quite literally soak up another 25% of government revenues according to Kyle Bass.
A 200 basis point sell-off in JGB’s would be lights out for Japan.
Of course when 10-year bond yields are at 0.75% it seems impossible to imagine a tripling of yields from here. But the market will always do the unexpected.
Click here to enlarge
If there is a profound shift in inflationary expectations then there will be a lot of traders looking for the exits at the same time. Yields can shoot higher very quickly in that scenario.
This may not play out for another year or two, but when it does happen it will happen in the blink of an eye.
Japanese GDP is falling rapidly and their exports are collapsing, especially to China, the country that soaks up 20% of their exports.
I think it would have a profound impact on investor psychology world-wide if the Japanese Keynesian experiment began to unravel.
The US and Europe are playing by the Japanese rulebook even though there is ample evidence that pump priming and money printing doesn’t work in the long term.
Political realities ensure that a quick fix and kicking the can are far more palatable than any other course of action. So there is no way the game will stop until someone kicks the can once too often and encounters a brick wall instead.
Japan is many years ahead of the rest of the world in playing this game so it makes sense that it will be the first to come face to face with economic realities.
There has been an increase in mergers and acquisition (M&A) activity out of Japan with Japanese corporates looking to diversify out of the Yen. So the elites are starting to manage their exposure to a currency that could continue to weaken over the medium to long term.
All eyes will be on the Bank of Japan to see if the pressure being applied to them will convert into action to increase Japanese inflation.
From there the behaviour of JGB’s and – as Kyle Bass said – a move in the swap curve pricing in inflationary expectations could spell some serious trouble. And not just for Japan, but the world’s belief in government and central bank ability to control the economy.
Editor, Slipstream Trader