The Quiet Implosion of Japan

If it weren't for the constant threat of intervention, $/JPY would already be at 170

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There’s a group of insects that - if you approach them slowly enough - don’t see you coming. That’s sort of how markets are about the global debt crisis that’s brewing and Japan - with its public debt of 240 percent of GDP - is at the leading edge of this.

I’ve done many posts explaining the key issue in Japan. To avoid a debt crisis, the Bank of Japan (BoJ) caps bond yields, which keeps the government’s interest burden manageable. But this means that risk premia aren’t reflected in bond yields, i.e. interest rates are too low versus the risk of crisis in the eyes of markets. That puts depreciation pressure on the Yen, since investors have little inventive to stay in Japan. The government periodically intervenes in foreign exchange (FX) markets to stop the Yen from falling too rapidly, but this approach is doomed to fail because it treats the symptom (Yen depreciation) and not the disease (too much debt). In fact, it’s my view that FX intervention is deeply counterproductive because it creates the illusion that nothing’s wrong when - actually - there’s a very serious crisis brewing.

In today’s post, I push back on the dominant narrative that nothing’s wrong in Japan. That narrative stems from the fact that the Yen is weakening only slowly. This creates the illusion that nothing’s wrong and the chart above illustrates this. It plots the $/JPY exchange rate, which - when it goes up - means that the Yen is weakening against the Dollar. The Yen is certainly falling, but it’s doing so in what seems to be a controlled fashion. Nothing seems to be running out of control.

What this perspective misses is that the fall in the Yen is only orderly and contained because of the constant threat of intervention. If it weren’t for that, markets would be aggressively selling the Yen and - in my mind - $/JPY would already be at 170. So the calm on the surface is just an illusion and patently unsustainable. That’s because the sting of intervention lessens over time as the chart above shows. Japan’s most recent intervention at the end of April was already less effective than the NY Fed rate check in January. There’ll come a point when markets will just ignore intervention.

The chart above gives a sense of how bad the underlying situation is. The blue line is the trade-weighted Yen, which means it’s the average of the Yen versus all of its G10 peers and not just the Dollar. The black line is the 30-year government bond yield in Japan versus its G10 peers, where I use the same trade weights as for the Yen to make this differential. The fact that the rate differential keeps rising, i.e. Japan’s yields are going up vis-à-vis everyone else, and the best the Yen can manage is to tread water is a warning that Japan is in a very tricky spot. Another way of illustrating this is the chart below, which - for all G10 economies - shows the 30-year government bond yield on the vertical axis and gross public debt on the horizontal axis. Despite its much higher debt burden, Japan’s 30-year yield is barely higher than that of Germany. This is the best illustration that Japan’s long-term yields should be much higher. As long as that’s not allowed to happen, the Yen remains under depreciation pressure and intervention will become increasingly ineffective. One way or another, $/JPY is going to 170.