Rabbit Out Of A Hat

Quietly and inauspiciously, the yield on the 10-year JGB has surpassed 2% for the first time in six years. Yes, you read both numbers correctly: 2 (two) percent and 6 (six, seis, sext, VI) years in coming. Anyone who had studied economics at an American university (in between beer-bongs, and debauched frat parties) would be asking themselves: "If you give something away for free, won't it's supply increase, thereby driving the price down (and if you're a bond trader) the yield up?" What dyslexia pray-tell has overcome the Japanese to invert such laws of supply and demand for so long? A 2% 10-year JGB following 52-months of continued expansion and SUSTAINED ZERO PERCENT SHORT TERM INTEREST RATES is the Houdini-inspired equivalent of a rabbit out of a hat.

But what's the truc du chef? It seems that for the past seven or so years, during which time ZIRP has been the policy du jour, there's been a leak in Japanese monetary plumbing (not to mention that of the international monetary system). All that YEN they've been so eagerly giving away, surreptitiously managed to find its way out of the beautiful isles of Japan. But gosh, golly that's a LOT of YEN!! Where'd it go? Well you see not all of it went abroad. Some stayed in Japan and helped the banks buy the JGB's that financed the 7% of GDP fiscal gap. And two percent is, after all, two percent, which it must be said is still a very nice loan spread when one is able to borrow for free. It is, for a bank, the very definition of "free money" (though even moderately astute observers or US S&L victims will attest it is not without its own risks). The rest of it is/was/has been happily taken it up by foreigners - banks, brokers, hedge funds, astute property developers, and everyone else who can and is in need of a unit of money, today, at no-cost - zip, zero, ZIRP. Of course, when they borrowed YEN, they would need to remove it from the domain of the Emperor, and in so doing they'd be required to sell the YEN in the currency market. Which I daresay was convenient for everyone. The banks made a turn in the FX market. The MoF (and most Japanese blue-chip exporters) were rather keen to see the YEN not appreciate, even depreciate especially vs. the USD and the Euro. And given the sizable trade surplusses being run by Japan Inc, the repatriation of which would most certainly have wreaked havoc upon the exchange value of the YEN, was averted.

But all good things that are free (clean air, clean water, Ketchup in fast food restaurants) must inevitably end. And the ZIRP is no exception. Whether due to victory by BoJ technocrats afraid of repeating the horrible episode of Japanese inflation, the concerted though unwanted attention from the G7, or through a plunge in the unit of exchange of the junkie-of-a-nation mainlining the free juice (the US Dollar), Japanese short-term interest rates will rise, and rise rather substantially.

So although inching across the 2% threshhold may seem inconsequential, it is delineating a trend. And as we know, the more a trend is delineated, the more persistent and inertial it tends to become. And that means a return to normality. Regression to the mean (or at least some longer-term process). What might that be? Let your imagination go wild.

IF officialdom raises rates, the carry trade explodes. If the markets do it, they push down the dollar, and force the unwind of the carry trade that way (or a mixture of both). For the dynamic is that there remains lots of speculatively financed borrowings in Yen which ultimately must be closed out. The smart ones have done this pre-emptively. The dumb ones will be in for a rude awakening. How rude? Recall Oct 1998. Everyone went to bed one night and the YEN was 132 to the dollar and woke up to see it at 118. It had risen from a denoument of ~145, some some had managed to get out, and even get short. But there was little if any trade between 132 and 119. A gap. A chasm. A painful impalement upon something very unpleasant. Of course, I can say precisely when. Or how much. But as Cassandra, I am issuing a pari-passu warning of an impending unwind in one of the largest fiascos the modern financial system has ever seen, and it won't be pleasant, and there will be collateral damage. Evenn Sakakibara cannot help with one....