This WSJ headline asks the question, “Why has the JGB dog not barked?” For those of you uninitiated to market lingo, a dog is a money-losing investment. JGBs have all of the hallmarks of a bad investment, and yet the price continues to appreciate down to lowest yield for any government issued debt in the world. The yield on a ten year JGB is 0.75%, which is lower than AAA rated countries like Germany, at 1.6%, and the Netherlands at 1.9%.
Japan retains an investment grade rating on its debt, yet it belongs in the club of speculative and defaulted nations according to its fiscal health. It’s debt to GDP ratio is the highest in the world and pay attention to the country in second place:
Japan’s budget deficit is persistently wide. With more and more Japanese retiring everyday, it will widen in the coming years. Again, note the country with the second largest budget deficit:
Japan has the fiscal profile of Greece but can borrow money at the lowest rates in the world. The article gives three reasons:
- Continued demand for JGBs from domestic purchasers.
- The belief that the Bank of Japan can control the market.
- Deflationary/Low inflationary expectation.
These three factors have changed or are moving against Japan rapidly. Eventually, reality will catch up to the JGB. As Keynes tells us, markets can remain irrational longer than you can remain solvent; the JGB trade deserves its reputation as the widow-maker.
Domestic demand for JGBs is declining. Domestic investors hold over 90% of Japanese debt, but this figure does not reveal a telling trend. Foreigners now account for a record 9.1% of JGB holdings. Moreover, in the 2012 fiscal year, foreigners purchased 18% of JGBs, another record.
Japan once ran massive trade surpluses, but that is no longer the case. It is running more trade deficits, so those large Japanese corporations have less foreign currency to repatriate, convert to yen and stash in JGBs. One leg of the system for preserving the value of JGBs is breaking down.
We live in the age of central bank intervention. No matter how powerful the central bank, in the long run it will always lose to market forces. The Bank of Japan must maintain low interest rates, or else the Japanese government will become instantly insolvent. As such, it maintains a zero interest rate policy and supports the price of JGBs via purchases in the open market. As long as investors believe that the BoJ can maintain low rates, they will behave accordingly. Remember that investors are fickle. Their confidence in the BoJ can turn to doubt in an instant, and it will.
The most important determinant in a bond’s price is its real rate of interest. The JGB actually has a higher real interest rate due to persistent deflation in Japan. Deflation is about to morph into inflation, despite what economists predict. This is the yen price of oil since the mid-November to early February:
The price has risen 33% in less than three months! Rising oil prices stoke inflation, but there is a lag. As this feeds through the economy, Japan will get the inflation it has wanted for years, but it will not drive economic growth. Rather, it may just set off the Japanese debt crisis that investors have been anticipating for years, but markets are inscrutable.
Fundamentals shift which should creative negative expectations, but they don’t. Indeed, it could be years before investors alter their behavior. All of the significant Japanese economic and fiscal figures indicate an imminent collapse, but the current situation can persist indefinitely.
Investors in JGB should be aware if one thing: every dog eventually barks.