Japan PM Abe's true test; rising government bond yields

[Ad Orientem]

(Reuters) - Abenomics' massive monetary stimulus was supposed to depress long-term interest rates to spur economic activity, but the Japanese government bond market has other ideas.

Banks, unable to make money on their Japanese government bonds (JGBs) anymore, have begun sloughing off their holdings, putting upward pressure on yields. Major banks sold off about 11 percent of their holdings in April alone.

Large lenders have hiked their prime rates to make up for the loss of earnings on JGBs, which threatens to price potential borrowers out of the mortgage market, while higher long-term rates could sap corporate Japan's already anaemic demand for loans.

That puts at risk the very activity Prime Minister Shinzo Abe had intended to spark with the Bank of Japan's massive quantitative easing (QE) on April 4, when it promised to inject $1.4 trillion into the economy over two years.

Read the rest here...
http://www.reuters.com/article/2013/06/ ... H720130616

[clacy]

As Kyle Bass has stated many times, Abe did not apparently think of "the rational investor paradox".

Essentially, the vast majority of JGB investors will expect inflation, and therefore will reduce their bond holdings, possibly chasing better returns in stocks.

That bond sell off, will result in Abe having to buy far more of the bonds he expected to purchase.  Apparently, the government has had to step in and support all but two bond auctions since this program was announced.

Bass predicts they will have to significantly expand the bond purchases...... Ultimately a vicious cycle.

It makes some sense.  If you feel that CB's can QE in perpetuity, why would you own government bonds.  Either the strategy works, in which case you're eliminating the need for bonds by investors.  Or the program implodes, but either way the CB's are boxed in.

[MediumTex]

As Kyle Bass has stated many times, Abe did not apparently think of "the rational investor paradox".

Essentially, the vast majority of JGB investors will expect inflation, and therefore will reduce their bond holdings, possibly chasing better returns in stocks.

That bond sell off, will result in Abe having to buy far more of the bonds he expected to purchase.  Apparently, the government has had to step in and support all but two bond auctions since this program was announced.

Bass predicts they will have to significantly expand the bond purchases...... Ultimately a vicious cycle.

It makes some sense.  If you feel that CB's can QE in perpetuity, why would you own government bonds.  Either the strategy works, in which case you're eliminating the need for bonds by investors.  Or the program implodes, but either way the CB's are boxed in.

But hasn't Bass been making that same argument for the last five years and he's been wrong up until now? (and now may just be a blip before yields head back down)

Bass has been talking about a secular bear market for Japanese bonds that will last many years and I don't see any evidence of that prediction coming true yet.

[clacy]

Only time will tell.  These things can take an awful long time to play out.  5 years from now we'll all have our answer on the MMT debate.

[AdamA]

5 years from now we'll all have our answer on the MMT debate.

What makes you say that?

[clacy]

5 years from now we'll all have our answer on the MMT debate.

What makes you say that?

Japan is putting the pedal to the metal on QE.  If they are still muddling around in 5 years, it probably means that money printing doesn't catch up with you when you're facing deflationary forces from demographics (like Japan has faced and will continue to face). 

If they lose control over interest rates due to current policy, it may mean that money printing does catch up with you, and it's not as easy as moving numbers around on a spread sheet.

I just picked 5 years, but that seems like a reasonable time frame for this to play out.

If Kyle Bass is correct, they blow up in under 5 years.  If he's wrong, it probably means that Abenomcis worked.

[MediumTex]

5 years from now we'll all have our answer on the MMT debate.

What makes you say that?

Japan is putting the pedal to the metal on QE.  If they are still muddling around in 5 years, it probably means that money printing doesn't catch up with you when you're facing deflationary forces from demographics (like Japan has faced and will continue to face). 

If they lose control over interest rates due to current policy, it may mean that money printing does catch up with you, and it's not as easy as moving numbers around on a spread sheet.

I just picked 5 years, but that seems like a reasonable time frame for this to play out.

If Kyle Bass is correct, they blow up in under 5 years.  If he's wrong, it probably means that Abenomcis worked.

Five years isn't that long.

2008 was five years ago, and that's when I first heard Bass making his arguments about Japan's imminent bond market crisis.

Bad monetary policy in developed countries is sort of like one of those bums you see living on the street.  You think to yourself: "That dude will surely die soon", but then you walk by him again in a year and he's still there, looking as bad as ever but still alive.

Dumb things in this world (especially those based on fantasies and delusions) can continue for a LONG time.  It's the same sentiment that is captured in the "markets can remain irrational longer than you can remain solvent" quip.

All of these dumb arrangements will surely blow up one day, just like the earth will, but the task for us in this moment is to figure out what to do next, and Newton's first law tells us a lot about the way markets are likely to behave tomorrow and next week.

The human imagination has created innumerable silly arrangements that seem to run on some combination of dreams, good intentions and unicorn droppings.  Just because we may be dealing with one of those silly arrangements in the form of the Japanese bond market doesn't mean that it isn't to be taken seriously or its longevity should be doubted.  What makes us think that investors tomorrow will be more rational than they are today?

[melveyr]

I really think that the pure expectations hypothesis is a great way to think about the long end of the curve. Under that model, the long end of the curve is best thought of as the geometric average of expected short term rates over the given period. That means that when yields spike on the end of the curve, investors are simply pricing in the increased probability of higher short term rates in the future. If this hypothesis weren't true, there would be arbitrage opportunities in the bond market. I always find it best to assume no arbitrage because I think markets are pretty good at what they do.

Since JGBs don't have explicit default risk (they can always create yen to pay off previous debts), I think the spike in the long end of the curve is reflecting the belief that the likelihood of higher short term rates has increased. Obviously short term rates are set by the CB. So this means the market either thinks that the economy will improve to a level where the CB can raise ST rates, or that they will tighten for some other reason.

[MediumTex]

I really think that the pure expectations hypothesis is a great way to think about the long end of the curve. Under that model, the long end of the curve is best thought of as the geometric average of expected short term rates over the given period. That means that when yields spike on the end of the curve, investors are simply pricing in the increased probability of higher short term rates in the future. If this hypothesis weren't true, their would be arbitrage opportunities in the bond market. I always find it best to assume no arbitrage because I think markets are pretty good at what they do.

Since JGBs don't have explicit default risk (they can always create yen to pay off previous debts), I think the spike in the long end of the curve is reflecting the belief that the likelihood of higher short term rates has increased. Obviously short term rates are set by the CB. So this means the market either thinks that the economy will improve to a level where the CB can raise ST rates, or that they will tighten for some other reason.

How does this approach explain an inverted yield curve?  Shouldn't an inverted yield curve cause short term rates to instantly fall because the obvious arbitrage opportunity to buy short term bonds today and sell them in the future when short term rates are lower based upon what the long end of the yield curve is telling investors?

[clacy]

Soros weighing in on Abenomics.....

http://business.financialpost.com/2013/ ... ros-warns/

“If the yen starts to fall, which it has done, and people in Japan realize that it’s liable to continue and want to put their money abroad, then the fall may become like an avalanche,”? Soros said Friday in an interview on CNBC.

[moda0306]

I really think that the pure expectations hypothesis is a great way to think about the long end of the curve. Under that model, the long end of the curve is best thought of as the geometric average of expected short term rates over the given period. That means that when yields spike on the end of the curve, investors are simply pricing in the increased probability of higher short term rates in the future. If this hypothesis weren't true, their would be arbitrage opportunities in the bond market. I always find it best to assume no arbitrage because I think markets are pretty good at what they do.

Since JGBs don't have explicit default risk (they can always create yen to pay off previous debts), I think the spike in the long end of the curve is reflecting the belief that the likelihood of higher short term rates has increased. Obviously short term rates are set by the CB. So this means the market either thinks that the economy will improve to a level where the CB can raise ST rates, or that they will tighten for some other reason.

I've been wanting to post on this for days but am swamped.

You said exactly what I wanted to say, but far more succinctly.  You always seem to, in fact.

[melveyr]

I really think that the pure expectations hypothesis is a great way to think about the long end of the curve. Under that model, the long end of the curve is best thought of as the geometric average of expected short term rates over the given period. That means that when yields spike on the end of the curve, investors are simply pricing in the increased probability of higher short term rates in the future. If this hypothesis weren't true, their would be arbitrage opportunities in the bond market. I always find it best to assume no arbitrage because I think markets are pretty good at what they do.

Since JGBs don't have explicit default risk (they can always create yen to pay off previous debts), I think the spike in the long end of the curve is reflecting the belief that the likelihood of higher short term rates has increased. Obviously short term rates are set by the CB. So this means the market either thinks that the economy will improve to a level where the CB can raise ST rates, or that they will tighten for some other reason.

How does this approach explain an inverted yield curve?  Shouldn't an inverted yield curve cause short term rates to instantly fall because the obvious arbitrage opportunity to buy short term bonds today and sell them in the future when short term rates are lower based upon what the long end of the yield curve is telling investors?

The inverted yield curve is an interesting case but it can still be explained using pure expectations hypothesis.

The market would be pricing in that monetary policy is currently too tight, and the fed will soon realize its mistake and lower short term rates below what they currently are on the long end of the curve. Remember, if you are only on the short end of the curve you have reinvestment risk. Under an inverted yield curve today's short term rates might be high, but the market knows that they are unsustainable so you cannot lock in that rate at longer maturities.

[moda0306]

melveyr,

What you refer to makes me wonder how much the fed can really think it can affect long rates by buying long-term bonds in the first place.

As a mental exercise, let's imagine a normal interest rate environment (3% or so), but the fed buys up all but a little bit of the long-term debt (similar to QE but on steroids), would we really expect the market to be in such high demand of long-term debt that the rate on long bonds drops well below the expected rate on short term bonds going out?  I can't imagine we would.  I think the fed can only really affect long-rates by changing expectation of short rates.  Maybe they can get a little wiggle out of long-bond QE or twist but in the end the market wouldn't be dumb enough to allow bonds of different durations allow such a drastic arbitrage one way or the other.

This is why, to me, that we've seen the biggest drops in interest rates since the 2008 come after QE ends... expectations on rates actually went down because the recovery was so weak.

I find it interesting that melveyr and I are finding ourselves on the side of arguing "But the market works so efficiently, can't you see!!??"

[doodle]

melveyr,

What you refer to makes me wonder how much the fed can really think it can affect long rates by buying long-term bonds in the first place.

As a mental exercise, let's imagine a normal interest rate environment (3% or so), but the fed buys up all but a little bit of the long-term debt (similar to QE but on steroids), would we really expect the market to be in such high demand of long-term debt that the rate on long bonds drops well below the expected rate on short term bonds going out?  I can't imagine we would.  I think the fed can only really affect long-rates by changing expectation of short rates.  Maybe they can get a little wiggle out of long-bond QE or twist but in the end the market wouldn't be dumb enough to allow bonds of different durations allow such a drastic arbitrage one way or the other.

This is why, to me, that we've seen the biggest drops in interest rates since the 2008 come after QE ends... expectations on rates actually went down because the recovery was so weak.

I find it interesting that melveyr and I are finding ourselves on the side of arguing "But the market works so efficiently, can't you see!!??"

So you are arguing basically that QE really is just a dog and pony show and that rates would be the same irrespective of fed action? Im not disagreeing, just trying to clarify.

[moda0306]

melveyr,

What you refer to makes me wonder how much the fed can really think it can affect long rates by buying long-term bonds in the first place.

As a mental exercise, let's imagine a normal interest rate environment (3% or so), but the fed buys up all but a little bit of the long-term debt (similar to QE but on steroids), would we really expect the market to be in such high demand of long-term debt that the rate on long bonds drops well below the expected rate on short term bonds going out?  I can't imagine we would.  I think the fed can only really affect long-rates by changing expectation of short rates.  Maybe they can get a little wiggle out of long-bond QE or twist but in the end the market wouldn't be dumb enough to allow bonds of different durations allow such a drastic arbitrage one way or the other.

This is why, to me, that we've seen the biggest drops in interest rates since the 2008 come after QE ends... expectations on rates actually went down because the recovery was so weak.

I find it interesting that melveyr and I are finding ourselves on the side of arguing "But the market works so efficiently, can't you see!!??"

So you are arguing basically that QE really is just a dog and pony show and that rates would be the same irrespective of fed action? Im not disagreeing, just trying to clarify.

Well kind of, but mostly on the long end of the curve.  I don't think rates are grossly "unnaturally" low given the economic environment, but I do believe the fed can effectively control short term rates, and therefore long term rates, but the latter mainly via market predictions on future short term rates.  I think melveyr's right about the arbitrage. It just wouldn't hold up.

[moda0306]

melveyr,

What you refer to makes me wonder how much the fed can really think it can affect long rates by buying long-term bonds in the first place.

As a mental exercise, let's imagine a normal interest rate environment (3% or so), but the fed buys up all but a little bit of the long-term debt (similar to QE but on steroids), would we really expect the market to be in such high demand of long-term debt that the rate on long bonds drops well below the expected rate on short term bonds going out?  I can't imagine we would.  I think the fed can only really affect long-rates by changing expectation of short rates.  Maybe they can get a little wiggle out of long-bond QE or twist but in the end the market wouldn't be dumb enough to allow bonds of different durations allow such a drastic arbitrage one way or the other.

This is why, to me, that we've seen the biggest drops in interest rates since the 2008 come after QE ends... expectations on rates actually went down because the recovery was so weak.

I find it interesting that melveyr and I are finding ourselves on the side of arguing "But the market works so efficiently, can't you see!!??"

So you are arguing basically that QE really is just a dog and pony show and that rates would be the same irrespective of fed action? Im not disagreeing, just trying to clarify.

Your question has got me thinking a bit deeper on all this... in terms of how much the fed actually has to "do" vs what Ben simply has to say.

I mean, if Ben came out tomorrow and said that his goal as fed chairmen is to bring about complete economic collapse of the U.S., we'd have a huge market panic, probably resulting in a quasi-collapse.

If Ben came out and said that no matter what, he's going to see to it that short-term rates are at 6% by this time next year, the market would adjust massively today.

All Ben really has to do is say something, and the market moves.  I wonder how much the actual buying and selling of bonds actually contributes to the fed's control of the markets.

[MediumTex]

I never really had any trouble understanding what Greenspan was saying.  There was a predictable thickness to the way he said things, but I think that he had a number of reasons for doing that.

The ironic thing about most of what he was saying is that it was so simple a third grader could understand it--i.e., he was making a message sound complicated that was actually much simpler than many of the messages in life we are asked to interpret.

The statement below is really just saying: "People get lulled into a false sense of security when things stay the same way for a long time, and then when things change many people are not prepared."

Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. But long periods of relative stability often engender unrealistic expectations of it's permanence and, at times, may lead to financial excess and economic stress.

Any time I was speaking to Congress, though, I would probably speak in the same thick way Greenspan did because it's not hard to impress most Members of Congress with big words, and if you sound like you know what you're talking about they are more likely to leave you alone.

If Greenspan was completely honest he would say that anyone who was Fed chairman during his tenure would have looked like a genius because the economy had a lot of tailwinds unrelated to monetary policy.  He would say that he really wasn't much more than a political hack who hung around long enough to get a really plum government job.  He would admit that he was barely an economist at all, having received his PhD in economics when he was 51 years old and his experience in the private sector consisted mostly of figuring out what his clients wanted to hear and then telling them that using fancy language and jargon that made it seem like something really valuable.

[moda0306]

I never really had any trouble understanding what Greenspan was saying.  There was a predictable thickness to the way he said things, but I think that he had a number of reasons for doing that.

The ironic thing about most of what he was saying is that it was so simple a third grader could understand it--i.e., he was making a message sound complicated that was actually much simpler than many of the messages in life we are asked to interpret.

The statement below is really just saying: "People get lulled into a false sense of security when things stay the same way for a long time, and then when things change many people are not prepared."

Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. But long periods of relative stability often engender unrealistic expectations of it's permanence and, at times, may lead to financial excess and economic stress.

Any time I was speaking to Congress, though, I would probably speak in the same thick way Greenspan did because it's not hard to impress most Members of Congress with big words, and if you sound like you know what you're talking about they are more likely to leave you alone.

If Greenspan was completely honest he would say that anyone who was Fed chairman during his tenure would have looked like a genius because the economy had a lot of tailwinds unrelated to monetary policy.  He would say that he really wasn't much more than a political hack who hung around long enough to get a really plum government job.  He would admit that he was barely an economist at all, having received his PhD in economics when he was 51 years old and his experience in the private sector consisted mostly of figuring out what his clients wanted to hear and then telling them that using fancy language and jargon that made it seem like something really valuable.

Wow.

+1