Eric Burroughs's Profile
Notes on Japan
It was a brutal and at times scary week. There are plenty of unknowns around the radiation risks tied to the Fukushima nuclear plant. But the fact remains that this nuclear crisis after the quake/tsunami shock may not deal the economy too severe a blow. If nothing else, the shock is prompting a policy response that was always lacking in Japan before: hefty fiscal spending is on the way, and the Bank of Japan has injected money into the system like never before, and via all kinds of channels. The BOJ’s response has helped to quickly stabilise funding markets and asset markets as a whole. The G7 is backing up Japan on yen intervention. Foreign institutional investors were cited in the last few days as steady buyers of Japanese equities, seeing this as an opportunity as the price-to-book on the TOPIX once again fell to a meagre 1.0 (for comparison, it is in the company of Serbia, UAE, Lebanon, Italy, Greece and Venezuela – so yes maybe cheap). From a markets point of view – a minor one in this crisis – Japan did an admirable job shoring up the markets after their were gripped by panic. Keep in mind that sharp policy responses to panics linger for a while, usually well into any recovery. Just as the Fed launched QE2 the moment the U.S. economy was picking up a head of steam, Japan may be countering an economic shock that may not be as big as feared. If so, it could be just the jolt the Japanese economy has long needed just as it was gathering momentum. All that said, the radiation risks, factory shutdowns and threat of power outages will add to the doubts about how quickly the economy will bounce back in the next few months.
JGB risks: The chart below says a lot. Over time, gradually, investors are seeing greater risks in JGBs. Not just those supposed speculators in CDS, but even in the mostly domestic market where the yield curve has stayed historically steep for a while now. The risks are now even greater. Does the need for greater borrowing push JGBs closer to a tipping point? The BOJ may step in to help fund some of the reconstruction costs, but it has showed a great reluctance to be seen underwriting the government. Whatever the BOJ does, the JGB outlook is one that keeps slowly deteriorating. Near-term risks include insurer selling and the lack of buyers heading into fiscal year-end. Beyond fiscal-year end is the big question. A lot of liquidity is in the banking system, and households may start boosting savings again. But the risks are building.
BOJ/G7 intervention: I’m a bit surprised by the G7’s intervention. You would think they’d have gotten more bang for their buck. If you’re going to do the first coordinated intervention in 11 years, a dollar/yen surge of less than two big figures seems underwhelming – it’s less than the BOJ got with its all-day barrage back in September. History, and firepower, are on the side of the G7. But the interventions by other central banks were pretty tepid affairs, allowing the crowded group of dollar sellers to push spot back to 80.60 by the end of the NY session. This means the short-term specs will be primed to test the BOJ’s resolve below 80 in coming days. Monday is a holiday in Japan, so we’ll see how eager the market is to have a go straight away. But there is no doubt plenty of dollar/yen selling pressure, especially with just two weeks left in Japan’s fiscal year. The BOJ appears to be using intervention as a policy easing tool as well, so it may be happy to intervene away in coming days. Will its G7 partners get more aggressive? We’ll see.
BOJ easing/yen money markets: There were lots of interesting money market angles last week. First, the BOJ has eased like never before – current account balances, the cash that banks park at the central bank beyond required reserves – are at 32.7 trillion yen ($403 billion), nearly doubling last week and approaching the highs hit during the BOJ’s first bout of quantitative easing when the c/a balance was the target. There’s a lot of liquidity in the system. Some of that may come out this week since money market conditions have stabilised. One of the biggest imbalances was from foreign banks struggling to get ahold of yen cash to settle margin calls during the stock markets plunge. That caused the yen LIBOR-TIBOR spread to widen sharply, if briefly. It has already pretty much normalised. Likewise, yen-dollar cross-currency swaps initially moved in favour of the dollar (repeat of Lehman environment) only to shift the other way as foreign banks/investors scrambled for yen cash. They are now little changed. Keep an eye on these market barometers.
Repatriation: This is still the big unknown. Digging into some of the hard numbers around Japanese insurers, the picture is one where repatriation doesn’t look like it will necessarily be big. For those wondering, Japanese retail investors don’t just suddenly sell urdiashi bonds in the South African rand or Brazilian real — there is no secondary market, these are buy and hold investments. But there could still be plenty of downward pressure on dollar/yen, beyond any repatriation.
Japanese margin traders: Almost certainly played a role in the dollar/yen plunge in early Asia hours on Thursday after having built up record longs in dollar/yen in the previous weeks. You can’t just blame Ms. Watanabe, but the speculators that Japanese authorities like to blame tend to be homegrown.
Exotic yen derivatives: Some of the market explosions last week were certainly due to exotic derivatives blowing up, this time as much Nikkei-linked as FX-linked. There is talk that Nikkei option-linked structures were one reason why the plunge on Tuesday was so severe. Some of these structures that made the 2008 selloff so nasty are still out there. And it makes sense. There was panic in the market on Tuesday as the radiation headlines spooked, but why would it be driven from futures trading in Singapore? The SGX was quick to impose some trading limits on its Nikkei futures contracts, just as the FSA cracked down on “arbitrage” trade between cash shares and futures. The initial market plunge was definitely futures-driven, and we saw a huge surge in Nikkei implied volatility via demand for puts — with implied vol on Nikkei options reaching 70 percent. The moves weren’t limited to the Nikkei. The Nikkei plunge caused a sharp move down in long-term swap rates, causing long-term swap spreads to go sharply negative. This happened during the Nikkei plunge, not the dollar/yen one Thursday. So clearly the biggest dislocations were coming from exotic derivatives tied to Nikkei futures, more than dollar/yen. But there is still the issue of importers and flat forwards.