Rising Sun? More Like Rising Fears

06/11/2013 9:00 am EST

Focus: GLOBAL

Japan's easy money policy may backfire, causing a bond market crash, says Mike Burnick of Money and Markets.

A 7.3% flash crash in Japanese stocks—the biggest decline since the 2011 tsunami and earthquake—was triggered by a more troubling sell-off in Japanese government bonds.

Recall that it was the Bank of Japan (BOJ) that originated QE decades ago. In a bid to engineer inflation and jump start its slumbering economy, Japan became the record holder for dispensing easy money.

Two lost decades later, Prime Minister Abe has put a new spin on the same old strategy with hopes to jumpstart Japan's economy, stagnant since its real estate and stock market bubbles burst in 1990. The plan calls for the BOJ to purchase $70 billion a month in Japanese government bonds (JGBs) to support credit in the economy until inflation hits 2%.

Abe's strategy to revive Japan's economy has caused yields to more than triple since April. This is nearly the same dollar amount of QE the Fed is pursuing—but in an economy just one-third the size of the US.

A potential unintended consequence of this policy is that fears of inflation could lead to a bond-market collapse, taking Japan's financial system down with it—just like in Europe.

Hedge-fund manager J. Kyle Bass, among others, has warned about this downside scenario, which is precisely what triggered the sell-off in Tokyo. Japanese government bond vigilantes "overwhelmed" the market with sell orders, according to a Bloomberg interview with Bass.

Yields on benchmark ten-year Japanese government bonds spiked dramatically higher, with more investors selling than the BOJ is able to buy. From a low of 0.3% in April, ten-year JGB yields topped more than 1% for the first time in over a year. Rates more than tripled off the record low reached just a month ago.

To put this massive bond market volatility in context: it would be as if ten-year US Treasury yields suddenly and without warning shot up to 4.8% from the recent low of 1.6%.

The problem lies in the fact that JGBs are mostly locally owned. Japanese banks, pension funds, and insurance companies are loaded up, and appear to be dumping them for fear of being caught on the wrong side of a Japanese bond-market rout.

A bond-market crash in Japan would likewise set off another banking crisis in Japan, similar to what has been slowly simmering in Europe for the past several years.

Japanese banks alone hold JGBs equal to 80% of the country's economy, as measured by GDP. This means a huge potential loss in mark-to-market accounting value if bond yields continue to spike higher. The IMF estimates that just a 1% rise in yields would result in a 20% haircut for regional banks' capital.

Japanese lenders may be starting to unwind their massive JGB holdings, recently reducing them to 164 trillion yen, down from a record 171 trillion yen a year ago.

Still, Japan cannot tolerate higher interest rates. Tokyo's debt-service costs would rise by 100 billion yen for every 0.1% increase in bond yields. Japan's outstanding debt was 991.6 trillion yen at the end of the first quarter, and is likely to reach a record 245% of the country's GDP this year.

To potentially profit from rising yields in Japanese bonds, you might consider PowerShares DB 3x Inverse Japanese Govt Bond Futures Exchange Traded Note (JGBD). This ETN is meant to rise 3% for each 1% fall in the price of Japan's ten-year government bond.

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