Saturday, November 1, 2014
Impending Shortage of JGB Fools
As a central bank drives up bond prices investors can make money holding bonds, even at low interest rates. However, at some point the prices get so high and interest rates so low that you really need a greater fool to buy them. Currently the interest on 10 year JGBs is less than 0.5% per year. The Yen was down more than 3% for part of the day yesterday and closed down 2.7%. It takes 6 years of interest at 0.5% to make up for a 3% loss in the currency. However, there will be many more losses over the next 6 years, so investors will never catch up. At this time there is no greater fool than someone holding 10 year JGBs, except someone holding 30 year JGBs. There will soon be an acute shortage of these JGB fools.
The normal method to get more people to hold bonds in a currency is for the central bank to let interest rates go up. This past week Russia let interest rates go up to try to make holding their bonds more attractive to the market.
However, Japan is in such a bad situation that this normal method will not work. The government is spending about twice what they get in taxes, a problem almost impossible to fix. The yearly taxes were 47 trillion Yen and the central bank is now monetizing at a rate of 80 trillion per year. The total Japanese government debt is over 1 quadrillion yen (1000 trillion yen). Money printing is much more than taxes and more than the deficit. The central bank is effectively funding the deficit and about that much again buying up bonds from the rest of the market, which on net is reducing bond holdings. Even the pension funds are now getting out of JGBs. The Japanese government debt is so high that if interest rates go up to about 4.7%, just paying the interest on the debt will use up all the money collected from taxes. Rates in Japan were this high in 1991. If people don't want to buy JGBs now, they won't want to buy them when all of government taxes just cover the interest on the debt. This is not an attractive situation to bond holders. Half this rate would mean half of taxes just to pay interest, twice this rate would mean interest twice taxes. Neither of these is attractive to bond investors either. The normal method of raising interest rates to improve demand for bonds will not work for JGBs. There is no interest rate that increases demand so the central bank is not forced to monetize even more than the total deficit at this point. This is a big problem, the central bank is effectively forced to print money with no way out.
When the central bank of Japan announced the increased rate of monetization they claimed it was because they are worried that lower oil prices are pushing Japan toward deflation, so they want to push harder toward inflation. I think the real reason is nobody else is buying JGBs and people are selling, so the central bank needs to buy even faster. Also, when they announced the first huge printing it was to double the money supply in 2 years. This had the implication that they would stop. Now they are saying they are printing at a rate of 80 trillion yen per year, which does not imply any ending.
At this point the Japanese Central Bank is really funding Japan's government deficit, with no way to stop. I think the market is starting to realize this and that is why people are starting to flee JGBs. Soon, if not already, there will be a death spiral where the more the central bank monetizes, the less people want to hold JGBs and the less people hold JGBs the more the central bank is forced to monetize. The only alternative is for the central bank to let the government fail, which never happens. This death spiral has many characteristics in common with positive feedback loops in nature, which tend to end in destruction. In this positive feedback loop, which also include higher velocity of money and loss of confidence, the end is the destruction of the currency.
Keynesians live in fear of a deflationary spiral, which in practice almost never happens and when it does is usually slight. They are now acting like anything less than 2% inflation is deflation, just so they have some real world examples to panic about. However, they can't seem to imagine or understand a high inflation death spiral, which happens rather often to fiat money and is a much greater danger. They need to study up on the theory of hyperinflation death spirals.
Mark my words, there will soon be a horrible shortage of JGB fools.