RBS Says Sayonara to World's Weirdest Bond Market
Japan has long been the world's living laboratory for observing what happens when a large chunk of the population grows old. Now, it's also a financial testing ground -- demonstrating how a huge, developed economy will live without a bond market.
The nation has loads of bonds -- 1 quadrillion yen ($8.67 trillion) worth -- but no real market for them. That's because the Bank of Japan, in its aggressive campaign to end deflation, is nationalizing the debt arena. In response, Royal Bank of Scotland is saying sayonara to Japan's debt business, giving up its position as a primary dealer.
Haruhiko Kuroda, governor of Japan's central bank, has been buying up roughly $100 billion in debt per month, immobilizing trading opportunities and giving new meaning to the old concept of "crowding out." That's when government dominates an area of the private sector to the point where the laws of supply and demand stop working. That's where Japan finds itself as the BOJ bigfoots individual buyers and narrows the investor base. With more than 90 percent of IOUs held domestically, Japan is already the Galapagos of debt realms. As yields disappear, it's looking like the financial equivalent of "The Matrix," where market reality is a simulated one.
It's impossible, after all, to rationalize a nation's 10-year bonds with a public debt two-and-half times bigger than the economy. Soon, quips Richard Duncan of Blackhorse Asset Management, people will be paying Japan's government for the right to hold its debt. "The very low JGB yields," he says, "certainly do indicate that something is very wrong."
It also indicates why central bankers in the U.S. and Europe need to tread carefully with their own quantitative-easing schemes. Japan is also the word's lab for the post-QE experience. How it copes without a conventional debt market will offer timely lessons for policy makers from Washington to Frankfurt.
Among the unknowns is how corporate borrowers price debt. Deciding on a security's coupon, maturity and structure is a challenge in the best of times. But when yields on 2- and 5-year Japanese debt are going negative -- and 10-year bonds are heading that way, too -- corporate treasurers might as well rely on a coin toss. That could lead to mispricing on an epic scale. Kuroda has been driving down sovereign yields to encourage investment in riskier corporate notes and stocks. But when it comes to measuring risk, says Marshall Mays, director of Emerging Alpha Advisors, Kuroda's massive easing efforts have obliterated the lines between perception and reality.
Another problem is the replacement of old bubbles with new ones. As I've written before, Kuroda is adding fresh fuel for the world's most obvious bond bubble. Even if the BOJ were to achieve its 2 percent inflation goal, it would struggle to keep yields from skyrocketing. Kuroda would need to buy up ever larger blocks of debt, further warping the financial system and forcing the BOJ to feed an expanding pyramid scheme.
How to mitigate the damage? Avoid encroaching so much on the bond market. While it's possible that Janet Yellen's Federal Reserve can avoid this fate, Mario Draghi's European Central Bank might not, as deflation grips the continent. Deadening the mechanics of European and U.S. bond markets, Japan-style, would raise the odds of another global crisis. What’s more, without the risk-measuring function that yields provide, investors won't see it coming.
Central banks also should turn up the heat on government policy makers -- something the BOJ has avoided. Becoming a crutch for risk-adverse politicians has its dangers -- including, in Japan, renewed recession and disappearing yields. Huge injections of liquidity should come with quid pro quos: We do X on monetary side, you do Y on the fiscal side.
For Japan, the end, as Duncan points out, may justify the means. "I believe the BOJ will eventually write off all the government debt it's acquiring through QE," he says. "I think that will be a good thing as it will greatly reduce the level of Japan's government debt."
But a functioning and trusted debt market is the backbone of any healthy economy. Japan no longer has one.
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