When will the BOJ commit Seppuku?

May 1945. The Soviet Red Flag of the sickle and hammer flew over the Reichstag in Berlin. The guns of war fell silent for the first time since September 1939.

As the Allies declared Victory in Europe (VE), Japan remained the sole Axis member to resist the Allied nations (led by the United States and Great Britain) in Asia and the Pacific. US marines were already engaging Japanese forces on Okinawa, and were fighting their way gradually to the main Japanese home isles.

Her war industries were devastated by Allied bombings and her logistics systems crippled by the loss of key areas of the empire. There was a lack of sufficient food as well as resources to continue the war effort, and the population was extremely war weary after fighting a war in Asia since the 1930s. It was only a matter of time before Japan would be defeated.

However, there was a denial of reality within the minds of the Japanese government. Their Bushido spirit wouldn’t allow them to accept failure. Failure meant shame and dishonour, and it is better to die than to be dishonoured. According to historian Tsuyoshi Hasegawa, policy-makers (of those who favour continued war against the Allies) in 1945 began to silent dissension and impose strict controls of the country, making all efforts to continue supporting the war.

It is not until the combination of 2 devastating nuclear bombs and the Soviet Union’s entry into the Asia-Pacific theater (the USSR and Japan maintained a non-aggression treaty during WWII) that the Japanese decided to accept the Potsdam declaration and unconditional surrender (and this is of course, only after the Emperor sided with the peace party according to Hasegawa). Tragically, only after hundreds of thousands of innocent lives and huge collateral damage did WWII in Asia-Pacific came to its final conclusion.


And humanity lived on, hoping to learn from the lessons of this dark period in history.

In Japan however, this Bushido spirit has surreptitiously lingered and lived on till today.

Remember the frothy times of the 1980s in Japan? After the Nikkei and the Japanese real estate bubble popped, the country entered a deflationary cycle, and the government decided to support the sectors and industries that have been devastated by the collapse of the bubble, leading to the result of what many call “zombie banks.” It took many years for the idea of “reform” to enter into Japan, and many of her politicians have tried and failed since the 1990s.

In November 2012, Mr Shinzo Abe became the Prime Minister of the country. He proposed a shock-and-awe package of reforms in the hopes of defeating deflation once and for all, involving monetary easing, fiscal packages as well as corporate reforms to address structural issues in Japan’s economy. His sidekick, the Bank of Japan (BOJ), under the leadership of Mr Kuroda, unleashed an extremely aggressive strategy of monetary easing, and for a while in 2013 and 2014, “Abenomics” seem to have made progress. Japanese equity and bond markets rallied, and the Yen got crushed, bringing the USDJPY pair all the way beyond 120.


However and unfortunately, since the third quarter of 2015, the tide seemed to have turned against Mr Abe and his gang of reformers:

(1) The Yen’s weakness has reversed (the USDJPY pair continues to fall below levels not seen since October 2014), and this spells trouble for many Japanese exporters as a chunk of their revenues are boosted by weakness in the Yen, weighing on the outlook for corporate earnings and potential gains in share prices

(2) Inflation is almost non-existent (deflationary pressures still exist, in fact, they are holding down Japan’s economy in the long term due to aging demographics and excess savings)

(3) The BOJ’s stimulus programme via asset purchases seems to be nearing its limits… (JGBs, J-REITs, ETFs…what else could they buy?)

(4) Corporate reforms seem to be taking longer-than-expected (structural issues take time)

Volatility has risen to 10 year highs in the Japanese government bond market (JGB), and according to a recent report by Bloomberg, it seems that the market’s functioning is starting to breakdown as the BOJ gets too big in the market for its own good. Recall what uberinvestor George Soros once said: “short term volatility is greatest at turning points, diminishing as a new trend becomes established.” It seems that an inflection point could be developing in Japan, and foreign investors (crucial to Mr Abe’s plan) have been net sellers of Japanese equities, disillusioned with “Abenomics”.

If boosting inflation, getting Japanese corporates to increase capex, getting Japanese consumers to spend instead of hoarding cash are the BOJ’s goals, it seems that they are hopelessly failing as of the present moment – when capex is muted and more Japanese households are holding more cash (measured via M2 supply) –  Jeff Gundlach has recently pointed out that steel fire-proof sales are taking off in Japan.

It also seems that every attempt to fulfill their goals makes things worse, as policy-makers fail to account for the fact that markets are dynamic and that there could be huge consequences for mistakes. Imposing a negative interest rate policy (back in January) shows the desperation of the BOJ – considering the fact that NIRP screws up your rapidly aging and retiring populace and the banks and insurance sector that supports the whole country.

Then there is also the law of unintended consequences. An NIRP and continued QQE by the BOJ has pushed everyone out further the risk curve, causing at present, a boom in the real estate market. Some of the richly-valued real estate developers (via EV/EBITDA) globally can be found in Japan at present. The Japanese REIT space has been red hot and has surged since the BOJ announced its policy of tiered negative deposit rates back in January; courtesy of Bloomberg:

J Reits

Whether or not this “boom” in Japan’s real estate market is genuine or sustainable remains to be seen…

Clearly, as was the case of the military government back in the last days of WWII, Abe and co. have failed in their objectives but will not admit defeat. Policy-makers may have realised that they have no way out, no back out option. Too much has been wagered on this blitzkrieg.. honour is at stake. Hence, they will do what they can in an attempt to salvage the situation. They will keep at it until the whole, ugly and terrible reality of failure starts to sink in… and perhaps collateral damage starts to surface… a JGB market breakdown? Possible default by the Japanese government (given their high debt to GDP levels and an increasingly huge asset liability mismatch starting to occur)? A massive devaluation of the Yen/ a new reissue of the currency? A long benign and obedient population slowly starting to defy their rulers?

So the question comes to mind: When will the BOJ Commit Seppuku?

Possible Courses of Action:

Betting against Japan has been dubbed ‘the Widow-maker’ over the years, as many people have lost their shirts doing it. Everyone knows Japan’s situation is unsustainable. Despite the government being able to issue endless amounts of new debt to its own populace, at zero or below rates, they all know that they are staring down fiscal abyss in the long term.

At some point however, this situation may change. A day will come when Japanese retirees will transit from net savers to net spenders, dipping into their retirement monies to fund their retirement. When that day finally dawns, there will be no one left to be a marginal buyer of JGBs. The government will have to prop up the bond market, or some form of reset will have to take place, and the value of the Yen could virtually go to NIL… but that’s the distant future (we hope)!

For now,  shorting “Hedged Equity ETFs”, or Japanese equity ETFs that have their underlying equity exposure hedged to the USD seems to be an interesting proposition at this juncture. These ETFs were designed with the intention to preserve a foreign investor’s returns in Japanese stocks as the Yen’s weakness drives the stock market up. However, when the Yen strengthens, the Japanese stock market goes down.

As selling pressure in Japanese equities continue, equity prices go down and the Yen strengthens against many currencies – delivering double whammies to an investor who’s long such a Japanese Hedged Equity ETF. Someone who’s short such an ETF could benefit if the current trend continues and a vicious cycle of a strengthening yen and plunging stock market begets more selling and more redemption, which leads to a further strengthening of the Yen as Yen shorts are scaled back (so far, technical price action has been favourable to an investor who is short such ETFs like the DXJ).

However, always be nimble and trade with caution. When policy-makers become desperate, one can never know what they can come up with!

*As for me, I am exploring the idea of going long on long term put options on both the Yen and JGBs. Timing is the key for this thesis; perhaps some day it’ll pay off…*

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