A yen bug in search of a windshield

Reuters recently reported that Mitsubishi UFJ Financial has drawn up contingency plans to rid itself of long-term Japanese Government Bonds (JGBs) should the nation’s current account slip into deficit. MUFJ expects the current account may slide into deficit in 2016, an event they believe would cause yields on 10 year JGBs to rise from 1.0% to 3.5%. Wondering how such an event might effect the value of the Yen, Beacon Reports turned to Banner Japan K.K., a Tokyo based financial services firm that offers financial advice to both foreign and domestic residents. Managing Director Trevor Reynolds and Director Chris Cleary spoke to Beacon Reports on behalf of Banner Japan.

Beacon Reports: Why is the Yen so strong?

Banner Japan: The Yen has had unprecedented strength over the last 4 years. That strength is not justified. The strength has come about because currencies are like trying to pick the prettiest girl at a leper colony. Today the Yen looks little or no better than the U.S. Dollar or the Euro.

Beacon Reports: But tomorrow?

Banner Japan: There’s not one that looks really better than any other. Why should the Yen be so strong given Japan has a declining population that lost about 200,000 people last year? In addition, Japan currently has a debt to GDP ratio of 225%. 30% of Japan’s current tax take goes to pay off interest on the debt, which currently yields just over 1%. So what happens when the interest rate rises to 2%? Well, all of a sudden 60% of the entire tax take in Japan goes to debt interest payment.

Beacon Reports: Do you agree with John Mauldin that Japan is a bug in search of a windshield?

Banner Japan: Yes, I think it is a big shinkansen train, cruising along not knowing the track will run out! And when the bug hits the windshield it’s going to break that windshield with cataclysmic affects. Kyle Bass explains it better than John Mauldin. Kyle Bass is a hedge fund guy out of the U.S. (Watch Kyle Bass being interviewed on the BBC’s HARDtalk here.) He’s one voice of many that’s beginning to realize that Japan may not be the safest places to be.

Beacon Reports: Again, so why is the Yen so strong?

Banner Japan: Currently the Yen’s strength is riding on the back of the unwinding of the carry trade. Up until a few years ago people could borrow Yen at a rate of 1% interest and reinvest it in U.S. Dollars paying 5%. Now the U.S. interest rates are a par with Japanese rates at 0%. This is money that was specifically borrowed to be re-invested in a different currency other than Yen. As soon as the FX rate started to change direction, people immediately began to pay back the debt. Otherwise they would be holding a depreciating asset in Yen terms. So you had a domino effect with all this money flowing back into Japan, which drove the Yen higher.

The Yen was gathering strength before the Lehman and global financial crisis of 2008. All this money came back to Japan, and hey presto, you have got suddenly a strong Yen during the period of the financial crisis. Then everyone thinks, ah, it’s a strong currency and everyone else’s currency is doing badly. You had a blowback. The Yen got far stronger than it needed to be and it carried on.

Beacon Reports: So then what is keeping the Yen strong today?

Banner Japan: The perception that the Yen is a strong currency continues. If you look what happened on March 16, five days after the earthquake, there was a sudden move in the Yen of more than 5%. And guess what, it wasn’t the Yen getting weaker. It was the Yen getting stronger. It was the first time that the central banks had intervened together in about 10 years. But tell me, if a country has just had a massive earthquake, which means trouble, why would its currency get stronger? The perception was that the Japanese insurance companies were all going to sell their U.S. Treasuries to repatriate the proceeds they needed to pay for the damage of the earthquake. That was the perception. It didn’t happen but that perception has maintained its strength. It still drove the Yen stronger.

Beacon Reports: Are there other factors supporting the Yen?

Banner Japan: The other thing that keeps the Yen strong has been the trade balance. Japan has had a positive trade balance over the last 25-30 years. Since 1980 Japan had not had a negative trade balance until last month.

Beacon Reports: What has caused the negative trade balance?

Banner Japan: Japan had 35 nuclear reactors working producing power. Now they are running only a few. They must buy oil and gas from overseas, sotheirtrade balance has disappeared. The reality is that if Japan no longer has a trade surplus, that will take away from the strength of the Yen in the future. It is something that can happen over the next 2 to 5 years.

Beacon Reports: Has the Yen hit a bottom?

Banner Japan: Has the Yen hit a bottom at 75 – 76? I think it is pretty close. And so therefore if you are sitting on significant Yen what is the incentive of keeping it unless you live here and you believe that the Yen is never going to weaken. If that’s the case keep your Yen in the bank or wherever you normally keep it. But if you think that the Yen has reached a point like it did in 1995 when it went down to 79, only to bounce back to 147 in 1998 then…… The question is, will history repeat itself? Are we in a situation where we are going to see a blowback on the other side should the Yen overshoot in the other direction?

With all the other factors that are coming together, the increasing government debt, the loss of the trade surplus, the fact that the spotlight may be coming off of Europe over the next two or three years…. once the spotlight leaves Europe where does it go? It looks like Japan may become the deer in the headlights. Also let’s not forget the demographics of Japan are actually horrific. Japan’s demographics are kite shaped. Over the next 30 years Japan’s population is expected to drop by 16%, with 50% of its people either too young or too old to work.

Beacon Reports: What will cause the Minsky moment?

Banner Japan: It will occur at the second bond auction failure. The first bond auction failure will be put off as being just a bad day.

Beacon Reports: Why is that?

Banner Japan: The Japanese are burning the candle at both ends.

Japanese pension funds and retirees are in the process of selling their Japanese bonds as retirees collect their retirement money. That is, they’re cashing in their bonds. Japan is paying out roughly $80 billion a year in pension benefits from a pension fund pot that is arguably $1 trillion in size. Less and less people are paying into the pension pot. Pensions used to be net buyers of Japanese Treasuries. They are turning into net sellers.

But who’s going to buy these bonds? In the past there was a trade surplus. Japanese companies invested this cash by buying Japanese government bonds. Now if the trade deficit widens, there is nothing to recycle. Who’s going to buy the bonds? There is your Minsky moment.

Beacon Reports: When do you forecast that event?

Banner Japan: Many people have lost their careers by picking a date. I’ll estimate a 3 to 7 year window. This is a gigantic supertanker that takes an enormous amount of time to change direction. Even if there is a Minsky moment, I think, the deficit is so big now that people will be taken by surprise, saying “oh no”, and it will be too late.

The point is there has to be a massive restructuring of the debt or a default. Now everyone thinks they have a Japanese government pension. But a Japanese government pension is full of Japanese government bonds.. JGBs are debt instruments, and sometimes people default. That has happened all throughout history. Governments default all the time.

Let me reiterate, 30% of Japan’s current tax revenue goes to debt repayment, so if interest rates rise above their current 1%, that will directly affect someone’s pension. Japanese believe their pensions are safe, but how safe really are they? The Japanese government can either print money (which is inflationary) or try to maintain the money supply (possibly leading to default).

The Japanese government will continue to spend more money than it has, again and again and again, until suddenly bondholders say, “well, no, it’s not going to happen.” There’s going to have to be a readjustment and that readjustment will be in the form of a change in the price of the Yen and inflation.

If you look what happened to two year Italian government bond yields between October and November, they went from about 3.5% to 6.5% in the month. That scenario can happen here too. If Japan has to go outside its borders to finance its next bond auction, suddenly that 1% will not be 3%. It could be 7% and at 3% we know current debt to GDP levels represents the entire tax take. So how are they going to pay the interest?

The international community has allowed the Japanese government to take on a massive amount of debt. It has allowed this to happen, in part because Japan has had a positive current account surplus. The international community said to itself, “Oh, that’s good…. they’re making money.” So they allowed them to do that. And they will allow them to continue to do that in the future until the boat is pushed out so far that there is little time for it to actually react to fix the situation.

Going back to the Minsky moment…. it should have occurred by now, and maybe in government they know it has, but they want to make sure that the population is quietly kept in the dark so that they don’t get worried about things. They hope to muddle through. In the process they just add more and more debt.

Getting back to the original question, the Yen is strong now but don’t bank on it remaining so over the next four or five years. It is time to take a really good concrete look as a foreigner to think about where the Yen is going to be in the next 2 – 5 years. When the value of the Yen starts to change, it is going to change quickly and people don’t realize it. By the time it happens, it’s too late. We’re not here to tell people exactly where the bottom is. Nobody rings a bell at the bottom or the top. In “horseshoes, hand grenades and currency trading”, this is pretty close.

Beacon Reports: How does one protect oneself then?

If you don’t believe the Yen will remain strong and if you’re a foreigner you should especially be investing outside Japan. Also if you’re Japanese and you want to make sure that the family money is sensibly invested, you too should be looking to invest a portion outside Japan. You need to create many little lifeboats all over the place. It’s a cacophony of many and an art to try to put it altogether. You should have many different currencies invested because we don’t know which currency is going to be strong or weak. The Aussie Dollar was doing wonderfully against the Yen for eight years. It went from Yen 44 to the Aussie Dollar to 107 and then collapsed in five months to 55 at the end of 2008 and subsequently recovered to 80 something. Given one versus the other, I’d rather give someone a portfolio where they have a number of currencies and then they don’t have to worry about it.

Trevor Reynolds, Managing Director (shown left) and Chris Cleary, Director, Banner Japan K.K., 4F Esperanza Ebisu Bldg., 3-2-19 Ebisu-minami, Shibuya-ku, Tokyo 150-0022. www.bannerjapan.com

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