During last months in Japan, extreme monetary policies – also known as Abenomics – implemented by the duo Abe-Kuroda to fight deflation and give a kick to the stagnant economy, have caused a huge reaction all over the markets: the Yen has been slashed, Nikkei index has been skyrocketing in an impressive rally and nominal government bonds yields have been pushed lower despite growing inflation promises.
There have been results also outside financial markets, since this week very good data went out, with 1Q GDP easily beating consensus (+3.5 annualized vs +2.8 expected), with private consumption +2.3%, but we think macroeconomics is not just a matter of how good your printer is.
First of all we suggest factorizing this data really carefully, since the measure unit – JPY – has suffered a shock since one year ago and Japan is a country that strongly relies on international trade.
But what concerns us the most and makes Japan a time-bomb to our eyes is obviously its sovereign debt standing at 230% of GDP, coupled with bad long-term macro variables (e.g. demography, competition from Korea and China).
So far interest rate (yield for investors) on that debt has been really low, in a deflationary safe-haven context first and in a QE bubble now, but it can be easily understood what would happen in a 200 basis-point spike case. To make it clear Japanese finance ministry declared that just a 2 percentage-point rise in the 10y yield would lift annual interest expense by 8 trillion yen within three years, turning speculations on default scenario suddenly quite realistic.
So the question is how and when this can occur.
In this moment there are two forces fighting on that yield: on one side we have BOJ (which plans to buy 7.5 trillion yen of JGB per month), central banks as a whole and their quantitative easing programs that support demand for Govies that are in a clear bubble everywhere, on the other side we have investors that especially in rising inflationary expectations have no interest in staying in an almost negative-real-rate investment and boost supply. Of course BOJ with an operation like this, is openly encouraging investors to sell their JGB and invest their money in the real economy but it will be really dangerous if this happens too fast, considering also the effect on mortgages and loans of a much higher rate.
On a longer time horizon the significant risk is that the demographically tragic situation will bring to an aged population which will save way less and will be more and more interested in investing abroad, with an exponentially increased role of the financial sector – instead of the celebrated patriotic households – in fulfilling government borrowing needs with all the related consequences.
WHAT HAPPENED THIS WEEK
Starting from Friday 10th, we witnessed to a kind of sell-off in JGB with yield on 10-years benchmark jumping to a thirteen-month record, up to 0.92 – which is 60bp more than April low – signaling that investors may be wishing to get out way quicker than BOJ would have liked.
On a more technical point of view we can see in this brilliant analysis made by Zerohedge the dynamics of what happened: at first institutional investors hedged their positions and did not sell, letting JGB rally. But when the strong demand for protection made its costs become too high (see implied volatility in the first graph below) they found JGB too risky and expensive and started liquidating positions.
To exploit this situation, we focused our attention on Japanese financials.
As known there is a clear relation between JGB prices and banks’ balance sheets and as a matter of facts it has been calculated that a 100bp rise in market yields would lead to mark-to-market losses of 20% of Tier-1 capital for regional banks and 10% for the major banks.
Furthermore, earnings forecasts released in the past few days by the major Japanese banks showed a worrying announced slump in profits with Sumitomo Mitsui (Bloomberg 8316:JP)’s -27% Mitsubishi UFJ Financial Group Inc. (Bloomberg 8306:JP)’s -11% and Mizuho Financial Group Inc. (Bloomberg 8411:JP)’s -11% in the year ending March.
From a technical point of view, it is easily recognizable that financials – with the whole market as well – are overbought and that they are likely to be going to experience soon a little correction at least. We believe that the reaction to the mentioned disappointing forecasts release could be a breaking point in the strong momentum showed so far by those three banks.
For the discussed reasons we suggest implementing on Wednesday Tokyo opening bell a short selling strategy against those three Nikkei financials conditioned by Tuesday night (CET) Kuroda speech: if no more easing is announced, place your short order.
In order to limit the risk we recommend going at the same time long the Nikkei index or buying just a diversified selection of strong-performing highs-breaking manufacturer exporters, such as the cameras and endoscopes maker Olympus Corp. (7733:JP).
We advise to pay maniacal attention on hedging positions against forex rate risk, because although we believe JPY is stabilizing a bit, we see some more room – maybe after a correction – for the yen to depreciate against the USD, mainly if game-changing events become reality such as FED starting to step out of the markets or JPY losing the safe haven status in a new risk-off tournée.
Lastly we would set a 2-weeks time horizon and a stop-loss threshold at 5.5% combined losses.