Kyle Bass: „The Next 18 Months Will Redefine Economic Orthodoxy For The West“

Kyle Bass covers three critical topics in this excellent in-depth interview before turning to a very wide-ranging and interesting Q&A session. The topics he focuses on are Central bank expansion (with a mind-numbing array of awe-full numbers to explain just where the $10 trillion of freshly created money has gone), Japan's near-term outlook ("the next 18 months in Japan will redefine the economic orthodoxy of the West"), and most importantly since, as he notes, "we are investing in things that are propped up and somewhat made up," the psychology of negative outcomes. The latter, Bass explains, is one of the most frequently discussed topics at his firm, as he points out that "denial" is extremely popular in the financial markets.

Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has, and that is why so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong - "it's really important to understand that people do not want to come to the [quantitatively correct but potentially catastrophic] conclusion; and that's why things are priced the way they are in the marketplace."

2:40 Bass begins

3:15 Central Bank Expansion

"We've essentially printed $10 trillion in the last few years"
"The first $5 trillion replaced the lost equity in the leveraged financial system and the second $5 trillion is making its way into deposits and expanding the monetary base"
"This is unprecedented... and it's not going to change."

The numbers that Bass reels off are incredible...

"What we've seen is a massive credit-led boom (+11% CAGR) and that can't last forever"

11:00 "The next 18 months in Japan will redefine the economic orthodoxy of the West"

"Japan is so far off the bell-curve that no one wants to talk about it"

"if you repeat things enough, everyone will believe them."

There are three key myths about Japan that Bass shows are simply false but remain repeated for the comfort of the cognitively biased investment community:

  1. The current account allows the country to self-finance its deficit
  2. The Bank of Japan is not monetizing debt
  3. Retail investors will always support the JGB marketplace

From the nation's own largest institutions forced to sell assets to the crushing demographics, Bass explains - in greater clarity than the soundbite-idiocy we get each night from Abe/Kuroda/Aso etc...

The smartest money is leaving Japan in a hurry already - Q4 2012 was the largest M&A quarter ever for Japanese firms buying foreign entities - Western productive assets - (just as was seen in Mexico before their crisis) as they try to get out of JPY

25:00 The Psychology of negative outcomes

"as an investor and a fiduciary, I get paid not to be an optimist or a pessimist; I get paid to be a realist"

"Denial" is extremely popular in the financial markets.

Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has. and that is whay so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong.

"no one is ever going to tell you something is wrong"

"we have blind faith in the people running our institutions...that they can figure things out. They are a mental crutch to insure and placate depositors and investors that everything is going to be ok"

"we are running a huge economic experiment," and you can't control it all since there are too many variables

Once you understand the psychology of the participants, the key is to understand their actions based on that.

"It is the qualitative shift in the market participants' belief systems that literally flips a switch overnight"

Bass reminds us of Taleb's work on central planning: "if you suppress volatility long enough, then when the 'event' happens it is greater than the sum total of all the suppressed vol over time."

He warns - these shifts happen so fast that you will never get hedged or out of the way in time...

32:00 Q & A begins

First he discusses the naysayers on a Japanese bear thesis

"I would like to live in a world where it's all rainbows and unicorns and we can make Krugman the President - but intellectually it's simply dishonest"

"If you were advising Abe, what would you say?" - "Quit!"

41:00 General China discussion (in the context of the Japanese-China rhetoric)

43:30 Iceland - not as great as some would suggest

"China is building an embassy in Iceland that can fit 500 people in it. Iceland only has a population of 300,000!"

"You have a roach motel of a country; the New York Times and Krugman saying it's "The Model"; but they still haven't addressed the problem of their debt."

46:35 Do you worry about the US?

"I quit worrying about them because it's just a waste of time - I always leave DC demoralized"

"The central bank is the great enabler of congressional profligacy"

48:00 How does the small investor play the Japanese market - Bass responds that they can't and shouldn't. Shorting JGB futures means high carry costs and negative convexity

And our favorites question!!

49:00 Why can't the Central Bank just buy all the JGBs and then forgive them?

A speechless Bass responds...

52:00 Bank VaR and under-capitalization


Well worth an hour of your time before the FOMC tomorrow...

(h/t David)

Frontrunning: June 11

  • Citigroup Facing $7 Billion Currency Hit on Dollar, Peabody Says (BBG)
  • World has 10 years of shale oil, reports US (FT)
  • ECB prepares to defend monetary policy in German court (FT)
  • BOJ Holds Its Ground (WSJ)
  • European Stocks Sink to Seven-Week Low as Treasuries Fall (BBG)
  • Fitch warns on risks from shadow banking in China (Reuters)
  • Riot police move in on anti-G8 UK protesters (Reuters)
  • Obama administration to drop limits on morning-after pill (Reuters)
  • ACLU asks spy court to release secret rulings in response to leaks (MSNBC)
  • U.S. Relies on Spies for Hire to Sift Deluge of Intelligence (WSJ)
  • SEC Nets Win in 'Naked Short' Case (WSJ)
  • SoftBank Raises Offer for Sprint to $21.6 Billion (WSJ)
  • Chinese rocket launch marks giant leap towards space station (FT)
  • Skyscraper Prices Head North (WSJ)


Overnight Media Digest


* The leaks by Edward Snowden reveal a vulnerability in U.S. intelligence since 9/11, triggered by a surge of information collected on people around the world and the proliferation of private government contractors to store it.

* U.S. regulators are stepping up scrutiny of overdraft fees charged by banks, a big revenue stream that is helping the industry lessen the hit caused by low interest rates and the sluggish economy.

* SoftBank said it had agreed with Sprint Nextel to raise its offer for the U.S. wireless carrier by $1.5 billion to $21.6 billion from $20.1 billion.

* S&P raised its outlook on the United States' credit rating but markets ignored the surprise endorsement, the latest sign of ratings firms' waning influence in some arenas.

* Yoga-wear maker Lululemon Athletica said Chief Executive Christine Day is stepping down after a 5 1/2-year tenure.

* An SEC judge ruled that a former Maryland banker perpetrated a short-selling fraud aided by one of the biggest stock-options brokers in the United States.

* The Bank of Japan refrained from taking any new measures to stimulate growth and ease market volatility, citing signs of economic recovery, but disappointing investors.

* Apple sought to recapture its authority as a tastemaker, unveiling the biggest redesign in iPhone software since the smartphone was introduced in 2007 and stressing that the company hasn't lost its cool.



Politicians and public sector unions have criticised Thames Water for reporting on Monday that it paid no corporation tax last year.

Almost all of American Airlines' senior executives are going to leave the company upon its merger with US Airways, the carriers said on Monday.

Private equity firm Terra Firma is hoping to raise over 1 billion euros ($1.3 billion) from a Frankfurt share listing of Deutsche Annington, Germany's biggest residential property company.

U.S. prosecutors in the SAC Capital case are finalising negotiations with the University of Michigan to gain access to computer files linked to an insider trading case against an ex-SAC employee.

Punch Tavern's restructuring plans - to reduce 2.4 billion pounds ($3.7 billion) worth of net debt - on Monday were rejected by bondholders for the second time this year.

Luxury brand Burberry Group's Chief Executive Angela Ahrendts was paid 16.9 million pounds in 2012 - more than any other FTSE-100 chief executive.



* Federal authorities and consumer lawyers say banks play a key role in giving questionable Internet merchants access to the financial system, enabling them to prey on consumers.

* Apple Inc introduced a major redesign of its mobile software system, as well as upgrades for some Mac computers.

* As mobile phones become all-in-one tools for living, suggesting where to eat and the fastest way to the dentist's office, the map of where we are becomes a vital piece of data. From Facebook Inc to Foursquare, Twitter to Travelocity, the companies that seek the attention of people on the go rely heavily on location to deliver relevant information, including advertising.

* Michalis Sallas has thrived in Greece's freewheeling business culture as head of Piraeus Bank SA, but financial oversight is increasing and may complicate his dealings.

* Two longtime friends - Jens Weidmann, the president of the Bundesbank and Jörg Asmussen of the European Central Bank - will appear before Germany's highest court on Tuesday to argue opposite sides of a fateful question: What if the promise that holds the euro zone together is unconstitutional?

* As investors rely increasingly on Finra's database to vet Wall Street professionals, some brokers and executives are trying to remove complaints.

* Veterinary drugs commonly administered to horses would render their meat adulterated under New Mexico law, meaning it would not be fit for human consumption.

* SoftBank Corp of Japan agreed late on Monday to sweeten its takeover bid for Sprint Nextel Corp to $21.6 billion, seeking to block a rival bid by Dish Network Corp .




* The Conservative government is putting public-service unions on notice that sick days will be targeted in the next round of collective bargaining. Treasury Board President Tony Clement said the government wants to move away from the current rules, where workers can use up to 15 paid sick days and five family days a year, in addition to vacation time.

* Hubert Lacroix, the president of Radio-Canada and the Canadian Broadcasting Corp, said the broadcaster shouldn't have changed its name to "Ici" so abruptly last week, dropping "Canada" from its public image and raising the ire of Canadians confused by the move away from a name that has served the broadcaster for decades.

* A 78-year-old woman dubbed the "Black Widow" for her criminal past with other men has admitted to slipping tranquilizers into her newlywed husband's coffee while they were on a honeymoon last year.

Reports in the business section:

* The finance ministers and central bankers who set the World Bank's agenda had just signed off on World Bank President Jim Yong Kim's request to set a deadline - 17 years from now, in 2030 - for the elimination of extreme poverty, defined loosely as subsistence on less than $1.25 a day.

* Japan's central bank ended a two-day policy meeting on Tuesday with an upbeat assessment for the world's No. 3 economy and a pledge to persist with its aggressive monetary easing policies aimed at ending years of growth-sapping deflation.

* Canada's biggest city already tops the list for the most high-rises and skyscrapers under construction in North America. It was also Toronto's frothy condominium market that helped push Finance Minister Jim Flaherty into his fourth round of mortgage restrictions almost a year ago.


* Ontario's Opposition accuses Premier Kathleen Wynne of being complicit in the mass deletion of emails on canceled gas plants by senior Liberals in former premier Dalton McGuinty's office.

* Senior figures in the Conservative movement are warning that unless Stephen Harper moves his House Leader, Peter Van Loan, and the Government Whip, Gordon O'Connor, more MPs will follow the unlikely rebel, Brent Rathgeber, out of the caucus door.

* An open booze bar, impromptu golf games, and a live dance band don't add up to value for taxpayers' money, says a Toronto District School Board trustee who has openly criticized a recent three-day gathering of some 200 public school board trustees held at a posh Muskoka resort.


* Air Canada says it is aiming to eliminate its multibillion-dollar pension solvency deficit by 2020 as part of a broader effort to cut costs ahead of a major international expansion.

* Canada's efforts to combat international tax evasion will be in the spotlight when Prime Minister Stephen Harper joins other world leaders next week at the G8 summit in Northern Ireland, with tax watchdogs worried Canada is already balking at some major reforms.

* Total SA is pressing its partner Suncor Energy to take a final investment decision on the Fort Hills project before the end of the year, according to its chairman.


Fly On The Wall 7:00 AM Market Snapshot



AmerisourceBergen (ABC) upgraded to Outperform from Market Perform at Leerink
Arthur J. Gallagher (AJG) upgraded to Buy from Neutral at Goldman
Catamaran (CTRX) upgraded to Buy from Neutral at UBS
Catamaran (CTRX) upgraded to Sector Outperformer from Sector Performer at CIBC
Disney (DIS) upgraded to Outperform from Neutral at Macquarie
Fly Leasing (FLY) upgraded to Buy from Neutral at Citigroup
Navistar (NAV) upgraded to Market Perform from Underperform at BMO Capital
Pinnacle West (PNW) upgraded to Buy from Neutral at UBS


Everest Re (RE) downgraded to Neutral from Buy at Goldman
Kinross Gold (KGC) downgraded to Hold from Buy at Canaccord
Kosmos (KOS) downgraded to Market Perform from Outperform at Raymond James
Moody's (MCO) downgraded to Hold from Buy at Benchmark Co.
XenoPort (XNPT) downgraded to Underweight from Equal Weight at Morgan Stanley
lululemon (LULU) downgraded to Neutral from Buy at UBS


Alnylam (ALNY) initiated with an Overweight at Morgan Stanley
BioAmber (BIOA) initiated with an Outperform at Credit Suisse
Casey's General Stores (CASY) initiated with a Buy at Benchmark Co.
Diamondback Energy (FANG) initiated with a Buy at Topeka
ING U.S. (VOYA) initiated with a Market Perform at Wells Fargo
ING U.S. (VOYA) initiated with a Neutral at Citigroup
ING U.S. (VOYA) initiated with a Neutral at Goldman
ING U.S. (VOYA) initiated with a Neutral at SunTrust
Marketo (MKTO) initiated with a Buy at Canaccord
Marketo (MKTO) initiated with a Neutral at Goldman
Marketo (MKTO) initiated with a Neutral at UBS
Marketo (MKTO) initiated with an Outperform at Credit Suisse
Restoration Hardware (RH) initiated with a Buy at Jefferies
Tableau Software (DATA) initiated with a Buy at UBS
Tableau Software (DATA) initiated with a Market Perform at BMO Capital
Tableau Software (DATA) initiated with a Neutral at Credit Suisse
Tableau Software (DATA) initiated with a Neutral at Goldman


Sprint (S), SoftBank (SFTBF) amended merger agreement, cash for Sprint holders now $5.50/share
Sprint (S) said DISH (DISH) proposal not likely to lead to superior offer
Sallie Mae (SLM) in new $6.8B credit facility, eliminated conduit financing
Kinross Gold (KGC) to cease Ecuador project development, take $720M charge
Royalty Pharma urged Elan (ELN) shareholders to vote against proposals
Texas Instruments (TXN) said Q2 tracking consistent with expectations, orders strong
GE Healthcare (GE) to invest $2B in software development over next five years
CEO David H. Murdock offered to acquire remaining 60% of Dole Food (DOLE)
Timken (TKR) retained Goldman Sachs (GS) to evaluate separation of steel business
lululemon (LULU) CEO Christine Day to step down
Cigna (CI) entered 10-year strategic PBM partnering agreement with Catamaran (CTRX)
Urban Outfitters (URBN) to open 35-40 new stores in FY14


Companies that beat consensus earnings expectations last night and today include:
Diamond Foods (DMND), Stewart Enterprises (STEI), Annie's (BNNY), Synergetics (SURG), lululemon (LULU), Limoneira (LMNR)

Companies that missed consensus earnings expectations include:
Pep Boys (PBY), Majesco (COOL), Coastal Contacts (COA)


  • The Consumer Financial Protection Bureau is increasing scrutiny of overdraft fees charged by banks, a big revenue stream that is helping the industry lessen the hit caused by low interest rates and the sluggish economy, the Wall Street Journal reports
  • S&P’s Ratings Services (MHFI) joined the bullish voices on the U.S. economy. But markets ignored the surprise endorsement, the latest sign of credit-ratings firms' waning influence over investors in large, heavily traded markets, the Wall Street Journal reports
  • The EU plans to lodge a case with the WTO against Chinese duties on specialized steel tubes, sources say, opening another front in a rapidly escalating trade conflict with Beijing. Reuters reports
  • The U.S. Navy plans to sign this week a five-year contract valued at near $6.5BB to buy 99 new V-22 Osprey tilt-rotor aircraft built by Boeing (BA) and and Bell Helicopter, a unit of Textron (TXT), Reuters reports
  • Apple’s (AAPL) move into the online-radio business may not turn out to be a Pandora Media (P) killer after all. The service shares many features with other Web-radio products, Bloomberg reports
  • Fannie Mae (FNMA) and Freddie MAC (FMCC) shareholders sued the U.S., alleging that the 2008 by the Federal Housing Finance Agency takeover of the housing lending giants was illegal and cost investors billions of dollars, Bloomberg reports


Atlas Resource Partners (ARP) 13M share Secondary priced at $21.75
Bright Horizons (BFAM) files to sell 8.5M shares for selling stockholders
Crosstex Energy LP (XTEX) 6M share Spot Secondary re-offered at $20.33
Himax Technologies (HIMX) files to sell 22.09M American Depositary Shares for holders
Portland General Electric (POR) to offer 11.1M shares of common stock

Yen Soars Most In Over Three Years, Nikkei Futures Plummet

Two days ago we made a very simple observation: "Whenever Goldman openly commands the muppets to buy, you know the situation is serious, and Goldman has a lot of unwinding to do. Which is precisely what just happened following the Squid's reco to buy Nikkei September futures (NKU3) ahead of the BOJ meeting. What is Goldman's thesis in a nutshell: hope may be fading in Abenomics, but the "incentives for Governor Kuroda to use the [upcoming BOJ] meeting to signal a firmer and clearer commitment to the easing course, and to highlight the potential to do more, are high and rising." In other words, please bet the farm on more of the same jawboning that lead to a 20% loss for anyone who bought as recently as 2 weeks ago. Oh, and by the way, complete the sentence, whenever a client is buying from a Goldman flow trader, the Goldman flow trader is [____]." The answer, by the way, was "selling", as any muppet who may have taken Goldman's most recent advice just found out.

Overnight, following the disappointing BOJ announcement which contained none of the Goldman-expected "buy thesis" elements in it, things started going rapidly out of control, and culminated with the USDJPY plunging from 99 to under 96.50 as of minutes ago, which was the equivalent of a 2.3% jump in the Yen, the currency's biggest surge in over three years. Adding insult to injury was finance ministry official Eisuke Sakakibara who said that further weakening of yen "not likely" at the moment, that the currency will hover around 100 (or surge as the case may be) and that 2% inflation is "a dream." Bottom line, NKY225 futures have had one of their trademark 700 points swing days, and are back knocking on the 12-handle door. Once again, the muppets have been slain. Golf clap Goldman.

Of course, all of the above wouldn't be quite as hilarious if one didn't keep the following primary objective of the Bank of Japan in mind:

Price Stability


The Bank of Japan Act states that the Bank's monetary policy should be "aimed at achieving price stability, thereby contributing to the sound development of the national economy."


Price stability is important because it provides the foundation for the nation's economic activity. In a market economy, individuals and firms make decisions on whether to consume or invest, based on the prices of goods and services. When prices fluctuate, individuals and firms find it hard to make appropriate consumption and investment decisions, and this can hinder the efficient allocation of resources in the economy. Unstable prices can also distort income distribution. For example, in times of high inflation, people holding only financial assets whose value is fixed in nominal terms, such as bank deposits, will suffer a decline in the value of these assets in real terms.

Funny, nowhere in the above does it say "maximizing year end bonuses for Goldman traders and partners"...

There was little else notable with the world's attention now focusing on the German Constitutional Court's hearing of the constitutionality of the ECB's OMT operation. Spoiler alert: nothing will happen. Why? Because the biggest beneficiary of the ECB's generosity is not Greece, not Italy, not Spain. The beneficiary is best captured by the following chart (hint: DB stands for Deutshce Bank):

The key overnight news bulletin highlights, via Bloomberg:

  • Treasuries fall as JPY surges as much as 2.3% vs USD after BoJ kept its stimulus unchanged and refrained from expanding tools to address bond-market volatility.
  • BoJ left unaltered its one-year fixed-rate loan facility and plan for JPY60t-70t annual rise in monetary base; Governor Kuroda said the central bank will discuss longer funding operations if they become necessary
  • Turkish riot police retook Istanbul’s Taksim Square, the center of nearly two weeks of unrest, from anti-government activists today, using tear gas and water cannons to break pockets of resistance
  • The Turkish central bank said it will tighten monetary policy to support currency
  • Former Goldman Sachs Asset Management chairman Jim O’Neill said investors should get used to U.S. yields nearer 4% than 2%, sees recovery of “equity culture” and end to bond market rally
  • The ECB’s OMT bond-buying plan may force Germany’s top court to choose between market stability and the principles of democracy, lawyers for political groups that oppose the plan said at a hearing; court will consider the case starting today
  • Germany’s finance minister Schaeuble said the ECB can’t be targeted in a German court; ECB’s Draghi said he trusts the constitutional court
  • Citigroup could lose as much as $7b on currency swings if Portales Partners analyst Charles Charles Peabody is right, putting the analyst at odds with peers who say the stock will be the best performer among big U.S. banks in the year ahead
  • U.K. industrial production unexpectedly rose in April, boosted by increased output at oil and water companies. Manufacturing fell after gains in February and March
  • Sovereign yields surge. Nikkei -1.5%; China closed for holiday. European stock markets, U.S. equity index futures gain. WTI crude, metals fall

SocGen's FX team lays out the key macro events:

The week got off to a calm start for financial markets, but will the German Constitutional Court hearings unsettle them today?

German Finance Minister Schaeuble, ECB member Joerg Asmussen and Bundesbank President Jens Weidmann will speak. The question is whether Germany will consider the ECB's Outright Monetary Transactions (OMT) program constitutional, given that the country is attempting to limit its potential commitment in the event OMT is activated. Although the German position has been known for a long time, any move to block the process could prompt tension on peripheral yields. We note that 10Y Bonos and BTPs yields increased last week, as the ECB indicated that it was in no hurry to activate OMT or use other non conventional measures. Although fire walls were put in place last year to contend with the euro debt crisis, they still have not been tested: until proven effective, the euro debt crisis will remain a downward risk factor for the EUR.

Turning to the UK, we will be looking out for industrial production data: any positive surprise will continue to put off further Quantitative Easing by the BoE. Could the EUR/GBP rapidly fall back to recent lows of 0.8430/0.84? That is the main risk.

* * *

DB's Jim Reid concludes the overnight event recap:

The Japanese central bank wrapped up its two-day policy meeting overnight by sticking to its target of increasing the monetary base by JPY60-70 trillion a year and keeping other policy unchanged. In what is likely to disappoint those looking for measures to stem to the volatility in JGBs, the BoJ refrained from making any reference to extending the duration of fixed-rate fundsupplying operations, as was expected by some forecasters. Also in terms of JREIT and ETF purchases, the BoJ refrained from expanding the pace of purchases which will likely disappoint equity markets. The central bank left the door open to future changes though, saying that it will “make (policy) adjustments as needed”.

The immediate market reaction following the BoJ’s policy statement saw the USDJPY and Nikkei futures lose 1% and 2.5% respectively but both have recovered some losses since. Japan 30yr yields are now unchanged after initially spiking 2bp. In its outlook, the BoJ described the economy as being on a moderate recovery path and that some indicators suggest a rise in inflation expectations. In terms of other measures, the BoJ said that it will disperse loans totalling JPY3.15trillion to 70 financial institutions under a scheme to help stimulate bank lending.

This all follows a remarkably steady session yesterday where the S&P500 closed broadly unchanged (-0.03%) after spending virtually all of the session range-trading within 4pts of its closing level of 1642.8. Sentiment in equities was buoyed at the open after S&P announced that it had changed its outlook on the US sovereign rating to “stable” from “negative”. S&P appeared to dampen the notion that the US could regain its AAA rating soon though, noting that no sovereign has ever recouped its AAA rating in less than 9 years. Indeed, it took Finland and Canada nine years to return to AAA according to the agency. S&P expects that net general government debt as a share of GDP will stabilise at around 84% for the next few years, allowing policymakers some additional time to take steps to address pentup age-related spending pressures.

Outside of equities, fixed income asset classes were again pressured by the rise in rates after 7yr, 10yr and 30yr UST yields hit fresh 1 year highs yesterday. This came despite dovish comments from St Louis Fed president James Bullard who said that he would support the continuation of QE in its current form if inflation remains below the Fed’s 2% target. Bullard said he wants “to see some reassurance” from inflation data “before we start to taper”. With the rates backdrop, protection in the major credit indices remained fairly well bid with CDX IG (+3bp), European iTraxx (+2.4bp) and Crossover (+14bp) all wider on the day while cash markets traded with a softer tone.

On a related note, EM weakness remains one of the main market themes globally. Mexican peso bonds are garnering a fair amount of attention following yesterday’s selloff that saw 10yr mbono yields add 17bp to close at 5.66%. The magnitude of the selloff has caught a number of investors off guard. Foreign holdings of fixedrate peso bonds reached a 13yr peak of 58% of outstanding in May 7th, around the time that 10yr yields reached their a record low of 4.43%. Since that point, 10yr yields have sold off by almost 120bp as foreign investors trim positions in a market that has been described as “one-directional”. The fact that the Mexican peso is 7.8% weaker during the same time frame is not helping matters for foreign investors either. The Mexican finance ministry will be auctioning 3yr, 5yr and 30yr bonds today as is probably worth looking out for.

Elsewhere Asian credit spreads are another leg wider overnight as the pressure continues to build. The Asia iTraxx IG index is 10bp wider on the day as we type and is about +40bp off its recent tights in early May. Indonesia and Philippine 5-year sovereign CDS are also 18bp and 15bps wider respectively in overnight trading and have now widened by about 60bps and 20bp since Bernanke’s JCE testimony on the 22nd May. Indonesia 10yr local rates are about 25bps higher overnight at 6.60% or about 110bps more than where they were a month ago. In corporate credit Asian HY is generally about 1pt lower overnight.

Elsewhere in Asia, equities are trading with a cautious tone with the Hang Seng (-0.8%) and KOSPI (-0.6%) seeing moderate losses. The Australian dollar is 0.5% weaker against the USD after disappointing housing finance numbers, extending its two month losing streak against the USD to almost 11%.

Turning to the day ahead, attention will turn to the German constitutional court’s hearings on the ECB’s OMT programme which will be attended by the Bundesbank’s Jens Weiddman and the ECB’s Joerg Asmussen. The two-day hearing begins today. The US data calendar features wholesale inventories, JOLTs job openings and the NFIB business optimism survey. The market's reaction to the BoJ and the price action in EM will likely dominate the agenda though.

BoJ Disappoints! Nikkei Drops 500 Points From Earlier Highs

UPDATE: Nikkei futures now -500 from US day-session highs

In what must be quite a surprise to Goldman (as we discussed here), the BoJ has decided not to give in to the market's demands:


The market's angry reaction... NKY -300 from US day-session highs, USDJPY gapped down 80 pips to 98.00, JGB Futs closed, JGBs unch. Full statement to follow:



which means:




Full statement:

Statement on Monetary Policy

1. At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan decided, by a unanimous vote, to set the following guideline for money market operations for the intermeeting period:


The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 60-70 trillion yen.


2. With regard to the asset purchases, the Bank will continue with the following guidelines:


The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 50 trillion yen, and the average remaining maturity of the Bank's JGB purchases will be about seven years.


The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at an annual pace of about 1 trillion yen and about 30 billion yen respectively.


As for CP and corporate bonds, the Bank will continue with those asset purchases until their amounts outstanding reach 2.2 trillion yen and 3.2 trillion yen respectively by end-2013; thereafter, it will maintain those amounts outstanding.


3. Japan's economy has been picking up. As for overseas economies, while the manufacturing sector continues to show a lackluster performance, they are gradually heading toward a pick-up as a whole. In this situation, exports have started picking up. Business fixed investment continues to show resilience in nonmanufacturing and appears to have stopped weakening on the whole. Public investment has continued to increase, and housing investment has generally been picking up. Private consumption has remained resilient, assisted by the improvement in consumer sentiment. Reflecting these developments in demand both at home and abroad, industrial production has been picking up. Meanwhile, financial conditions are accommodative. On the price front, the year-on-year rate of change in the consumer price index (CPI, all items less fresh food) has been negative, due to the reversal of the previous year's movements in energy-related and durable consumer goods. Some indicators suggest a rise in inflation expectations.


4. With regard to the outlook, Japan's economy is expected to return to a moderate recovery path, mainly against the background that domestic demand increases its resilience due to the effects of monetary easing as well as various economic measures, and that growth rates of overseas economies gradually pick up, albeit moderately. The year-on-year rate of change in the CPI is likely to gradually turn positive.


5. Regarding risks, there remains a high degree of uncertainty concerning Japan's economy, including the prospects for the European debt problem and the growth momentum of the U.S. economy as well as the emerging and commodity-exporting economies.


6. The Bank will continue with quantitative and qualitative monetary easing, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. It will examine both upside and downside risks to economic activity and prices, and make adjustments as appropriate.


Such conduct of monetary policy will support the positive movements in economic activity and financial markets, contribute to a rise in inflation expectations, and lead Japan's economy to overcome the deflation that has lasted for nearly 15 years.

Japan’s Ruling LDP Party Joins JGBi Market In Fears that „Abenomics Could Fail“

With JPY back around 98 and the Nikkei 225 indicating further advances, perhaps the fears in the market are mis-represented - at least that's what the other Goldman desk would have you believe.

But, as The Japan Times reports, even glorious leader Abe's own LDP party are beginning to voice concerns that all this fluff is - well - just that. As we outlined here, the market is already concerned, domestic funds were very unwilling to partake of the exuberance - since they know the limitations of QE in their 20-year balance sheet recession environment - and as Goldman notes, the fact that the JGBi expected inflation level - a now symbolic indicator of policy success since Kuroda quoted it -  is now suddenly moving counter to its previous extended trend could possibly indicate the markets’ early signal questioning the credibility of the BOJ policy.

The recent stock price collapse, Lower House LDP lawmakers noted "shows the market expects little (of Abenomics)." The sky-high approval ratings (and business confidence) for the Abe Cabinet have been bolstered by the resurgence of the benchmark Nikkei since 'Abe(g)nomics began. The stock market’s downturn, therefore, has created a sense of crisis among some members of the ruling LDP, and while they are likely to give the nod to Abe’s 3rd arrow growth strategy, many are pushing for significant fiscal expansion because "Abenomics could fail."

Re: The Market doubts...

Via Goldman Sachs:

We should note that there has also been a notable reversal in the expected inflation rate. The breakeven inflation rate, embedded in inflation-linked JGBs (JGBi), had been following a sustained upward trend from the middle of 2012. The JGBi market is very small and illiquid, and thus we have not regarded BEI as a reliable proxy variable for expected inflation.


After the change in BOJ leadership, however, Governor Haruhiko Kuroda has referred to the JGBi expected inflation rate on several occasions, stressing that inflation expectations have turned positive as a result of the regime change.


The JGBi expected inflation is therefore a symbolic leading indicator of the policy success of the new regime, and we believe the fact that it is now suddenly moving counter to its previous extended trend could possibly indicate the markets’ early signal questioning the credibility of the BOJ policy, which is beyond the issue of communication inconsistency.





Mortgage rates are already rising, and a higher rate environment could damage the precious positive trend that has developed in the economy. JGB market volatility may also dampen the risk appetite of investors, which could in turn have a negative impact on the equity and forex markets. The BOJ needs to make every effort to stabilize long-term rates to avoid such consequences.


In light of these issues, we think the main theme of the upcoming policy meeting will be improving communications surrounding the intentions and impact of the new policy scheme. We also see them discussing an extension of fund-supplying operations against pooled collateral to two years (from the current 1-year limit) in order to contain immediate market instability.


Re: The Politicians doubt...

Via The Japan Times:

Liberal Democratic Party lawmakers have begun to openly express discontent over Prime Minister Shinzo Abe’s economic growth strategy ahead of July’s Upper House election.


Many LDP members have turned on “Abenomics” since the Nikkei 225 stock average nosedived Wednesday on the market’s underwhelmed reaction after Abe unveiled the “third arrow” of his strategy earlier that day.


The sky-high approval ratings for the Abe Cabinet have been bolstered by the resurgence of the benchmark Nikkei since the government and the Bank of Japan hammered out a set of drastic fiscal and monetary stimulus steps earlier this year. The stock market’s downturn, therefore, has created a sense of crisis among some members of the ruling LDP.


As stock prices plummeted following the announcement of Abe’s structural reforms for the economy and a draft of his government’s fiscal consolidation plan, Hitoshi Kiuchi, a Lower House LDP lawmaker, told a joint meeting with the government Friday that “this shows the market expects little (of Abenomics).”


At the gathering, Kozo Yamamoto, another LDP member of the House of Representatives, demanded the government implement fiscal measures that can fully offset the negative impact of the consumption tax hike scheduled for next April. Raising the levy to 8 percent from the current 5 percent “is the biggest risk for Abenomics,” he stressed.


Many other LDP participants voiced their opposition to the growth measures unveiled by Abe last week, especially a plan to eliminate the current ban on online sales of nonprescription drugs. Scrapping this regulation runs counter to the policy platform presented to voters during the LDP’s victorious campaign for December’s Lower House election, one party member argued.


If the Abe administration keeps sidelining the LDP regarding policy management, in disregard of deteriorating macroeconomic indicators, it will have an adverse impact on the party’s fortunes in the upcoming House of Councilors poll, the party sources said.


“Abenomics could fail” and to prevent this, the government should adopt the ruling party’s proposals, a veteran LDP lawmaker stressed.


Yet the LDP is still expected to give the nod to Abe’s growth strategy and other policy measures as early as Monday to avoid internal strife before the looming election, analysts said.


Still, if stock prices and long-term interest rates continue to fluctuate with their recent volatility, this would shake the LDP even deeper, they added.

Eight Drivers

There are many events and economic reports that can roil the market in the days ahead.  Yet, just as importantly, there are already forces at play that will shape market developments.  Here are 8 thoughts about what to expect.  

1.  The US employment data failed to have much impact on expectations the timing of the Fed's tapering.  A recent news wire poll found a median expectation for it to begin in Oct and by about $20 bln.  The key issue is whether the appreciation of this is sufficient to stabilize long-term US interest rates.  It does not appear to be, which means, barring a significant surprise, US yields do not appear to have peaked yet.  The 10-year yield can rise into the 2.25%-2.40% area.  This need not be supportive of the dollar against the other major currencies, if it is part of a larger unwind of positioning.  

2.  The interest rate on a 30-year fixed rate mortgage has risen from 3.6% to 4.1% in recent weeks.  It is first time its is above 4% in a year.  Yet, the impact on the housing market may be mild.  Rates are still not high, by nearly any metric.  Activity has been lifted by participants, like institutional investors, that are less sensitive to marginal interest rate changes.  Moreover, the real hindrance has not been the cost of credit, but the access.  If lenders have greater confidence of a self-sustaining recovery, then perhaps they would increase their willingness to lend.


3.  After testing 1600 last Thursday, the S&P 500 gapped higher on Friday.  It extends from Friday's opening and low print of the session (1625.27) to Thursday's high (1622.56).  Although there are several different types of gaps, this one appears to be one of  two kinds. The first kind would be filled over the next day or two and that would suggest a near-term set back.  The second kind will not be filled in the near-term and it is a type of break-away gap.  After retreating by 5% over two-weeks, the gap signals the end of that move, which means new advance is at hand.  We are inclined toward the latter and anticipate it will lead to new highs for the index.  

4.  The S&P 500 peaked on May 22, the day before the Nikkei.  The Nikkei has slumped 21%, which brought it within spitting distance of a 50% retracement of its gains since the election was called in mid-Nov '12.  The pre-weekend rally in the S&P 500 and the recovery of the dollar against the yen following the US employment report, points to a likely recovery of Japanese shares.

5.   The key political event of the week is the German Constitutional Court ruling that is expected Tuesday or Wednesday.  As has been done with other measures that are forging greater European integration, there is a legal challenge to the ECB's Outright Market Transaction program.  It could side step the issue and refer the ECB powers to European courts, claiming perhaps that it does not have the authority to rule.  It could agree with the complainants and find that the ECB has encroached on a right that belongs to the German people through the parliament.   It could find that the OMT is not an infringement on Germany sovereignty and use the case as another opportunity to draw conditions or lines that need to be respected, which is what we expect.

6.  The Bank of Japan and the Reserve Bank of New Zealand meet in the week ahead.  The BOJ concludes on Tuesday.  There may be some minor operational tweeks and it could announce a new longer-term repo facility (2-years) as a possible way to help stabilize the JGB market.  The RBNZ meets on Thursday and we see it in no hurry to raise interest rates, though that is the direction of the next move in rates.   The New Zealand dollar has dropped nearly 10% against the US dollar since early April, though has gained 1.5% against the also falling Australian dollar.   The central bank, which has begun intervening in the foreign exchange market, no doubt welcomes the weaker currency.  

7.  There are several economic reports that offer headline risk in the days ahead.  At the start of the week, in Japan, a small upward revision in Q1 GDP is not great shake, but April's current account will be scrutinized.  The increase in bank lending is expected to continue, bolstered by reconstruction efforts and foreign investment.  Machinery orders are likely to have been set back at the outsized March jump.  A rise in corporate goods prices reflects higher cost imports, including energy, and this has been aggravated by the weakness of the yen.  Weekly MOF portfolio flows have taken on greater interest of late.  It is a light week for European reports, but the focus will be on industrial production reports (including the UK and Sweden).   The UK also reported on the latest labor market conditions.  The euro area reports CPI figures at the end of the week.   The two economic highlights for the US will be the retail sales report on Tuesday and industrial production on Thursday.  The consensus looks for a 0.4% and 0.2% rise respectively in the headline figures, while the retail sales measure used for GDP calculations is expected to rise 0.3% while manufacturing is expected to have risen by 0.2%.  Risk seems asymmetrically distributed to the downside of both reports.  

8.  There are several central banks in the emerging markets that meet, including India, Korea, Philippines, Chile and Russia.  None are expected to cut key lending rates, though there is some expectation for the Philippine Central Bank to cut its special deposit rate by 25 bp (to 1.75%), which it has done three times this year to try to curb the short-term capital inflows.  Brazil's markets will also be closely watched after last week's lowering (technically not abolishing) the tax on foreign purchases of Brazilian bonds to zero and S&P put the country's ratings outlook on negative watch.  South Korea may also be interesting after 3 nuclear reactors last week were suspended indefinitely for using forging safety certificates.  At the end of last year 2 other pans were closed for similar reasons.  With seven other reactors out of service due to routine maintenance, the country has lost about a third of its electricity capacity.  The government warned of "unprecedented shortages".  This may be another headwind for the South Korean economy that could last the better part of the summer.  

Richard Koo: „Honeymoon For Abenomics Is Over“

As we noted just two weeks ago - before the hope-and-change-driven exuberance in Japanese equities came crashing down - "those who believe in Abenomics are suffering from amnesia," and Nomura's Richard Koo clarifies just who is responsible for the exuberance and why things are about to shift dramatically. Reasons cited for the equity selloff include Fed Chairman Ben Bernanke’s remarks about ending QE and a weaker than expected (preliminary) Chinese PMI reading, but, simply put, Koo notes, more fundamental factor was also involved: stocks had risen far above the level justified by improvements in the real economy. It was overseas investors (particularly US hedge funds) that responded to Abe's comments late last year by closing out their positions in the euro (having been unable to profit from the Euro's collapse) and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher. Koo suspects that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible...

Had they understood this, they would not have behaved in the way they did.

Many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies - should be effective. In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher.


Via Nomura's Richard Koo,

Divergence in investor behavior fueled virtuous cycle of lower yen and higher stocks

More specifically, the sharp rise in equities that lasted from late in 2012 until a few weeks ago and the several virtuous cycles that fueled this trend were themselves made possible by a special set of circumstances.

Whereas overseas investors responded to Abenomics by selling the yen and buying Japanese stocks, Japanese institutional investors initially refused to join in, choosing instead to stay in the bond market.

Because of that decision, long-term interest rates did not rise. That reassured investors inside and outside Japan who were selling the yen and buying Japanese equities, giving added impetus to the trend.

Japanese institutional investors understand private demand for funds is negligible

The next question is why domestic and overseas investors responded so differently to Abenomics. One answer is that many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies—should be effective.

Short-term rates in Japan have been at or near zero since around 1995, some 18 years ago. The BOJ engaged in an aggressive quantitative easing initiative from 2001 to 2006, under which it supplied more than ¥30trn in excess reserves at a time when statutory reserves amounted to just ¥5trn. Yet neither the economy nor asset prices reacted meaningfully.

In the last few years, Japanese corporate balance sheets have grown much healthier and interest rates have remained at historic lows. Yet private demand for funds did not recover because 1) firms were still in the grip of a debt trauma and 2) there was a shortage of domestic investment opportunities.

Japan’s institutional investors were painfully aware of this reality, which had left them facing a lack of domestic investment opportunities for more than a decade. From their perspective, there was no reason to expect another foray into quantitative easing by the BOJ under pressure from the Abe administration to lift the economy, and therefore no reason to change their behavior.

But overseas investors bet on bold monetary easing

Meanwhile, overseas—and particularly US—hedge funds that had been betting on a worsening of the euro crisis until last autumn were ultimately unable to profit from those positions because the euro did not collapse.

Then in late last year, the Abe government announced that aggressive monetary accommodation would be one of the pillars of its three-pronged economic policy. Overseas investors responded by closing out their positions in the euro and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher. I suspect that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible. Had they understood this, they would not have behaved in the way they did.

Bond and equity markets took very different views of Japan’s economy

The yen weakness and stock market appreciation brought about by this money began to buoy sentiment within Japan, paving the way for further gains in equities. They also prompted retail investors to enter the market, providing more fuel for the virtuous cycle. Japanese equities were up 80% from their lows at one point. However, this virtuous cycle was based on the key assumption that interest rates—and long-term interest rates in particular—would not rise.

This condition was satisfied as long as domestic institutional investors remained in the JGB market, but consequently the views of the Japanese economy held by equity and bond market participants diverged substantially.

Moreover, even though the moves in the equity and forex markets were led by overseas investors with little knowledge of Japan, the resulting improvement in sentiment and the extensive media coverage of inflation prospects forced domestic institutional investors to begin selling their bonds as a hedge.

Honeymoon for Abenomics finally ends

The result was a correction in the JGB market from mid-April onwards, with the ensuing turmoil prompting a correction in equities as well.

In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher. This means further gains in equities will require stronger corporate earnings and a recovery in the economy.

Yen weakness likely to persist on trade deficits

The share price increases driven by the prospect of improved corporate earnings due to the weaker yen will probably persist going forward. Now that Japan is running trade deficits, the yen is unlikely to see the kind of appreciation observed in the past. Naturally, exchange rates are relative things, and the yen might well rise back into the 90–100 range against the US dollar depending on conditions in the US economy. But I do not expect USD/JPY to return to the area below the mid-80s.

The yen’s decline to around 100 against USD has definitely been a positive for the Japanese economy. But authorities will need to tread carefully when dealing with additional yen weakness, including the question of what might stop the yen from falling further. Excessive drops in the currency could spark a “sell Japan” movement like that seen in 1997, when investors simultaneously sold off the yen, Japanese stocks, and Japanese bonds.

In addition, the cheap imports represented by the proliferation of so-called ¥100 shops have played an important role in maintaining the living standards of ordinary Japanese consumers at a time of sluggish or falling incomes. Further declines in the yen might benefit a handful of exporters but could also lower living standards for the majority of people.

Virtuous cycle for Abenomics has reached turning point

Now that USD/JPY has fallen to what I see as a comfortable level and the Japanese bond market has broken its silence, I think the virtuous cycle for Abenomics in evidence since late last year is at a critical juncture.

That is not to say that current exchange rates or long-term bond yields are cause for concern. Compared to where they were before, current levels are both reasonable and comfortable.

But from this point on, the environment will be very different in the sense that there will be greater emphasis on 1) consistency between the bond and stock markets and 2) the negative implications of a weaker currency.

“Bad” rise in rates continues, fueled by inflation concerns

The Bank of Japan began buying longer-term JGBs on 4 April with the goal of pushing yields down across the curve. The outcome of those purchases, however, has been exactly the opposite of what Governor Haruhiko Kuroda intended, with long-term bond yields moving higher in response.

Domestic mortgage rates have increased for two consecutive months as a result. This is clearly an unfavorable rise in rates driven by concerns of inflation, as opposed to a favorable rise prompted by a recovery in the real economy and progress in achieving full employment.

The more the market senses the BOJ’s determination to generate inflation at any cost, the more interest rates—and particularly longer-term rates—will rise, adversely impacting not only Japan’s economy but also the financial positions of banks and the government.

Recovery can offset many negatives of rising rates

As I also noted in my last report, a recovery-driven rise in rates occurs when the economy rebounds and approaches full employment, fueling concerns about inflation and pushing interest rates higher.

Because the economy is in recovery, banks are lending more to the private sector and government tax revenues are expanding. Even if higher interest rates cause losses on banks’ bond portfolios or increase the cost of borrowing for the government, there is sufficient offsetting income. In other words, the government and banks are both capable of absorbing significant increases in interest rates as long as the economy is in recovery.

But higher rates before recovery weigh on economy

However, today’s BOJ is recklessly easing monetary policy to generate inflation expectations in the hope that those expectations will spark a recovery in the real economy. In this case, inflation expectations precede the recovery, creating the risk that rates will rise before the economy picks up.

Since there is no increase in bank earnings from additional lending activity and no increase in tax revenues from a recovering economy, the financial positions of banks and the government deteriorate in direct proportion to the rise in long-term interest rates. The resulting shrinkage of equity capital constrains banks’ ability to lend, while the government is forced to cut spending or increase taxes. Both of these outcomes will naturally weigh on the economy.

Of special concern is the risk that a rise in rates prior to a pick-up in private loan demand will force the government to engage in fiscal consolidation. The economy could quickly sink if the government stops borrowing and spending at a time when there are no private-sector borrowers.

Fiscal consolidation counterproductive if it precedes pick-up in private demand for funds

In this regard, it was shocking to note that BOJ Governor Kuroda, senior IMF official David Lipton, and even a handful of private-sector economists in Japan have over the last two weeks urged the government to engage in fiscal retrenchment to prevent a further rise in interest rates.

I would have no objection if they were making the argument because they had proof that private demand for funds was about to increase substantially. But without such evidence, they risk sending Japan’s economy back into the abyss.

If private demand for funds were actually on the rebound, the private sector would be able to borrow and spend the unborrowed private savings that have weighed on Japan’s economy for the last 20 years without any need for fiscal stimulus. That, in turn, would free up the government to put its finances in order and in fact would mean it was time for it to do so. But fiscal consolidation in any other circumstances could lead to a repetition of the Hashimoto government’s failed experiment in 1997.

Unfortunately, the lack of data for the period since Mr. Kuroda’s policies began makes it difficult to draw any certain conclusions at this time.

Real estate purchases have no impact on unborrowed savings…

It should be noted that the sharp rise in share prices has refocused attention on the real estate market, prompting some investors and individuals to buy property now before inflation sends prices higher. Although the resulting demand for loans does increase the demand for funds, transactions like these that merely involve a transfer of ownership do little to resolve the problem of unborrowed savings that is at the heart of Japan’s economic malaise. A transfer of ownership only shifts savings around within the financial system—the buyer’s deposits decrease and the seller’s deposits increase, but the savings remain within the financial system. The money must be used for consumption or investment in order for the problem of unborrowed savings to be resolved.

But increased investment does

In addition to new demand for loans, the deployment of businesses’ retained earnings for new investments can also reduce unborrowed savings, since any reduction in retained earnings represents a decline in unborrowed savings languishing somewhere at financial institutions.

Increased investment demand therefore reduces the need for the government to borrow and spend, enabling it to pursue fiscal consolidation without adversely affecting the economy. In this regard, the claim in the 3 June issue of the Nikkei that large Japanese enterprises plan to invest 12.3% more in FY13 than they did in FY12 is a welcome development. This probably includes export-related firms and companies competing with imports that have decided to ramp up domestic production for the first time in many years in response to the weak yen.

“Bad” rise in rates renders two of three pillars of Abenomics powerless

We cannot be too complacent, however, because the size of the surplus private savings problem in Japan is huge. At the moment we only have data through 2012 Q4, and they show that private sector savings amounted to a seasonally adjusted 7.11% of GDP in spite of zero interest rates. This means the public sector must be borrowing and spending a comparable amount in order to keep the economy going.

If the level of savings is largely unchanged today, Japan’s economy could easily stall if the government were to stop borrowing and spending the private sector savings surplus. The second pillar of Abenomics—fiscal stimulus—was put in precisely to address this risk. If an unfavorable rise in interest rates not only prevented the government from borrowing and spending but actually forced it to raise taxes and cut back on expenditures, that would be putting the cart before the horse.

It would effectively mean that an excessive reliance on the first pillar—monetary accommodation—had prompted an unfavorable rise in rates, forcing the government to abandon the second pillar, which is essential when the private sector is saving so much at zero interest rates.

“Bad” rise in rates should be addressed with adjustments to monetary policy

In this regard, we need to watch out for the possibility of an increase in long-term rates driven by mounting inflation concerns without a recovery in private demand for funds. If, for example, people see inflation picking up before long—even if there is no inflation today—they will no longer be willing to hold 10-year government bonds yielding less than 1%. If they decide to convert their JGBs to cash and buy them back once prices have fallen, long-term rates will rise sharply. This kind of selling is already being observed in some quarters.

When facing this kind of unfavorable rise in rates fueled only by inflation concerns and not by a recovery in private demand for funds, the government should respond not with fiscal consolidation but rather with adjustments to the BOJ’s overly accommodative monetary policy.

If the BOJ refused to modify its policy and forced the government to engage in fiscal retrenchment, the Japanese economy will suffer badly given the weakness of private demand for funds.

On the other hand, when interest rates are rising because of a recovery in private demand for funds, the proper response for the government is to raise taxes and cut spending in order to keep upward pressure on interest rates in check. If the Japanese economy were actually in such a phase, the economy could probably continue making progress even after the consumption tax is hiked next April.

Unfavorable rise in rates must be dealt with carefully

Then-BOJ Governor Toshihiko Fukui, who understood all of this, said in 2005 that there was no problem with fiscal consolidation as long as its scale was consistent with the recovery in private demand for funds (see my report dated 8 March 2005 for details). But the officials now making a case for fiscal consolidation—Mr. Kuroda, Mr. Lipton, and private economists—give no sense of having confirmed that private demand for funds is actually picking up.

The implication is that they may respond to an unfavorable rise in rates by scaling back fiscal expenditures instead of making adjustments to monetary policy. We need to watch out for this risk very closely.

Only 22% of people surveyed by the Nikkei felt Japan’s economy is actually recovering (27 May 2013), suggesting relatively few have benefited from Abenomics’ honeymoon thus far.

Moreover, an increase in long-term rates at a time when 78% of the population is not personally experiencing a recovery is most likely a “bad” rise in rates, and the authorities need to address it very carefully, keeping a close eye on private demand for funds.

The Problems With Japan’s „Plan (jg)B“: The Government Pension Investment Fund’s „House Of Bonds“

“So long as public funds ultimately are governed by the government, which is controlled by representatives of the general public, risk tolerance is subject to the general public’s risk tolerance, and the general public’s risk tolerance is not necessarily high. If and when the stock market collapses and performance goes negative for some time, people, the media and politicians will complain loudly... Who exactly is responsible for the future payment of benefits? Those who make the promise today may not be the people to actually deliver on the promise in future decades. It is much easier to make a promise that somebody else is supposed to carry out. Here the future generation is not in a position to sign the contract at all. This is the critical agency problem.

          -  Yuji Kage, former CIO, Pension Fund Association

Now that the BOJ's "interventionalism" in the capital markets is increasingly losing steam, as the soaring realized volatility in equity and bond markets squarely puts into question its credibility and its ability to enforce its core mandate (which, according to the Bank of Japan Act "states that the Bank's monetary policy should be aimed at achieving price stability, thereby contributing to the sound development of the national economy) Japan is left with one wildcard: the Government Pension Investment Fund (GPIF), which as of December 31 held some ¥111.9 trillion in assets, of which ¥67.3 trillion, or 60.1% in Japanese Government Bonds. Perhaps more importantly, the GPIF also held "just" ¥14.5 trillion in domestic stocks, or 12.9% of total, far less than the minimum allocation to bonds (current floor of 59%). 

What the GPIF has going for it is that with a total asset size of just about $1.1 trillion, it is the largest government pension fund in the world. It is almost equal to the size of Korea's economy, has nearly six times as much assets under management as CALPERS, the biggest US pension fund, and nearly four times as much as Europe's largest pension plan, Stichting Pensioenfonds ABP of the Netherlands. Which means that the mere whisper of capital reallocation sends assorted asset classes scrambling.

It is this massive potential buying dry powder that has led to numerous hints in the press (first in Bloomberg in February, then in Reuters last week, and then in the Japanese Nikkei this morning all of which have been intended to serve as a - brief - risk-on catalyst) that a capital reallocation in the GPIF is imminent to allow for much more domestic equity buying, now that the threat of the BOJ's open-ended QE is barely sufficient to avoid a bear market crash in the Nikkei in under two weeks.

There are some problems, however.

The first of which, is that GPIF appears to be a "jack of all trades" when it comes to its potential utility. It was only in March that HSBC wrote in "Japan's trillion dollar bond rotation" that "there is clearly a bias to shift more public funds into international markets", and that "Crucially, the GPIF is conducting a review to accelerate divestments in domestic bonds in favour of EM." Wait, reallocation from domestic bonds into international markets, and specifically bonds? Oh yes, that's because back then Europe needed backstopping and the mere threat of a Japanese carry trade tsunami was sufficient to send peripheral bond yields plunging to near record lows (despite Europe's imploding economy).

Fast forward to today, when we now learn that this mythical reallocation from domestic into international bonds has been put on hiatus (PIIGS yields plunging notwithstanding), and has been replaced by a new narrative - one which is suddenly the much more critical, and Abenomics preserving one: reinvesting out of domestic bonds and into domestic stocks, thus providing a backstop to the BOJ. Problem is, cry capital-reallocating wolf enough times, and soon someone will demand to see proof before taking you at your word.

This problem is compounded by another problem: as we wrote several years ago, in 2010, due to the demographic crunch of Japanese society, the GPIF became, for the first time ever, a net asset seller. This can be seen on the charts below.

Worst of all, and as can be very vividly seen on the charts below, not only has the GPIF been consistently leaking assets in the past four years, it has already been actively reallocating away from bonds: in fact, at 60.1% of total assets, the JGB holdings as of December 31 a % of total assets are the lowest they have been in decades (and just above the 59% threshold), while the allocation to domestic stocks has soared from 12.3% in Q3 to 14.5% in Q4: the highest in two years. Just how much dry powder does this pension fund really have before it literally bets the bank on the riskiest of all asset classes, and - in the off chance it bets incorrectly - dooms tens of millions of people to retirement in poverty? So the GPIF needs a reallocation program?  Sounds to us like it needs to invest more into JGBs!

Total GPIF assets:

Relative GPIF assets:

So will the GPIF indeed scramble to reallocate into equities or is this merely the latest bluff in a long series of pseudo-political gambits? Here are some thoughts from HSBC on this issue:

Domestic equities might be an obvious target for the reallocation of assets, especially if the impressive rally in the Nikkei continues. But Japanese investors will be very reluctant to immediately pile into the local stock market. The asset bubble that burst more than 20 years ago left its mark. More than half of households’ USD15trn financial assets were kept in cash as of September 2012 and only 6% in equities, according to BoJ data. Other significant domestic holders of JGBs such as banks and pension funds will also be constrained to match liabilities and meet regulation requirements, implying bond investments, including overseas bonds, are more likely than equity investments.

Well that's great for Spanish bonds, but does nothing to help what may soon be the next great Japanese equity market bubble. 

But wait, it gets worse.

As we have been showing over the past several weeks, suddenly a far bigger problem that has emerged for Japan is not what happens to the Nikkei, but whether it suffers an out of control collapse in its bond market, and sees a rapid, vicious and sharp sell off in the JGB complex as nearly happened on May 23, the day when the the Nikkei225 crashed. It is this that is the biggest structural threat to Abenomics, not whether or not Mrs. Watanabe will have generated enough money daytrading to avoid the 20% price surge in McDonalds.

So if indeed the GPIF does reallocate into equities (a very big if considering its multi-functional usage depending on the dry-powder threat need du jour), it will have to sell JGBs. Even more than it has sold so far. Which will then precipitate yet another rout in the JGB market, from where we go into such issues as the "VaR shock" we described two weeks ago (a topic the FT caught up with today), and all too real capital losses for Japanese banks who mark JGBs on a MTM basis.

Here is what HSBC had to say on this issue:

There is also an asymmetric risk to JGB yields in the very long term (ie beyond the next couple of years), making diversification compelling on a risk-adjusted basis. If official policies in Japan begin to bite and inflation rises on a more sustainable basis, this would place pressure on interest rates and materially reduce the value of JGBs held by banks. Yet, given the scale of such holdings, reducing exposure to JGBs would be difficult. Japanese financial institutions hold a substantial amount of JGBs. According to the BIS, Japanese banks hold 90% of their tier 1 capital in JGBs. Japan’s largest bank, Bank of Tokyo-Mitsubishi, has already acknowledged that reducing its USD485bn holdings of JGBs would be disruptive for the markets

Wait, what? Let's read more from the FT, shall we:

Nobuyuki Hirano, chief executive of Bank of Tokyo-Mitsubishi, admitted that the bank’s Y40tn ($485bn) holdings of Japanese government bonds were a major risk but said he was powerless to do much about it....The risk facing Japanese banks from their vast holdings of government bonds has been underlined by the chief executive of the country’s largest bank who said it would struggle to reduce its exposure.

Well that's not good: if the largest Japanese bank can't handle what may soon be concerted selling by one of the largest single holders of JGBs, who can? And what can be done then?

Oh, that's right: this is where Kuroda's plea to please not sell bonds, just to buy stocks comes into play. The problem is only the BOJ can come up with money out of thin air, for everyone else buying something, means selling something else first. So unfortunately unless the BOJ wishes to further increase its QE, which will be needed to absorb all the selling without a surge in yields (something Kyle Bass warned about last week), a move which however would further break the connection between bonds and inflation expectations, and further destabilize the equity, FX and bond markets.

So in short: Japan's Plan B is not only not a panacea, but it is a House of Bonds Cards that would not survive an even modest gust of wind, and an even more modest contemplation into its true internal dynamics. We would urge Messrs Abe and Kuroda to come up with a fall back plan to the fall back plan before it, once again, becomes too late.

Finally, for those who just can't get enough, we recommend the following piece by James Shinn for Institutional Investor which should explain all lingering questions about what really goes on at Japan's Plan B.

Guest Post: Japan’s Easy Money Tsunami

Submitted by David Howden of the Ludwig von Mises Institute,

The Bank of Japan has embarked on one of the most inflationary policies ever undertaken. Pledging to inject $1.4 trillion dollars into the economy over the next two years, the policy is aimed at generating price inflation of 2% and further depreciating the Yen. The idea is to fight “deflation” and increase exports.

The end result of this policy will be an assuredly larger balance sheet at the Bank of Japan (projected to nearly double to $2.9 trillion). Despite being lower than it was 25 years ago, the Japanese Stock Index has increased by 70% since November of last year. However happy people have been about higher stock prices, eventually the economic effects will be harmful; indeed the recent stock price crashes foreshadow still more troubles to come.

In my own contribution to Guido Hülsmann’s recent edited book The Theory of Money and Fiduciary Media, I take a critical look at these exact policies - expansions of the money supply aimed at stimulating output by way of manipulating the exchange rate. At the 100-year anniversary of the publication of Ludwig von Mises’s The Theory of Money and Credit, we can see that Mises had already grappled with the issues of currency depreciation in a manner superior to modern monetary economics. Furthermore, with the refinement of his business cycle theory in his book Human Action, we find that Mises also outlined the detrimental effects of such expansionary monetary policies.

The exchange rate determines the price a foreigner will have to pay for a domestically produced good. Increases in the money supply will generate inflationary price pressures that will in turn increase prices. This leads to a higher exchange rate, which means it takes more domestic currency to purchase a unit of foreign currency. This makes it cheaper for foreigners to buy our goods so exports increase. Conclusion: countries can stimulate exports and increase the number of jobs in export industries by inflating their money supply.

Unfortunately, this is not the end of the story.

Depreciating your currency does make your export goods cheaper for foreigners to buy. However, it also makes it more expensive for you to buy imported goods. This helps to close a trade deficit and reduces foreign investment in your economy. However, if the goods you sell to foreigners are composed of many inputs that you have to purchase from foreigners the effect will be to drive up your cost of production.

Therefore, Japanese exporters will pay more for the inputs that they will need to import to construct the same goods they intend to sell to foreigners. This effect is especially noticeable in countries with large export markets, but only a small ability to supply the inputs for goods destined for export. No other large economy fits this description better than Japan.

Mises’ key insight was in looking at the long-term effects of such a policy, and in the process he examined the logic behind the short-term results as well.

The ineffectiveness of the policy in the long run is apparent when one understands how prices – both domestic and foreign – interact to determine exchange rates. Exports will be promoted in the short run, though the effect will be cancelled in the long run once prices adjust.

If the policy is ineffective in the long run, Mises demonstrated that the short-run gains are illusory. The same monetary policy aimed at depreciating the currency to promote international trade will reap domestic chaos.

Higher monetary inflation will reduce interest rates. One result of this policy will be greater consumption expenditures – what Mises coined “overconsumption” – as consumers save less and spend more. The other result of reduced real rates is what Mises referred to as malinvestment. Production plans must supply not only the amount of goods consumers want in the present, but also orient these production plans to produce goods in the future. The interest rate is what coordinates all these plans over time and is what entrepreneurs use to determine when to produce goods, and how long a production process should be employed. The negative effects of distorting the interest will only be revealed much later.

Upsetting the natural rate of interest through an inflationary monetary policy unbalances both consumption and production plans. The economy eventually succumbs to an Austrian business cycle as it tries to regain footing, and move to a more sustainable pattern.

The more things change, the more they stay the same. Ludwig von Mises was able to correctly identify the pitfalls of expansionary monetary policies over 100 years ago. Policy makers have yet to learn these important lessons, and consequently continue to plague their countries with the results of these failed measures.

Apple as Another Sony?: Talking to Michael Whalen

First, happy Memorial Day to all of our service men and women around the world and at home (see my comment on 

Over the past decade, I have been discussing the tech sector with my brother Michael Whalen who is currently the Head of Digital Rights Administration for TuneSat,LLC. TuneSat’s audio fingerprint technology monitors hundreds of TV channels in 14 countries and crawls millions of websites.  Mike is a professor at NYU and The City College of NY, a two-time Emmy® Award-Winning composer as well as an internationally-known recording artist. In terms of reference points, let’s just say that Michael put me on to Apple Inc. (AAPL) over a decade ago, just before the introduction of the iPod and iTunes.  He has been watching the transformation – maybe decomposition – of the media industry from the front row.  I caught up with him last week in NYC. -- Chris


RCW:  So Michael, we have not spoken in some time about the tech/media sectors.  Let's start off with the obvious topic, namely AAPL.  A year ago this company could do no wrong and the stock was neat $700, but now AAPL's future prospects are very much in doubt and the stock is below $450.  Vast piles of cash is just not the same as growth, I suppose.  How do you see AAPL today and going forward?

MW:  Ah, AAPL... it's pretty clear that their transition from being a innovation company to a company that manages the innovation they've already created is just about done. Look at their pipeline - it's all improved versions of what we have already got: lighter iPads, faster Macs and iPhones with more stuff. Beyond the endless rumors of a really expensive television, Tim Cooke's big idea seems to be AAPL moving from the hardware business to the information business – namely iCloud.

RCW:  Is that a bad thing?  How many new gadgets can any company spawn in a decade?  Why do I feel a sense of déjà vu? 

MW:  It's highly debatable whether AAPL iCloud is making the inroads that they predicted. AAPL is building military-grade data centers around the country - but the jury is out on the short-term wisdom of this strategy. In other words, how many times can you re-sell me my own iTunes library over iCloud? For the long-term, this idea MIGHT work but then anyone who is serious about being in this business is looking at how data services have become commoditized and they're everywhere - - with the price slashing and much lower margins that come with it. Look at the Amazon (AMZN) business data services - they have more "virtual servers" than just about anyone and they're feeling the downward price pressure. So, the "data wars" have started to happen and the overall picture is muddy at best.

RCW:  Agreed on AMZN cloud servers, which is a great but commodity product.  How can anyone compete with irrational players like AMZN or Google (GOOG)?  So what would you do?

MW:  I think AAPL's best play is to take what's left over cash from their very ill-advised stock buyback plan and to start BUYING technology companies. If they don't have the creative wherewithal to do it internally - they have the checkbook to make some serious strategic acquisitions. Here's idea #1: buy companies OUTSIDE of media, technology and entertainment.

RCW:  So, what, steel mills?  I know you are not very keen on the media space as a store of value.  Where do you go in terms of M&A if you are AAPL?

MW:  The television networks and film studios, which are looking to be bought (did someone say Sony (SNE)?), aren't worth their current valuations.  It's already a buyer's market out there. So staying away from "media" companies is smart. But how about alternative energy companies? There are all kinds of conversations about "wireless electricity" and optimizing solar. You need energy to power all those servers - right? (laughs).

RCW:  You’re kidding, right?

MW:  AAPL has some major decisions to make and building a new billion dollar campus in Cupertino (Steve Jobs' design) is further evidence that they're looking in the wrong direction.

RCW:  Agreed. I have to chuckle hearing your analysis.  For all of those years when AAPL could not get out of its own way operationally, nobody would have ever suggested that they become an M&A platform.  It’s easy to buy when you spend other people’s money. Now that AAPL is the top dog in a declining space, do you really want them to start buying more operating assets?  Your comment on SNE is very telling here because it reminds me of AAPL today.  What value do you see in the media space?  I am not sure that I'd want AAPL to spend my money on deals.  Isn't the stock buyback the best course? 

MW:  You'd think that the stock buy-back would be "prudent" for AAPL. However, what kind of economic weather is AAPL preparing itself for? Are we rolling up the drawbridge in Cupertino and getting into a siege mentality? If the widely anticipated "depression" on 2008 hasn't happened yet in the United States – does APPL know something we don't? Frankly, they've done very well as a publicly traded company predicated mostly on the "heat" of their brand. I assert that if Steve Jobs was still at the wheel at APPL he'd be taking that money and putting it into development. So, given that they have about 45 billion dollars left over (mostly offshore - by the way), I would like to see them investing outside of their declining space. There is VERY little value in the media space long-term.

RCW:  As you and I have discussed, entertainment as an economic proposition seems to be sliding backward into a model where artists have sponsors rather than revenue. Think the Middle Ages here.  If you are not Tom Cruise, then the studios can’t monetize your content.  What does any media company do with a pile of cash?

MW:  The Internet media business is a business that moves at light speed. People under the age of 21 don't "view" content - they devour it. So, as a response, the film studios have become banks to finance the few "big" movies they do produce and they are making fewer and fewer of those pictures. Also, they have co-opted their investments into bite sized clusters that almost eliminate their risk – but these projects don’t build anything for the future either. The studio bosses are patting themselves on the back with their 2012 numbers - but they know in reality that the party is over. The future of media is about being a lean, mean and a profitable machine.

RCW:  That does not sound bad.  But explain why the major media companies are not building foundations for future revenue? 

MW:  You might have seen the strategy of Netflix (NFLX) to create "high end" content for their customers. In some ways, this strategy has paid off in the short term by converting some of the “boo birds” on Wall Street to stop telling investors to sell after 2 very long years and give the company a second look. Their shows have created some positive buzz and their subscriber base is over 40 million worldwide. The bad news is that they cannot possibly keep spending money on content and over-priced licenses. Reed & Co. at NFLX have done a good turnaround but their moves are just a version 1.0 of the realignment that I am talking about. Said another way, you won't see Netflix spending $100 million on another series EVER again or certainly not without a lot of cooperative help/risk sharing. And investors will have to hold their breath again when their major licenses come due.

RCW:  So more of the same “withering away” of the economic model for new content we talked about last year?  Does this movie have a happy ending?    

MW:  Said simply, internet-based media companies will have to be transformed to make whatever money they're going to make in a DAY or a weekend. Their production and operational costs will have to be almost literally zero. Look at GOOG and the new subscription channels they are offering. YouTube earns money at about $25 million dollars an hour in advertising. However, look at how lean these new content channels are and will be. No one around Eric Schmidt is urging GOOG to write a big check to an A-list actor. They don’t NEED to.  Also, most of this new Internet content will be made for phones and mobile devices. Yes, we have seen for some time now that people want their entertainment on the move and no one wants to pay for the content. So, welcome to an entire industry looking for "back end" money or the ability to monetize eyeballs somehow some way. There won’t be any money in the front end.

RCW:  You’ve been describing this process for some time, where legacy content is losing value and only super brands can attract eyeballs.   Does this really mean that all other content goes begging? 

MW:  The monetization of endless catalogs of audio and video content over long periods of time with ancillary licenses and sales are OVER as well. So, when SNE Pictures is up for sale – what is SNE selling? They'll tell you it is brands that people know and can be capitalized in the future. This is not really true because the future they're talking about is 5 - 7 years. They won't tell you that the generation of people who would buy "The Godfather" in any format a decade ago isn’t buying anything anymore.

RCW: Well, I give Spotify $9 a month.  Your point about SNE is interesting, though.  Once upon a time, SNE came up with some clever, albeit derivative consumer products like the WalkMan.  Remember that?  Kind of like the many "new" AAPL products in that they were a refinement of an existing product/functionality.  New technology allowed SNE to make a tape recorder or TV smaller, better, portable.  But much of the SNE product line was basic conventional TVs, cameras and sound equipment.  Is AAPL the next SNE in a sense that they are now being eclipsed by new technology and use trends?  Remember when AAPL kicked SNE et al out of the professional audio/video segment?  The other day, our cousin Billy Demarco, a veteran TV animation artist, told me he is almost ready to take his studio back to PCs after a decade on the MAC.  Is the age of AAPL over?   

MW:  Let’s talk about SNE first.  It's pretty clear when you parse through their "shiny" numbers from Q4/2012 that water is flooding into the SNE engine room. Third Point Capital has made an offer to create an "IPO" for 15 - 20% of SNE's entertainment business. The idea here is to put together a war chest of cash to fund the electronics division of SNE. Frankly, SNE would be happy to SELL the entertainment division if it meant the bleeding would stop and the rapidly shrinking asset that they paid top dollar for over the last 15 years would just go away. SNE needs to reestablish itself in the technology space. But the problem is that the market they want to reclaim has all but disappeared.  

RCW:  Wait, is this another benefit of technology? 

MW:  Some 20 years ago, it was brilliant to have a consumer electronics company and a media company together. Now, you have competing balance sheets, foggy outlooks for both sides. SNE's real problem is that their overhead versus cash flow is killing them. They have the infrastructure of an "old" media company with the declining sales of a new one. You can only fire so many people from a large, legacy company before it completely implodes. SNE’s content side could be relevant again but not riding shotgun with an ailing legacy sister company added to a own mountain of operational and market issues. In this environment, the culture of innovation that spawned devices like the WalkMan, BETAMAX video, Blu-Ray video and more isn't possible. When you're trying to survive - the creative juices don't flow very well. 

RCW:  No indeed.  One of the reasons that the Bank of Japan is printing money like crazy is a desperate effort to save old line companies like SNE.  The Koreans, Taiwanese literally chased the Japanese out of the device business.  But tech hardware, like autos, is a commodity business that eats capital.  So where does this annihilation of value in both hardware and content leave AAPL?  Everyone assumes that “content is king.”  Does that sound correct in your view?

MW:  I think AAPL has been smart to stay OUT of the content creation business. However, I think you're assertion is correct - looking 3 to 5 years out - AAPL's position will be weakened due to inroads made by HUNDREDS of technology companies – not by a single huge competitor.  GOOG is not the AAPL killer – but rather the tiny new companies that will nibble all of the giants into irrelevance. The age of hardware made by large, dominant brands is OVER. In this environment, killer software and popular apps can take hold for VERY little money (or overhead). There is so much downward pressure on hardware prices that more and more major companies will opt out of the hardware business.  The model in simple terms is to be a data and information systems company. 

RCW:  IBM was the early first mover example of running away from hardware.  What’s the bottom line on AAPL for you? 

MW:  It's interesting to note here that Third Point Capital dumped a huge position in AAPL in February. It's dangerous for even professionals to jump in and out of the mud in the media space - the pieces are moving very quickly.  But vast arbitrage opportunities do pop up. 

RCW:  It’s just the wonder of the free market in operation.  Thanks, Michael.

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