Things About Japan

Points in favour of Japan:

Most importantly, fiscal and monetary policy are moving in directions that will be helpful to an economy that has its interest rates stuck at the zero lower bound:

  • Fiscal policy is stimulative. Real government expenditure is seeing strong YOY growth — mostly, I suspect, because of reconstruction spending. With short-term interest rates stuck at zero, increased government spending is the best way to stimulate the economy.
  • Monetary policy has turned more stimulative. In Q1 the BoJ announced a 1% inflation “goal”. I didn’t take this very seriously — it is well known that Mr. Shirakawa does not think that the BoJ can end Japan’s deflation alone. Nonetheless, inflation expectations have increased significantly since then, and that is pretty much the only way to provide monetary stimulus to an economy that has its short-term interest rates stuck at zero. I think that the important point here is that politicians have become more assertive in demanding that something be done about deflation (hence the inflation “goal” and the blocking of a hawk for the BoJ’s board). The BoJ’s inflation “goal” is just the first chink to open in its armour. Japanese society appears to be lumbering towards actually doing something about its persistent deflation.

There are also some short-term factors that should be supportive of the economy:

  • Oil prices are coming down and nuclear reactors have started to be switched back on. Noda allowed two reactors to be switched on this week. Since Tohoku, a lack of nuclear power has turned Japan into a net energy importer; with lower energy prices and a return of nuclear, the current-account deficit should narrow, which should add to GDP growth.
  • Data in Q2 appear to have been depressed by seasonal-adjustment factors (because of the financial crisis, the timing of the Chinese new year, and so on). Japan may be stronger at present than the market realises.
  • The VAT hike appears to have been agreed. Bloomberg reported this week that the DPJ and LDP had agreed the hike, in return for the DPJ’s having dropped an election pledge on pensions. The hike in VAT will mechanically raise inflation; when it happens, that may feed into higher inflation expectations. More importantly at the present time, in advance of the hike consumers ought to bring forward consumption expenditures in order to avoid paying the higher rate of VAT. This should provide a consumption boost to the economy.

These observations suggest that Japan really could be at a long-term turning point, and that a short-term turning point could also be on the cards. In the very short term, a bounce in risk appetite from the slow improvement in the European situation could carry Japanese equities upwards. This combination of long-term, short-term and very short-term factors seem to add up to a good buying opportunity.

What should one buy? It would make sense to buy domestically-focused equities and I wonder whether a good proxy for these might be the Topix Second Sector index. On the other hand, I wonder whether one could capture a good part of the trade just by buying the Nikkei. It is quite correlated with JPY and with global risk, but in the very short term those factors may well be supportive.

Spanish Banks

I think I have been very stupid on the question of the Spanish banks. I could not see why 3-year LTRO’s should be so much better than 3-month LTRO’s when it came to the funding of Spain’s government deficit. This was because I was thinking in macro terms. The right model is a micro model. If a Spanish bank suffers a deposit outflow, it is likely in the short term to borrow from the ECB/Bank of Spain rather than reduce its assets. Hence, deposit outflows are funded by the ECB. This is a passive decision. In order to increase their holdings of government bonds, on the other hand, the banks need to make an active decision. In other words, they have to see Spanish bonds as a good money-making opportunity. It is likely that they look at the asset and its funding together — i.e. they see Spanish bonds financed with cheap 3-year loans as a single good trade. Spanish bonds financed with cheap 3-month loans is not such an attractive trade.

What does this tell us about what needs to happen for market yields on Spanish debt to fall? One of three things needs to happen:

1. The ECB signals that short-term funding will continue to be available for a long period.
2. Available funding is lengthened — i.e. another 3-year LTRO.
3. Deposit outflows from Spain become deposit inflows — perhaps on account of a successful bank recapitalisation.

If none of these three things happens, then Spain will likely be driven into an EU bailout. The bank recapitalisation plan may mean that 3. is getting nearer, but I am not sure that a resolution of the banks’ problems will reverse the capital flight from Spain unless government bond yields fall — i.e. this solution to the problem will probably not work unless the problem is already solved. That means that ECB action is the way to halt the increase in Spanish yields. But the ECB seems determined to drive Spain into an EU bailout. I suppose that this is an argument that, now that Spanish yields have risen, an EU bailout is inevitable.


Would it be a good idea to buy silver? Silver and gold appear to have halted their decline (which is explained by the fact that USD has rolled over). If risk appetite is turning, then USD should fall still further in the coming weeks and gold and silver should rally. Gold has already had quite a run up, but silver has lagged. Often when this happens, silver later follows gold upwards. So I wonder whether this would be a good trade.

Is global risk appetite turning? I think that it may well be. Two weeks ago, markets were pricing a Syriza victory in Greece and a possible disorderly breakup of the Eurozone. Now that possibility is fast receding. Yes, the outflows from Spain and Italy remain a problem, but they are a problem in the sense that they require continued monetary financing — which is happening smoothly and successfully. Spain may be driven into a bailout, but so what? Italy has a much smaller structural deficit so is likely not nearly as vulnerable. And the Europeans are moving forward again, albeit constrained as usual by politics and ideology (or, if you like, incompetence — incompetence has causes). It is hard to see things getting worse from this point on, and it is not hard to see things getting better.

How far has the sell-off in markets in the past couple of months been driven by worries about Europe. There is also some evidence of a slowing in the US (about which everyone seems to be panicking, while it actually looks rather early not to think it is a blip) and the situation in China. But I think that Europe has been the main thing that has driven markets down, and that therefore a turnaround in Europe should allow markets to rally. Any easing move by the Fed this week (at the least, I hope they will extend OT) should help this along.


  • UK CPI 2.8% YOY d.e. May. Core 2.2% d.e.
  • German ZEW economic sentiment -16.9 d.e. The biggest fall since 1998.

Coming Up

  • US building permits
  • US housing starts
  • Japan monetary policy minutes
  • Japan trade balance
  • UK employment data
  • UK MPC minutes