“This is what the Japanese 5-year bond yield has done in recent days. It has erases 12 months of declining yields in the space of a week. This kind of volatility, and this kind of sell-off in response to the QE news is worrying. Remember, interest payments are 30% of Japanese government revenue. If Japanese rates go up in response to this QE experiment, it will end in disaster.
“The first great QE experiment of the modern era was in France in 1715. France issued the first Fiat currency (notionally backed by France's land claim over the Mississipi Territory) after King Louis XIV died, having effectively bankrupted the French state. Under monetary largesse, the French stock market rallied hard for four years but then collapsed.”
Eoin Treacy's view Thank you for this note from UOB contributed in the spirit of Empowerment Through Knowledge. In Tuesday's Subscriber's Audio, I discussed the implications for JGBs of Japan's quantitative easing but let us revisit this topic.
The Bank of Japan announced a unanimous decision to double its purchases of JGBs last Thursday. This lent credence to the belief that Japan's administration is willing to do what is necessary to break the almost two decade long deflationary cycle.
A number of newspaper reports have highlighted the surge in orders for expensive foreign manufactured goods such as sports cars. While overbought in the short term, real estate has been the best performing sector this year not least because investors are betting inflation will ensure that prices will be higher in years to come. In local currency terms, the stock market is the world's best performer this year and the Yen has been among the weakest if not the weakest currency.
However, inflation is not positive for government bonds. Inflation protested bonds offer some shelter in an inflationary environment and yields could contract further, as has already happened with UK inflation protected bonds following the Bank of England QE. However JGBs offer no such protection. In order for yields to hold close to record lows, the Bank of Japan will need to step up purchases significantly. At the present juncture there is every reason to expect that they will do so. What happens when they eventually achieve their inflation target is another question.
The recent surge in JGB yields is noteworthy. While the volatility is certainly extreme on a short-term basis, there have been much larger spikes in yields during the course of what has been a phenomenal bull market for the asset class. These long-term charts for 30, 10, 5 and 2-year JGB yields illustrate just how low yields are and emphasise just how small a move will be required to cause a problem for the government's ability to service and roll forward is debt.
One of the primary arguments in favour of JGBs is that the vast majority are held within Japan. However, if inflation does take hold they represent a significant risk for pension funds and other passive holders. The temptation to diversify beyond Japan's borders in order to harvest both the yield and currency differential must be compelling and may be a factor in the New Zealand Dollar rallying to test its 2011 peak this week.