Bond-pocalypse Now: Will Japan Be Ground Zero For The Implosion?

Well we woke up to red screens, or at least what counts for red screens in these manipulated markets. “Mixed” is the new “down.”

This screengrab from CNBC.com pretty much says it all:

While any Japan fatigue you’re feeling is understandable (we suppose there’s yet another way to use the term “Japanification”) we pretty much have to talk about the country first thing every day because it’s looking more and more like Tokyo may be ground zero for the next bust as opposed to Beijing.

It was always a race to see which imploded first, Japan’s lunatic easing effort or China’s massive debt bubble and attendant currency conundrum. Incredibly, it looks like Japan may actually beat out China for the dubious honor of becoming the guy who ruined the party for everyone.

Yesterday we discussed the selloff in Japanese government bonds (JGBs). Allow us to remind you again why sudden rate selloffs are bad news. Here’s JPMorgan:

“What is causing VaR shocks and why are they happening often? We argued before that one of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks.”

Right. And you saw one last spring in German bunds. Guess where we’ve also seen painful VaR shocks? That’s right - Japan. Have a look:

(Chart: JPMorgan)

Bloomberg had a bit on this on Wednesday morning:

“For some investors and economists, and at least one member of the BOJ’s policy board, this year is reminiscent of 2003, when benchmark yields almost tripled within three months. Known in Japan as ‘The VaR Shock,’ an initial jump in yields triggered a sudden selloff by breaching models banks were using for estimating potential losses, based on the statistical technique of ‘value at risk.’ BOJ member Takehiro Sato said in June he sees a similar vulnerability.”

(Chart: Bloomberg)

Clearly, the worry is that a continuation of the JGB selloff will spillover into US Treasurys and German bunds and catch everyone flat-footed, precipitating a sell-feeding bloodbath.

So what gives with the JGB selling? Well, everyone is scared to death that Kuroda’s “review” of BoJ policy combined with the fiscal package announced by Prime Minister Abe signals a shift away from monetary easing and towards fiscal accommodation. Here’s SocGen with some color:

“That was the theme of the day on Tuesday, at least on the basis of people coming to us and asking the question. We have been of the view that central banks do not have much firepower left, and that was a central theme in our mid-year outlook (That’s all folks). The BoJ has strongly reinforced the idea. By announcing a review of its policy tools, the BoJ has revealed introspective doubt about the net effect of negative rates and a QE engineered flat curve. Investors are asking whether fiscal policy will be taking the lead if monetary policy is doomed. In other words, is Japan showing the way? The question deserves attention, and contributes to our view that global bond yields may turn the year at slightly higher levels.”

Yes, “slightly higher levels” - because there’s certainly not a lot of room for them to rise (sarcasm).  And here’s a bit more from SocGen (who incidentally delivered good numbers this morning) on the above-mentioned Japan/China race to ruin the financial universe:

“The Chinese authorities, with easy fiscal and monetary policies and carefully orchestrated FX devaluation, seem to be doing what the Japanese want (ought?) to be doing, whereas even if the actual fiscal boost from Mr Abe’s latest plan is modest (sub 1% GDP), the real disappointment is the impression the BOJ have given that they are almost completely out of ammunition (and perhaps, ideas). We may well get more asset purchases in due course and that might, too, reverse the push higher in JGB yields, but I can’t help thinking that a chance has been missed to weaken the yen, drag inflation expectations higher and give the fiscal ease a bit of turbo-charge.”

So, not enough easing. There’s never enough easing these days. Paradoxically, the BoJ’s open market ops are running into trouble. That is, they’re having a harder and harder time finding willing sellers so that they can ease. Consider this, out this morning from Goldman:

“The BoJ’s NIRP foray in January led many market observers to question if the shift away from expanding asset purchases signalled that the central bank was constrained by how ‘big’ it could go on its accumulation of JGBs. ‘Poor’ results in the ‘rinban’ operations for super-long maturity JGBs in March, followed by repeated reductions in the size of the planned purchases of long and super-long JGBs, has further fuelled the idea that the QQE programme is running into operational difficulties (Exhibit 1).”

“The QQE sustainability discussion is unlikely to die down unless there is a shift in market expectations. If domestic investors become convinced that – thanks to the policy mix – bond prices tomorrow will be lower than today’s because higher inflation expectations are priced in, their incentive to sell overvalued fixed income instruments into the BoJ purchases would increase. To achieve such a shift in expectations, we think that what is required is a more convincing interaction between fiscal expansion and monetary policy accommodation, potentially leading to something akin to debt monetization.”

(Charts: Goldman)

Think about that for a minute. The market is taking a look at what are basically failed auctions and an apparent unwillingness to expand JGB purchases as a sign that QQE has reached its limits. So what needs to happen is the BoJ needs to coordinate with the government on what amounts to helicopter money in order to create the illusion that inflation is on the horizon. That way investors will think rates are going to sell-off thus encouraging them to sell more of their JGB holdings to the BoJ. It’s absurd.

We’ve now gone from analyzing how easing measures are accidentally tripping over each other to trying to figure out how they can deliberately trip over each other because that’s the only way to keep this merry-go-round from spinning off its axis and killing all the children on the fake horses.

You might want to get off this ride post-haste.

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