Japanese After-Shock Could Derail
U.S. Treasuries
By Jeff Opdyke, editor, Emerging Market Strategist
Dear Sovereign Investor,
When I turned on the TV in the wee hours of Friday morning and saw what had become of Sendai, it instantly rekindled memories of the Great Hanshin Quake that rocked Kobe in January 1995. I was just beginning my career as an overseas investor back then, and I vividly recall the currency movement that took place in the months that followed.
Natural disasters necessarily have an impact on financial markets because they force investors and governments to react.
In the early days of Japan’s current and expanding crisis, the initial analysis is, rightly, on the Japanese markets. But the fallout is global as Japanese supply chains crimp production processes all over the U.S. and Europe and as Japanese consumers stop spending on superfluous European fashion. Perhaps most important is this question: how does Japan’s 9.0 quake and resulting tsunami shake up and wash over America’s Treasury market?
Let’s see...
Japan is about to undertake one of the biggest rebuilding efforts since the end of World War II. The country has to replace everything from airports and runways to bridges, ports, roads, highways, train tracks, power stations, houses, shopping centers, schools, hospitals, utility and cell-phone towers, parking garages, post offices, production plants... the list would take pages to print out.
The effort is going to cost tens, and more likely, hundreds of billions of U.S. dollars to accomplish.
Japan is fortunate in that it is one of the world’s wealthiest nations, and the citizenry is exceedingly patriotic. As such, Japan has the wealth to accomplish the mission Mother Nature has forced upon the island nation. And it has a population willing to put to work its own savings to rebuild Sendai, Minami-sanriku, Fukushima and others.
But just like pushing on an inflated balloon causes distortions elsewhere, Japan’s now singular focus on a domestic emergency means it has little interest in playing in U.S. Treasury and equity markets.
Indeed, it seems highly likely that Japan will be a net seller off U.S. debt and U.S. equities as Japan’s government, companies and citizens raise cash to fund the rebuilding.
That will have knock-on effects in America.
If Japan Disappears from the Treasury Market
...Then What?
All told, Japan owns an estimated $3 trillion of U.S. securities, both stocks and bonds. With $886 billion of U.S. Treasuries, Japan is the world’s #2-holder of U.S. debt. In the past year it’s bought, on average, $10 billion worth of Treasuries every month.
You don’t easily replace the second-largest buyer of Treasury bills, bonds and notes. Not many countries have pockets deep enough to step up with that kind of financial firepower.
China does, but it already owns more U.S. debt than it needs, and has been putting its cash into other currencies and gold out of a sense of financial prudence. Some of the Middle East nations could pick up some of the slack... but they have their own uprisings to quiet. They’re throwing bags of cash at protestors to quash the dissent, or at security personnel to quash the protestors.
The U.S. Will Have Little Choice But to Raise Interest Rates
A more likely scenario is that Japan largely disappears from the Treasury market, with China and a few others filling in some of that vacuum. And the Federal Reserve, which is slated to end it QE II campaign in June, will likely extend the remainder of its $600 billion buying program over several more months.
But it doesn’t seem likely that the willpower exists in Washington for the Fed to increase the size of QE II. And that means there will be some shortfall. And shortfalls are bad for the U.S. government because the government has a certain amount of debt it has to sell every month to fund all of its bloated spending commitments.
When the world is already stuffed with American paper, though, there’s only one way to bring buyers to the table: Higher yields.
As such, one of the aftershocks of the Great Sendai Quake will ripple 6,600 miles away, in Washington, DC, where the Treasury Department will have to pay more to access the money it needs to fund America’s overgrown spending demands.
That will make it even more expensive for America to fund its obligations.
Who knows what the ramifications of that will ultimately be? Will Congress accede to QE III? Will rising interest rates here be mildly inflationary (after all, the Fed can’t cut rates any lower)? Will Congress be more amenable to raising tax rates?
And what of stocks? Japan owns more than $1 trillion in U.S. stocks, equal to about 6% of the total value of the New York Stock Exchange. Selling off any sizeable portion of that will clearly put downward pressure on American equities.
History is Our Guide...
This isn’t just random musings. What I’m laying out has precedent in the 1995 Kobe quake. Times are different, yes. Japan is in far worse shape financially, as is America. Interest rates are at a different point in their cycle. But one fact - the only fact that matters - remains identical: Japan has a national crisis that it must address.
In ‘95, the Japanese repatriated hordes of cash to pay for the rebuilding effort. As a result, the Japanese yen surged in value, rising about 25% against the dollar between January and April 1995. Japan’s stock market, meanwhile, sank about 20% during the same period as retail and institutional investors pulled out of stocks to repair damage to their own lives or to buy Japanese bonds to help the government repair Kobe.
That’s happening again in the wake of the Sendai quake. The yen is rising against global currencies, and Japanese stocks are tanking. Partly that’s a reflection of fear and panic related to a potential nuclear mishap and the government’s warning that nuclear fallout remains a real risk.
But part of it also reflects people and businesses raising cash for the spending needs they clearly see. Insurers are bringing yen home and selling securities globally because they know a flood of claims is coming.
For investors, such moments offer opportunities and point to risks.
The risks: Being short the Japanese yen and long most of the Japanese stock market, at least in the short run. Over the next few months, the yen will continue to strengthen as the repatriation effort goes on, and stocks will suffer as the sell off continues. Worse, the risk of nuclear tragedy is so pronounced in the investor mindset right now, that any substantive release of radiation will cause another down leg in Japanese stocks and another upsurge in the yen, which has become a safe-haven currency of sorts.
So, avoid being short the yen at the moment. And avoid the temptation to buy Japanese shares on the cheap.
Also, don’t play in U.S. Treasuries. Though they are strengthening at the moment on the fear trade, if Japan does leave the market, Treasury yields will nudge higher - and Treasury prices will fall. A safer bet is simply to park your idle cash in a money-market account since they are the first to react to any rise in interest rates.
The opportunities: The exact opposite of the risks. The Japanese economy is fundamentally flawed and the yen is ultimately a reflection of that. Plus, the government is throwing the equivalent of billions of U.S. dollars into a stabilization effort, and that will work over time to push the yen substantially lower.
The weakening yen, in turn, will benefit Japan’s exporters, who historically fare well when the yen is falling.
So, you see the yen break below 80 to the dollar and move well into the 70s, it will be time to reverse course and short the yen again. And it will be time to buy the exporters - companies like Honda, Takeda Pharmaceuticals, Komatsu and Canon.
Just look back at Kobe. After the brief period of yen strength/stock weakness, the trend reversed. The yen plunged and Japanese stocks gained 50% of the following 12 months.
Until next time, keep a global view...
Jeff Opdyke
Editor, Emerging Market Strategist
U.S. Treasuries
By Jeff Opdyke, editor, Emerging Market Strategist
Dear Sovereign Investor,
When I turned on the TV in the wee hours of Friday morning and saw what had become of Sendai, it instantly rekindled memories of the Great Hanshin Quake that rocked Kobe in January 1995. I was just beginning my career as an overseas investor back then, and I vividly recall the currency movement that took place in the months that followed.
Natural disasters necessarily have an impact on financial markets because they force investors and governments to react.
In the early days of Japan’s current and expanding crisis, the initial analysis is, rightly, on the Japanese markets. But the fallout is global as Japanese supply chains crimp production processes all over the U.S. and Europe and as Japanese consumers stop spending on superfluous European fashion. Perhaps most important is this question: how does Japan’s 9.0 quake and resulting tsunami shake up and wash over America’s Treasury market?
Let’s see...
Japan is about to undertake one of the biggest rebuilding efforts since the end of World War II. The country has to replace everything from airports and runways to bridges, ports, roads, highways, train tracks, power stations, houses, shopping centers, schools, hospitals, utility and cell-phone towers, parking garages, post offices, production plants... the list would take pages to print out.
The effort is going to cost tens, and more likely, hundreds of billions of U.S. dollars to accomplish.
Japan is fortunate in that it is one of the world’s wealthiest nations, and the citizenry is exceedingly patriotic. As such, Japan has the wealth to accomplish the mission Mother Nature has forced upon the island nation. And it has a population willing to put to work its own savings to rebuild Sendai, Minami-sanriku, Fukushima and others.
But just like pushing on an inflated balloon causes distortions elsewhere, Japan’s now singular focus on a domestic emergency means it has little interest in playing in U.S. Treasury and equity markets.
Indeed, it seems highly likely that Japan will be a net seller off U.S. debt and U.S. equities as Japan’s government, companies and citizens raise cash to fund the rebuilding.
That will have knock-on effects in America.
If Japan Disappears from the Treasury Market
...Then What?
All told, Japan owns an estimated $3 trillion of U.S. securities, both stocks and bonds. With $886 billion of U.S. Treasuries, Japan is the world’s #2-holder of U.S. debt. In the past year it’s bought, on average, $10 billion worth of Treasuries every month.
You don’t easily replace the second-largest buyer of Treasury bills, bonds and notes. Not many countries have pockets deep enough to step up with that kind of financial firepower.
China does, but it already owns more U.S. debt than it needs, and has been putting its cash into other currencies and gold out of a sense of financial prudence. Some of the Middle East nations could pick up some of the slack... but they have their own uprisings to quiet. They’re throwing bags of cash at protestors to quash the dissent, or at security personnel to quash the protestors.
The U.S. Will Have Little Choice But to Raise Interest Rates
A more likely scenario is that Japan largely disappears from the Treasury market, with China and a few others filling in some of that vacuum. And the Federal Reserve, which is slated to end it QE II campaign in June, will likely extend the remainder of its $600 billion buying program over several more months.
But it doesn’t seem likely that the willpower exists in Washington for the Fed to increase the size of QE II. And that means there will be some shortfall. And shortfalls are bad for the U.S. government because the government has a certain amount of debt it has to sell every month to fund all of its bloated spending commitments.
When the world is already stuffed with American paper, though, there’s only one way to bring buyers to the table: Higher yields.
As such, one of the aftershocks of the Great Sendai Quake will ripple 6,600 miles away, in Washington, DC, where the Treasury Department will have to pay more to access the money it needs to fund America’s overgrown spending demands.
That will make it even more expensive for America to fund its obligations.
Who knows what the ramifications of that will ultimately be? Will Congress accede to QE III? Will rising interest rates here be mildly inflationary (after all, the Fed can’t cut rates any lower)? Will Congress be more amenable to raising tax rates?
And what of stocks? Japan owns more than $1 trillion in U.S. stocks, equal to about 6% of the total value of the New York Stock Exchange. Selling off any sizeable portion of that will clearly put downward pressure on American equities.
History is Our Guide...
This isn’t just random musings. What I’m laying out has precedent in the 1995 Kobe quake. Times are different, yes. Japan is in far worse shape financially, as is America. Interest rates are at a different point in their cycle. But one fact - the only fact that matters - remains identical: Japan has a national crisis that it must address.
In ‘95, the Japanese repatriated hordes of cash to pay for the rebuilding effort. As a result, the Japanese yen surged in value, rising about 25% against the dollar between January and April 1995. Japan’s stock market, meanwhile, sank about 20% during the same period as retail and institutional investors pulled out of stocks to repair damage to their own lives or to buy Japanese bonds to help the government repair Kobe.
That’s happening again in the wake of the Sendai quake. The yen is rising against global currencies, and Japanese stocks are tanking. Partly that’s a reflection of fear and panic related to a potential nuclear mishap and the government’s warning that nuclear fallout remains a real risk.
But part of it also reflects people and businesses raising cash for the spending needs they clearly see. Insurers are bringing yen home and selling securities globally because they know a flood of claims is coming.
For investors, such moments offer opportunities and point to risks.
The risks: Being short the Japanese yen and long most of the Japanese stock market, at least in the short run. Over the next few months, the yen will continue to strengthen as the repatriation effort goes on, and stocks will suffer as the sell off continues. Worse, the risk of nuclear tragedy is so pronounced in the investor mindset right now, that any substantive release of radiation will cause another down leg in Japanese stocks and another upsurge in the yen, which has become a safe-haven currency of sorts.
So, avoid being short the yen at the moment. And avoid the temptation to buy Japanese shares on the cheap.
Also, don’t play in U.S. Treasuries. Though they are strengthening at the moment on the fear trade, if Japan does leave the market, Treasury yields will nudge higher - and Treasury prices will fall. A safer bet is simply to park your idle cash in a money-market account since they are the first to react to any rise in interest rates.
The opportunities: The exact opposite of the risks. The Japanese economy is fundamentally flawed and the yen is ultimately a reflection of that. Plus, the government is throwing the equivalent of billions of U.S. dollars into a stabilization effort, and that will work over time to push the yen substantially lower.
The weakening yen, in turn, will benefit Japan’s exporters, who historically fare well when the yen is falling.
So, you see the yen break below 80 to the dollar and move well into the 70s, it will be time to reverse course and short the yen again. And it will be time to buy the exporters - companies like Honda, Takeda Pharmaceuticals, Komatsu and Canon.
Just look back at Kobe. After the brief period of yen strength/stock weakness, the trend reversed. The yen plunged and Japanese stocks gained 50% of the following 12 months.
Until next time, keep a global view...
Jeff Opdyke
Editor, Emerging Market Strategist