Japan’s "Widow-Maker" Bond Trade Still Looks Lethal

[MachineGhost]

Bond traders have been betting against Japanese government debt for years — and losing spectacularly. Victims of the so-called “widow-maker”? trade of shorting JGBs thought the March disaster would vindicate them. Rebuilding, after all, will add to Japan’s sky-high debt and, with a shrinking workforce and rising pension costs, push yields up. But the quake hasn’t disrupted the self-perpetuating money machine that drives JGBs. Doomsayers still run the risk of becoming road kill.

http://blogs.reuters.com/breakingviews/ ... ks-lethal/

[Ad Orientem]

Japan's bond market is a bug waiting for the windshield. I don't know when the two will meet. But meet they will. And when they do, it's going to be U G L Y. In the meantime I am content to stay far far away from any form of speculative investing connected with the land of the rising sun.

[Gumby]

Japan will keep on getting downgraded, but it probably won't make much of a difference. Technically, as an autonomous currency issuer, the only way Japan defaults on its debt is if Japan chooses to default on its debt.

Unlike our own Federal Reserve, the government-owned Bank of Japan is allowed to (and does) buy government bonds directly from Japan's Treasury (known as the Ministry of Finance). And, of course, any interest payments on the bonds is refunded back to the Treasury. The BOJ holds Japanese government debt in excess of 100% of the nation’s GDP. And since the government owns the bank, the loan is always interest-free and can be rolled over indefinitely. An interest-free loan rolled over indefinitely is the equivalent of printing fiat money.

There is no issue of solvency with Japan's debt servicing. Inflation is the main concern, but Japan does not (yet) have an inflation problem.

[AdamA]

Unlike our own Federal Reserve, the government-owned Bank of Japan is allowed to (and does) buy government bonds directly from Japan's Treasury (known as the Ministry of Finance).

I hear this point made a lot, but don't really understand why this important.  Why does it matter that the Fed can't buy bonds directly from the Treasury?

[Gumby]

Unlike our own Federal Reserve, the government-owned Bank of Japan is allowed to (and does) buy government bonds directly from Japan's Treasury (known as the Ministry of Finance).

I hear this point made a lot, but don't really understand why this important.  Why does it matter that the Fed can't buy bonds directly from the Treasury?

In 1947, Federal Reserve Chairman Marriner Eccles testified before Congress on the issue of direct purchases of Government securities by Federal Reserve Banks. The Federal Reserve had been allowed to purchase securities directly from the government from its inception in 1914 until the Banking Act of 1935, when...

A provision was inserted in that act requiring all purchases of government securities by Federal Reserve banks to be made in the open market, which means purchased chiefly from dealers in Government bonds. Those who inserted this proviso were motivated by the mistaken theory that it would help to prevent deficit financing...

Nothing constructive would be accomplished by the proviso that the Reserve System must purchase Government securities exclusively in the open market. About all such a ban means is that in making such purchases a commission has to be paid to Government bond dealers.
Source: http://fraser.stlouisfed.org/docs/histo ... rchgov.pdf

It's important for a few reasons...

First, because it proves that the Treasury is where our fiat fiscal spending comes from. The Fed cannot buy bonds directly from the Treasury — it is only authorized to transact with Primary Dealers. Since the Fed can only conduct asset swaps and short term loans with primary dealers, this means that the private sector is ultimately responsible for finding the net financial assets needed to pay taxes and purchase government bonds on its own.

Where does the private sector get those net financial assets to pay taxes and purchase government bonds from? From the Treasury. The government issues a net deposit of Treasury Bonds in the private sector and those new Treasury Bonds assets are swapped by the Fed into cash, as needed, to purchase future government bonds and pay taxes. When you look at this process from a Macro perspective, it's clear that the funds to pay taxes and buy government securities come from government spending. Those who don't want to believe that this is what actually happens will try to point out that the Fed can monetize private credit instruments (such as MBS, CDS, etc.), but what those individuals fail to realize is that the private credit instruments must eventually be paid off, plus interest, causing a net loss for the private sector when they are owed to the Fed.

Second, by requiring the private banking system to purchase all Treasuries at auction, the government is required to issue more and more Treasuries to pay the interest due to the private banking system. And when you combine this phenomenon with the issuance of private credit for all private sector money creation (loans, mortgages, agency debt, commercial paper, etc.), you have a situation where new Treasury issuance is the only way the private sector can pay down its own loans to itself — particularly when private credit isn't being issued fast enough.

But, basically, if the Fed could purchase Treasuries directly from the Treasury, the Treasury would barely need to make any interest payments, since the Fed would just return its profits from interest payments back to the Treasury. It's basically debt-free money.

In Japan's case, the interest on Japanese debt held by the Bank of Japan is refunded back to its treasury (the Ministry of Finance), leaving no net cost to the government on this debt. In other words, the Japanese government doesn't need to issue more and more debt to pay the interest on its debt. It's basically just printing whatever it needs and has no problem doing so (other than triggering inflation). Japan has already monetized a lot of its debt this way. The Fed can't really monetize the debt since it needs the Primary Dealers to obtain the assets it needs, on its own, in order to monetize any debt.

If you're wondering why the Fed still isn't allowed to purchase Treasuries directly from the Treasury, it's because the private banking system wants to be the receiver of all the interest payments (both public and private). So, big banks have done everything they can to keep it that way.

[Gosso]

Unlike our own Federal Reserve, the government-owned Bank of Japan is allowed to (and does) buy government bonds directly from Japan's Treasury (known as the Ministry of Finance).

I hear this point made a lot, but don't really understand why this important.  Why does it matter that the Fed can't buy bonds directly from the Treasury?

Apparently the Bank of Canada falls into the same camp as the Bank of Japan and can also purchase bonds directly from the Canadian Government.  They recently increased the minimum amount from 15% to 20% of all bond auctions.  http://www.bankofcanada.ca/2011/10/noti ... purchases/

[Ad Orientem]

Japan will keep on getting downgraded, but it probably won't make much of a difference. Technically, as an autonomous currency issuer, the only way Japan defaults on its debt is if Japan chooses to default on its debt.

Unlike our own Federal Reserve, the government-owned Bank of Japan is allowed to (and does) buy government bonds directly from Japan's Treasury (known as the Ministry of Finance). And, of course, any interest payments on the bonds is refunded back to the Treasury. The BOJ holds Japanese government debt in excess of 100% of the nation’s GDP. And since the government owns the bank, the loan is always interest-free and can be rolled over indefinitely. An interest-free loan rolled over indefinitely is the equivalent of printing fiat money.

There is no issue of solvency with Japan's debt servicing. Inflation is the main concern, but Japan does not (yet) have an inflation problem.

I concur that an overt default on Japanese sovereign debt is exceedingly unlikely. But Japan's debt has long since passed the point of unsustainable. It has one of the steepest rates of population decline in the developed world and a cultural xenophobia that makes immigration all but impossible. So you have a population that is rapidly shrinking and aging coupled with the highest debt/GDP ratio of any industrialized nation. All they have left is debt monetization. Yes, you can do that for a while. But eventually numbers will overwhelm the BoJ. Once the inflation they are creating gains momentum how will they stop it? I don't think they can. The effects on the their bond market will be catastrophic.

Will it be hyperinflation? I doubt it. But I suspect that it will be much worse than the inflation we dealt with in the United States 30+ years ago.  Japan is a disaster on wheels and they don't have a clue how to get out of the debt trap they are in. For that matter, neither do I.

[moda0306]

Ad,

I'd challenge you (as I challenge myself) to think of HOW bond prices will get out of control if there is no default risk spiral... I think then it ONLY comes down to iflation risk, and since that applies to the currency as well as bonds, I don't really see that affecting rates on risk free Japanese treasury debt.

Basically, when you have a currency like Japan's, where their bonds are just uber-safe financial assets on their population's balance sheet, just like their yen are, (and the fact that I doubt legal tender laws is what's keeping them from spending the treasury bonds on their balance sheets), I'm quite sure that by logical conclusion the bond market is not really a real market... therefore not subject to the same forces.  The only "sustainability" to consider is inflation, and since inflation (holding real GDP constant) will increase nominal GDP, and therefore decrease Japan's debt-to-GDP ratio, as long as their society remains productive, I see more of a self-balancing mechanism than one that can "tear out of control." 

This is something I'm not 100% sure of, but it seems pretty tight to me.  I mean we know that the fed can control rates... so why do we ever consider debt unsustainable unless it's in terms of inflation?  It seems to me that inflation is the natural result of having "too many" uber-safe financial assets on peoples' balance sheets... not some kind of fiscal crisis, when we've already established that rates for the currency issuer (gov't) are set by the gov't.  I simply think that sovereign fiat bonds are so similar in nature to the currency themselves:  The government sets or heavily manipulates the price of the assets in the banking system, while the market decides how fast to try to get rid of them, based on the decay of value, as well as the debt-servicing considerations on their balance sheet, and what currency is in common use in their region.  Either way, I think the risk is inflation... not interest rates rising, as the gov't controls interest rates.  Remember, the US banking system has to hold US dollars, even if it's losing 8% of its value every year, they will demand bonds at 1% if the gov't sets them at such because losing 7% to inflation is better than 8%.  Now the private debt market might not work like that, but I think we have to start at the treasury first.

[Gumby]

Japan's debt has long since passed the point of unsustainable.

Not true. The Bank of Japan can, and does, monetize its debt. And nearly every last yen that gets spent into existence (and ultimately saved by Japanese citizens) finds its way to the Japanese Post Bank — which funnels all those savings into risk-free Japanese Government Bonds. There is no solvency risk for the Japanese government. Japan can only default if it chooses to default.

[moda0306]

To build on my babbling post before, I think we need to answer this:  Can the fed always set rates to whatever it wants?

I tend to think it can, but will it.  The 1970's were probably an example of the fed bouncing rates around to try to help boost the economy but then later try to tame inflation, moreso than "the markets" setting rates super high... I mean we often refer to 1981 as the year the fed "choked off inflation."  Few point that out as the market setting rates.  So when, if ever, does the fed really lose control of interest rates?  If they're trying to slow inflation by raising rates, well then that's different than interest rates breaking away from fed control.

The next question is, then, if they CAN always set rates, what does that do to the market for the dollar & US bonds.... if inflation is 8%, and the fed insists on keeping rates at 1%, what happens to bonds that aren't responding to "market" pricing but instead fed price-fixing?  Since, in aggregate, we can't "get rid" of our money (or our bonds), what happens? In a world of the US dollar as legal tender, does velocity speed up as people attempt to dissave?  That would seem to be what would cause inflation in the first place... and maybe that's where the viscious cycle lies... the road to hyperinflation... keeping rates artificially low for year after year would erode peoples' will to hold US dollars.

So since the market can't really set prices of sovereign bonds (or so we're assuming for now), what's the final market indicator of the will to hold currency and/or bonds when there's high inflation and low interest rates?  I'd have to argue velocity and price level are probably both indicators.  Demand for loanable funds might be another (which would certainly go up if private rate-setting by US banks (which have to hold US dollars) is "artificially" low... aka, less than expected inflation).

Using those indicators, price level is telling a mixed story, but is largely pretty low in terms of inflation.  Velocity of US dollars is way down, I'm almost positive, as is demand for loanable funds.  This is very likely due to a high level of need for US dollars to service existing private obligations such as student loans, car payments, mortgage payments, etc.  So with the possible exception of price level, aren't the most likely thermometers on the demand for the US dollar & t-bonds yelling at us pretty loudly that demand is high?  Low velocity?  Low demand for loanable funds?  We know we can't use interest rates... or at least we are pretty sure we can't... as a gauge of demand for our confetti... I think we have to pound through exactly what we should use as a gauge.

[cabronjames]

good informative post, on the topic of how interest is paid on sovereign bonds of a nation with fiat currency.

Perhaps you can verify if I'm understanding this correctly"

--
There is a spectrum.

Japan is on the direct end of spectrum, where 100% of the bonds are directly bought, & thus the interest payments are rebated from the central bank to the gov Treasury.

USA is on the indirect/bank$ter welfare queenery end of spectrum, where 0% of the bonds are directly bought, 100% are indirectly bought via the bank$ter Primary Dealers.

Canada takes a hybrid approach, 20% direct, 80% indirect/welfare.

Am I understanding this correctly?
--

How do the other major nations, that are at least minor reserve currencies, operate?  UK, Germany, Switzerland, Australia, BRIC nations, S Korea, etc?

Somehow I fear that the US is the only nation on the 100% bank$ter welfare spectrum end.

[Gumby]

Japan is on the direct end of spectrum, where 100% of the bonds are directly bought, & thus the interest payments are rebated from the central bank to the gov Treasury.

Not exactly. It's not 100% of their total debt. In 2011, the Bank of Japan was holding 100% of Japan's GDP as bonds purchased directly from their Treasury. This was the equivalent of the Fed purchasing $15 trillion in US debt directly from the US Treasury (which it can't do, since it needs to go through Primary Dealers) and then returning nearly all of the interest back to the Treasury. All the remaining debt (and there is a lot) is simply purchased by Japanese Savings accounts and anyone else who wants a risk-free yen-denominated asset in the open market. The net financial assets to fund these savings accounts comes from government spending. Yen is spent into existence, and stays in the Japanese banking system. It's not like everyone in Japan needs to think about buying bonds. All Japanese citizens have to do is put their money into savings accounts and the banks (mostly Japan's "Post Bank") take care of the risk-free bond purchases for them behind the scenes.

Japan has many problems, but servicing its debt isn't one of them.

USA is on the indirect/bank$ter welfare queenery end of spectrum, where 0% of the bonds are directly bought, 100% are indirectly bought via the bank$ter Primary Dealers.

Yes.. And as long as we keep issuing Treasuries, there is no issue of solvency.

Canada takes a hybrid approach, 20% direct, 80% indirect/welfare.

Japan is a hybrid as well. Government bonds are ideal risk-free assets for the private sector, so it wouldn't be very useful for the central bank to hoard all of the bonds.

How do the other major nations operate?  UK, Germany, Switzerland, Australia, BRIC, S Korea, etc?

Every country has some nuances. I'm not entirely familiar with all of them. If a country has a free-floating exchange rate (no pegs to a commodity or another currency), is the sole-issuer of a currency, and only holds debt denominated in its own currency, it is a true currency issuer and has true fiat powers. But, I don't know enough about each country to know if their central bank has direct purchasing powers or not.

Somehow I fear that the US is the only nation on the 100% bank$ter welfare spectrum end.

Yeah, it's not an ideal setup. The bankers hold too much power and grow larger and larger over time. It tends to lead to a more fragile economy (boom to bust, rinse, repeat).

[moda0306]

I think another thing that deserves a look-see, is why the US and Japan can get such high debt/GDP ratios without much inflation (if we can even agree that's the only real risk)... Japan has an asterisk next to it because they're crazy savers... ours just might be that we're a reserve currency.  I mean if we're supplying foreign GDP's with base assets with which to save/spend, not just our own, that's going to vastly increase our need to run deficits, and decrease the risks of hyperinflation just because debt is XXX% of GDP.

[Gumby]

if we're supplying foreign GDP's with base assets with which to save/spend, not just our own, that's going to vastly increase our need to run deficits, and decrease the risks of hyperinflation just because debt is XXX% of GDP.

Yes. I keep thinking about that statistic you showed us a few weeks ago — about how much currency we export to the world, as a reserve currency. Our domestic private sector is constantly losing dollar assets to the foreign sector — which is the paradox of having a reserve currency (i.e. the Triffin Dilemma) so the only way to prevent the domestic private sector to grow its savings (of net financial assets) is for the government to run an even larger deficit.

[moda0306]

It's funny how equating T-bonds with US Dollars to an extent changes your view of the flows of the system... I guess equating them COULD be wrong if we're somehow wrong about the fed/treasury relationship, but if we're right (and it appears almost all the evidence, including a lot of pertinent observations from HB and other Austrians about the fed controlling interest rates, points to us being correct about their relationship), and looking at financial assets & balance sheets is the core of the issue, not M3 (much less the oft-abused M1 graphs), it really completely changes how you view the system in terms of productivity, sustainability, why people choose to spend/save/deleverage, etc.

And really, it starts to make so much more sense when you look at it in terms of balance-sheets and NFA's vs the quantity of "money"... such a nebulous term, especially today when technology allows such liquidity of once illiquid assets. 

When you see peoples' balance-sheets in this country, and that they've got so much debt to service in dollars with too-little wage income to do so, it becomes much more obvious why people DON'T CARE that the dollars they're trying to obtain are falling in value by 2-3% every year, or whether they hold T-Bills or dollars on their balance sheets.  A balance sheet, debt-service ratio, and employment outlook can probably tell you a bajillion times more about somebody's (and a society's as a whole) consumption/saving decisions going forward than any debt-clock or M1 graph ever will.

[Gumby]

It's funny how equating T-bonds with US Dollars to an extent changes your view of the flows of the system...

Since we live in a debt-based monetary system, I think you really have to equate T-bonds with US Dollars in order to understand it. There's no way to pay off the interest on debt-based money without issuing more debt.