It took nine years and the Bank of Japan expanded its balance sheet to the $5 trillion mark, but Asia’s second-largest economy is finally seeing some inflation.
Tokyo officials are realizing the hard way, however, that it pays to be careful what you wish for as bond yields rise.
Admittedly, the consumer price gains reported by Japan are negligible compared to those of the United States and China. And inflation is still far from the BOJ’s 2% target. However, the 0.5% rise in consumer prices in January over one year is already worrying the bond market. It followed a 0.8% jump in December and marks the fifth consecutive month of increases.
The concern is that inflation in Japan is of the “wrong” type. Haruhiko Kuroda was hired as BOJ Governor in March 2013 to end deflation. Kuroda triggered tidal waves of cash. It sent the yen down 30%, generated record corporate profits and propelled stocks on the Nikkei 225 Average to 31-year highs.
Yet even after inflating the BOJ balance to the point where it exceeded gross domestic product, inflation remained elusive. The reason: The lack of bold reforms has left corporate CEOs hesitant to raise salaries or invest big in new innovations.
Then came Covid-19. As economies reopen and supply chains deteriorate, global inflation spikes head towards Japan. Soaring energy and other commodity costs are causing Japan to import the inflation the BOJ hoped to generate organically at home. And bond traders don’t like it.
Over the past few weeks, 10-year government debt yields have hit a six-year high of 0.2%. That won’t seem problematic, given the comparable US Treasury yield of 1.93%. But Washington’s debt is nowhere near the 250% to GDP ratio that Japan faces. The US population is not shrinking, nor is it aging at an alarming rate from year to year.
Soaring rates were enough to catalyze Kuroda’s team to smooth things over in Tokyo’s $12 trillion government debt market. Earlier this month, the BOJ stepped in to enforce its “yield curve control” policy for the first time since 2018.
For this, there are two clear takeaways. First, the idea that the BOJ will decline anytime soon is rather fanciful. Second, the Japanese bond market could become a bigger risk to global financial stability than investors realize.
The first debate was lively just a few months ago. At the end of 2021 there were indications that Japanese GDP was returning to pre-Covid levels. Japan’s 5.4% annualized growth in the October-December period has put it firmly on a path back to the 2019 range.
Yet the BOJ is haunted by past efforts to end the quantitative easing that has been the Japanese norm since 2001. In 2006 and 2007, for example, then BOJ Governor Toshihiko Fukui ended to QE and managed to lift short-term rates away from zero with two tightening moves. In 2008, Fukui’s successor brought Japan back to zero and QE.
Japan, as Kuroda learned, is addicted to free money. The national government, provincial leaders, banks, business leaders and investors have become accustomed to zero rates. Any effort by the BOJ to wean the economy off the money sauce goes awry very quickly. So, the BOJ cut in 2022 seems like a no-start.
And yet, the bond market could be vulnerable to the stumbles that are rapidly globalizing.
Admittedly, a Japanese bond crash has been something of a widow’s trade over the past decade. Short-sellers betting that Japan’s crippling debt would go awry underestimated the BOJ’s determination to maintain calm. They also seemed to miss the cornerstone role of the government’s IOUs plan in Japan.
Of course, this is true of most nations. In the case of Japan, however, government bonds are the financial equivalent of the sun, around which everything else orbits. They are the main anchor assets of banks, corporations, endowments, insurance pools, local governments, pensions, postal system, massive ranks of retirees, universities and any other institution that you can name.
In other words, the entire universe of Japan Inc. has a prime incentive to keep the peace in the bond realm. And yet, it gets harder and harder as the inflation that Kuroda & Co. has wanted for years starts to happen.
Tokyo is now one of three colossal markets at risk amid the Covid-19 dislocations. The United States suffers the largest increases in inflation in 40 years, while the national debt exceeds 30 trillion dollars.
In China, President Xi Jinping’s efforts to reduce leverage among property developers have been met with Covid-related dislocations. At the end of 2021, global markets were spinning in response to defaults by China Evergrande Group, Fantasia Holdings, Kaisa Group and others.
And now Japan is having its own dose of activist traders pushing up debt yields. When the world’s three most watched debt markets are arguably simultaneously on shaky ground, it’s hard not to worry.
Of course, Team Kuroda has a few tricks up its sleeves to keep financial peace. But with inflation on the way, its ability to control the ticking time bomb that its $5 trillion balance sheet has become can no longer be taken for granted.