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Sunday, October 27, 2013

Why Will The JGB Market Collapse?

Chart: 10-year JGB Yield - A Very Slow-Paced Bear Market

In this article I examine reasons why I believe the Japanese Government Bond (JGB) market will eventually collapse. My explanation is simple: the JGB market will collapse when it is in the national interest of Japan for the collapse to occur.

I define a “collapse” as a rise in the 10-year JGB yield to at least 5%, although not necessarily in one fell swoop. This is a move well outside the experience of the JGB market for the 15 years or so. Headline writers may not agree with this, being desperate for snazzy article titles. For example, if the 10-year JGB yield doubled to 1.20% in the next three weeks, the airwaves will be filled with JGB bears announcing “I told you so”. (My favourite potential headline "Japanese bond yields rise by 100%!") But a 60 basis point move that just returns the 10-year yield to the middle of its multi-decade trading range – who cares? I am talking about a serious bear market here.

I am giving a framework for thinking about why the JGB market will collapse, but I am not worried yet about timing. For reasons that shall be seen, I expect that the JGB market will manage to hold on below 5% for a while longer. Pinpointing the timing will require a deeper dive into Japanese data. However, Japanese data are very difficult to follow; for example fiscal data seems to be invariably presented in a manner to maximise the apparent size of Japanese debt levels. I used to cover Japan as a rates strategist before 2006, and I have seen a lot of basic errors made by analysts who have used Japanese economic statistics without understanding their context. In order to avoid making similar errors myself, I will remain very general herein and do a deeper analysis of the data in later articles.

Theoretical Background

Why do I argue that the collapse in the JGB market will occur when it is in the national interest of Japan for this to happen? This is based on my preferred way of analysing the bond market. In summary (see linked articles for a longer explanations of these points):
  1. As per Modern Monetary Theory, government bonds act as a reserve drain; government spending creates reserves, and then bonds are issued to mop up reserves to keep interest rates from falling. This means that increased supply of bonds does not raise yields; in fact, we see the opposite pattern in practice.
  2. Government bonds are an asset of the non-government bond holders. This is an important insight of Stock-Flow Consistent modelling (and of Hyman Minsky, who can be viewed as a forerunner of Stock-Flow Consistent modelling). In order to disrupt the bond market, you need to disrupt the portfolio preferences of the private sector, which have considerable inertia.
  3. With supply and demand effects neutralised, bond yields instead track the expected path of the short-term rate. This rate is set by policymakers, and therefore rising bond yields have to reflect policymakers’ preferences.
  4. Quantitative easing does not work; all the Bank of Japan gymnastics with the monetary base have had no impact on the economy. Thus the inflation predicted by the Quantity Theory of Money has not happened.
These factors explain why previous predictions of the demise of the JGB market have not panned out.

Why would policymakers want the JGB market to collapse? There are two very good potential reasons.
  1. The Japanese domestic economy is growing rapidly, and inflation has become a serious concern. Rates will be hiked to moderate inflation*.
  2. The Japanese yen is falling in value, creating inflationary pressures. Policymakers will want a higher policy rate to increase the demand for the currency.
I will discuss these two possibilities in more detail below. (Note that the two scenarios could occur at the same time, as both can be viewed as variants of the same idea - the yen is losing purchasing power.) I believe the first possibility is the more likely of the two, but I imagine that many analysts will prefer the second.

This mode of thinking is probably alien to many people. I believe this is based on thinking about government finances in terms of household finances, or the Gold Standard experience (introductory economics textbooks often make assumptions that are equivalent to having a Gold Standard in place). If a bank offers you a mortgage for 4%, you do not respond by saying that the rate should be 5% in order to better regulate the operation of the economy. However, this is exactly how you have to think if you are the central government borrowing in a currency you control.

Rapid Growth Forcing Rate Hikes

Chart: Japan - A Long Way From Steady 5% GDP Growth

Policymakers historically have tended to follow the rule proposed by the neoclassical growth model: nominal interest rates ought to be close to nominal GDP growth rates. I think that rule is probably a bit of economic superstition, but it can be seen as an approximation to typical central bank reaction functions. As the chart above shows, Japanese nominal GDP growth has been well below the 5-6% level that would appear consistent with the collapse I discuss here. But it is seems too pessimistic to assume that this will be the case forever. Here are a list of possible reasons for faster real growth and/or inflation.
  1. Some serious fiscal policy moves to tighten the labour market (targeted job creation), or a properly targeted tax cut. (Previous fiscal policy moves were enough to stabilise the economy, but not cause an inflationary boom. My reading is that is exactly what was desired.)
  2. The labour market could be tightened up by reducing potential work hours. For example, increased maternity and paternity leaves in order to push up the birth rate.
  3. A new labour-intensive consumer good or service becomes a new large source of demand. This could be related to population aging, for example. Note that if it is a manufactured product, it may be that the production is automated and employs few people, but the installation is labour intensive.
  4. A booming export sector.
I do not see this growth boom happening in the near-term, but I may be missing something. It seems pessimistic (or complacent, if you are a JGB investor) to assume that this will not happen on a multi-year horizon.

One key issue is that it may be very hard to dislodge Japanese inflation expectations. Japan has achieved price-level stability, and it may be hard to convince locals that this will change. (This is in contrast to many foreign commentators, who obsess either about Japanese deflation or hyperinflation, or both at the same time.)
Chart: Japan CPI - Price Level Stability

Rate Hikes As A Currency Defence

A collapsing yen is a popular story among JGB bears, but I feel it is less of a risk than a domestically-led expansion.

The key vulnerability of the yen is Japan's need for energy  and other commodity imports; an upward spiral in energy prices could put the yen under immense pressure versus the currencies of energy producers. However, an upward spike in energy prices will simultaneously wipe out the purchasing power of other developed world consumers (particularly in the U.S.). As we saw in 2008, the global economy does not handle surging energy prices well. This limits the capacity of energy prices to remain at extremely elevated levels. It will take time to create the structural conditions we had in the 1970s that will allow the world economy to absorb energy price rises via a generalised inflation.

Otherwise, I find it hard to worry about the yen. The Japanese government has been intervening massively to hold down the value of the yen, and has an immense store of reserves to preserve its value versus other currencies without needing to raise rates.

Chart: Japan Has Persistent Current Account Surpluses, Not Deficits
And we cannot ignore the private sector holdings of non-yen assets. Given the configuration of the Japanese economy, with an aging population and slow domestic growth, we should expect that Japan would run persistent current account deficits. The earnings on foreign assets should be mobilised to finance the purchase of imports. The fact that Japan has been running current count surpluses makes it unsurprising that the yen has been uncomfortably strong.

For the foreseeable future, Japan will not need to attract foreign investors to finance a current account deficit; the economy only has to draw back a stream of proceeds from domestically-owned foreign currency assets. Given that domestic investors are typically managing their portfolios versus yen-denominated liabilities (financial debts or actuarial liabilities), they are more comfortable with Japan's optically low interest rates than foreign investors would be. 


A Final Note

If and when the JGB market collapses, there will be plenty of quotations by Japanese policymakers complaining about “too high” interest rates. This does not disprove my argument; it only shows that many individuals do not think very carefully about governmental finance. The policy rate will be hiked voluntarily by a committee of policymakers.

Bond yields will rise before the rate hikes; that is the nature of trading expectations. But unless policymakers ratify those rate hike expectations, bond yields will come back down again. For example, this has been the case for the past few years in the U.S.; the market has repeatedly priced in relatively aggressive rate hike paths, and the market was forced to back down each time. The fact that bond yields rise before rate hikes does not mean that bond investors force the rate hikes; bond investors were just doing their job within the current institutional framework of government finance. In other words, I am not worried about the so-called “Bond Vigilantes”.

* Many non-mainstream economists (in particular, MMT economists) have doubts about using rate hikes to control inflation. I have some sympathy to this viewpoint, but I will have to examine this some other time given the complexity of the subject. From the point of view of central bank watching, I expect the Bank of Japan would stick to the mainstream consensus that rate hikes are the best method to control inflation.

(c) Brian Romanchuk 2013


  1. The Japanese government is spending about twice what they get in taxes even with interest rates like 0.19% on 5 year bonds. If interest rates went up to anything rational the government would be clearly bankrupt. So the central bank is working overtime to hold interest rates down. But with the Yen losing 1% per week it is crazy to hold bonds that net only a total of 1% after 5 years. So people are selling fast. The central bank is already buying so many bonds that they are increasing the money supply by about 1.6% every 10 days. With debt around 250% of GNP, huge deficits, and rapid monetization they have the perfect setup for a dangerous feedback loop. What will happen is that as inflation picks up more even more people will get out of bonds at such crazy low interest rates. But as more people get out, the central bank will make money faster and buy bonds faster. This will cause more inflation. This will cause more people to get out of bonds, etc. You get a bad feedback loop. In the end this will make hyperinflation. The hard part is just the "when?".

    1. Yen are a liability of the government of Japan, and can be created costlessly (since most yen is in the form of electronic entries). As such, I cannot wrap my head around what "bankruptcy" means. Unlike the countries that suffered hyperinflation, Japan does not have foreign denominated liabilities (either debt, or a severe trade imbalance).

      As for what investors in JGB's think, who cares? There has been no point in the past 15 or more years where JGB yield levels were high enough to make investors happy. But the bears have been crushed by carry and rolldown. Even from the point of view of a JGB bull (I am officially neutral from the point of view of this blog), JGB yields are too low. But the bears apparently lack the capacity to fight the carry and rolldown.

      The quantity theory of money has not worked particularly well in predicting Japanese inflation over the past couple of decades. I will do a post on that point sooner or later.

      As for the yen, it is still overvalued. Extrapolating the last couple of weeks of trading activity in a currency that has a history of strengthening 5 big figures at 2 am Eastern Standard Time Monday Morning seems dangerous.

    2. JGB goal is unsustainable. 2% inflation interest rate will lead to loss in 10 year jgb. No one wants to loss money. At 3% yield, 70% japan revenue will go to pay interest on debt . There are clearly two option. First option: Hit 2 % inflation target and use most of revenue for paying interest ( which can lead to hyperinflation or collapse bond market oe so called bankruptcy for nation). Second option: Japan will not hit 2% inflation target. Japan economy will remain the same as it has been since last two decade...slowly dying giant

    3. 1. Not all Japanese debt consists of 10-year bonds. The bulk of financing is done at the front end of the curve.
      2. If interest payments increase, the money does not disappear from the economy. Higher nominal GDP growth means higher nominal incomes, hence higher taxes. Deficits will shrink as that happens.
      3. Even if the entire debt stock is financed at 3%, the net interest cost would be something like 3-4% of GDP (net debt is something in the neighbourhood of 130% of GDP). This is not a big deal, despite what you may have read on the internet.

    4. point 1 :agree. On point 2: since it has 240 % debt to gdp ratio, increase in payment will be much more higher than increase in revenue. In addition, real gdp can grow only by two increase productivity and/or increase population. Population is unlikely to go up. Only reason productivity can go up is decreasing value of yen. Low value of yen had lead to higher cost import and negative trade deficit and negative current account surplus. Japan has seen negative account surplus in long time. on point 3, I partially agree. But you have to count total debt because you have to pay interest on total debt, not on net debt, and more import ration is % of revanue than % of GDP.

      I think psychology is also playing major role. It is known as window maker trade. My main point I am trying to make here is they are trap in debt. I wish someone can explain me that how japan can reduce its debt to sustainable level.

    5. You need to look at net debt for the debt service cost, the government receives interest on the part of the debt that it holds itself (such as retirement accounts). Although some of that is used to finance a very large position in USD bonds (reserves). If the yen falls, they will make a lot of money on those reserves.

      The current account has only recently moved into a deficit, there was a trade deficit earlier. The current account deficit is tiny when compared to the stock of foreign currency assets held by Japanese nationals.

      Since they have carried the debt at similar levels for more than a decade, it has been sustainable by any reasonable definition. The debt ratios will only fall when the private sector no longer wants to hold financial assets at such a high ratio to income. It is unclear why the private sector preferences will change.

    6. japan debt has steadily increase since 92( as a % of gdp). It has significantly increase after 08. On net debt point, japan government assest will not be only consistent of pension funds. There must be significant non-liquid assets. In addition, increasing real wages is really tough job. In the environment where people just understand deflation, it will take while to have real wage jump. Till than people will suffer.

      Although, Japan current account surplus start to hit negative in recent time, but trend is really strong , it is steadily declining since 2006 at the same time they have growing debt.

      Important statistics is how much GDP is increased per yen spent. QE helps to go through tough time, and it is not mean to live on it. At some point, too much QE can lead to worthless currency..

      I think they are smart enough to see this and they will not hit 2% inflation, and choose to die slowly. This whole abenomics idea will end in couple of years and they will have what they used to have. ...that is deflation.

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