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Bad News for Oz from Japan

The Bank of Japan's new QE boom looks all good at first...


ON FRIDAY, writes Greg Canavan of Sound Money, Sound Investments, we learned that the US economy added just 88,000 jobs in March against expectations of a 200,000 gain.

Previous months' jobs numbers were upwardly revised, tempering some concerns, but taken at face value it was not a good number.

Are you really surprised, dear reader? The US economy is not in recovery mode. It's sick, very sick. It responds to heavy doses of monetary and fiscal stimulus but then relapses, needing ever larger injections to maintain some semblance of health.

But we don't intend to pick on the US today. It's sick, but it's not terminal yet. Japan on the other hand...
Following new Bank of Japan (BoJ) Governor Kuroda's first foray into monetary insanity, with his intention to increase Japan's monetary base by $1.4 trillion by the end of 2014, it's very difficult to see how Japan isn't in the terminally ill ward. Or, at the very least, under the supervision of Nurse Ratchet, awaiting a lobotomy.

What does it actually mean though, to 'increase the monetary base'? Well, a nations' monetary base consists of physical currency (usually a very small percentage in the modern age of electronic banking) and bank reserves. 'Bank Reserves' are the portion of depositor funds that are not lent out to clients. It is a regulatory requirement that banks keep some funds in 'reserve' to meet withdrawal requests. These reserves are usually held by the nations' central bank.

The planned increase in Japan's monetary base will mostly come from an increase in bank reserves. The BoJ will achieve this by buying Japanese Government Bonds (JGBs) and to a lesser extent equity and real estate exchange traded funds.

It works like this: they buy the JGBs from a bank or a pension fund (via a bank), and the bonds then sit on the asset side of the BoJ's balance sheet. To pay for the purchase, the BoJ creates 'money', which shows up on the liability side of their balance sheet in the form of bank reserves.

This is just a technical way of saying that the BoJ is expanding its balance sheet. Balance sheet expansion and an increase in the monetary base is basically the same thing. By increasing the 'base', the BoJ hopes to increase all the other forms of credit money that sit on top of this base.

Doubling the base in less than two years is a crazy gambit. If it 'works' it will smash the yen and, in time, pop the asset bubble that is the Japanese bond market. Remember, when bonds yields decline, the price of a bond increases. Japanese bond prices have been increasing for...we don't know how long. A long, long time. So long that not many Japanese investors think they could ever fall.

Following Kuroda's announcement last week, the yield on 10-year JGBs spiked down to 0.30%. In other words, the bond price spiked to all-times highs. Then prices tanked as yields plunged back to 0.60% on the same day. Welcome to the future in the volatile JGB market.

But the point to think about is this...what will be the effect of the bursting of a huge bond market bubble? Japan's total debt outstanding is around US$10.5 trillion. Over 60% of it is held by Japanese banks (around 40%) and Japanese pension funds (around 20%). If Kuroda succeeds in generating inflation of 2%, bond prices will fall, potentially wiping trillions off the market price of the outstanding bonds. These losses will hit bank and pension fund equity, and destroy a large swathe of middle class savings.

The BoJ, in their lobotomised insanity, will try to prevent this by buying up every bond that hits the market. They may even reach their monetary base target ahead of time. Which means the only way to release the short term pressure building due to this extraordinary situation is via the currency, the yen. It will take the full brunt of this unprecedented Japanese experiment.

In time, the JGB market will topple too. Japan's vaunted savers are growing older and will need to consume more and save less. They won't be able to keep on financing the government's deficits, which means the BoJ will eventually directly finance government spending. When this happens, there is really no hope left for a country. There is only currency collapse and a huge fall in living standards for the people.

What all this means for Australia and Australian investors we haven't yet worked out. It's something we'll take an in-depth look at in tomorrow's edition of Scoops Lane, a subscriber only weekly email.

But as Australia's second largest trading partner, it's worth looking into. Because when a currency collapses, the country in question cuts back on its purchases of foreign goods.

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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