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Japanese Bonds Are Key to Abenomics Watch

Stocks in this article: JGBL FXY EWJ

NEW YORK ( TheStreet) -- Following are some numbers on Japanese public debt, compiled from various reports at Japan's Ministry of Finance:

Total debt outstanding: about 1 quadrillion yen, of which 821 trillion yen consists of bonds as of March 31 (the end of the 2012 fiscal year). For those of us without Ph.D.s in large numbers, 1 quadrillion is 1 followed by 15 zeros. Budgeted bond issuance for fiscal 2013 is 170 trillion yen. A reasonable estimate would be 1.2 quadrillion yen in total debt by the end of fiscal 2013.

Total national debt service (interest payment): 22 trillion yen, or 24% of government revenue (90 trillion yen), as of fiscal 2012.

Given that the average maturity of outstanding Japanese debt is about eight years, a 1% increase in the yield of eight-year Japanese government bonds translates into 1.7 trillion yen in extra cost in new issuance for fiscal 2013, and an 8% capital loss (or 80 trillion) for bondholders, 69% of which are domestic banks, insurance companies and pension funds.

The yield on the eight-year JGB increased from a recent low of 0.305% on April 4 to 0.797% on May 28. That's a mark-to-market loss of about 40 trillion yen for bondholders in less than two months.

(One way to invest in Japanese government debt is the PowerShares Japanese Government Bond Futures ETN (JGBL), but be aware of its very low volume.)


The increase in JGB yields has been quite furious, as you can see from the chart below. Note that the increase in the immediate aftermath of earthquake/tsunami/nuclear-meltdown disaster of March 2011 was buried in the noise in the chart.

More important than the fast rise is that this is happening after the Bank of Japan announced unprecedented qualitative and quantitative easing, as part of three-arrow Abenomics, including an estimated JGB purchases of 80 trillion-plus yen.

JGB Eight-Year, 15-Year and 30-Year Yields From Jan. 1, 2008 to Now

Chart by Bo Peng. Data courtesy of Japan's Ministry of Finance

When the market doesn't want to front-run you, despite your public announcements over every loudspeaker in every corner of the globe, you ought to be worried.


Why doesn't the market want to front-run the Bank of Japan? There are two possible reasons:

  1. Inflation expectations are higher. This would be exactly what the Bank of Japan wants. Unfortunately, as Goldman Sachs research recently showed (via ZeroHedge), the inflation expectation remains mostly flat, at less than 1% out to 2016 after taking into account the planned consumption tax increase in April 2014.
  2. The market is worried about the risk of BoJ losing control of the yield curve. This is nonsensical at first glance: They'd just print more money and buy up JGBs. But in reality there's another limit to how much BoJ can buy: the repo market. As recently happened in the U.S., banks may run out of Treasuries as collateral if the central bank monetizes too much. This severely disrupts banking and money market operations.

Unless the Bank of Japan manages to stop the yield surge soon, a positive feedback loop may kick in and push things out of control: The major JGB holders, Japanese banks, insurance companies, and pension funds, would be hit with a triple whammy of:

  1. massive mark-to-market losses,
  2. sharply increased risk reserve requirements heavily dependent on JGB volatility, and
  3. collateral squeeze.

If/when forced selling starts, it would become a chain reaction.

And if the yen ( CurrencyShares Japanese Yen Trust ETF (FXY)) surges at the same time, it could only mean one thing: Japanese repatriation of its massive overseas investment to fight fire at home, as happened following the 2011 earthquake. This could make the Lehman moment seem petty in comparison.

I'm not saying this would happen soon. Systems with such great nonlinearity are extremely hard to predict and particularly difficult to time. The point is that the situation is very unstable and warrants close attention.

If you're in the market in any asset class (but especially Japanese equities, e.g., iShares MSCI Japan Index ETF (EWJ)) without adequate hedge in terms of big adverse movements or volatility, you'd better be very nimble if/when it comes.


Or, if you're prepared to take some pain, potentially a lot for a long time, follow Kyle Bass and be early on the widow-maker trade, in exchange for the potential reward of being early on the biggest trade of the century.

At the time of publication, Peng had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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