Is a Japanese banking crisis on the way?

[ChpBstrd]

Japanese bond yields have soared, as "bond vigilantes" have gone on strike. Japanese 30y bonds have gained about a full one percent of yield since the start of this year. Their 40 year bonds have gone up about 1.5%. I can't help but to think this looks a lot like what happened in the US in 2022-2023, which eventually culminated in a small banking crisis and deposit flight. Bond convexity when coming off of very low yields is extreme.



Article: https://www.marketwatch.com/story/bond-vigilantes-are-sending-warnings-globally-what-does-that-mean-for-your-portfolio-545944c3?mod=home_lead

It's fair to ask where the investment flows are going. European stocks (Germany, France, Spain, Italy) are having a moment in the spotlight, as Euro rates are cut, but these don't seem to be alternatives to Japanese bonds. In the bond world, yields of Brazil, Mexico, India, and South Korea have fallen YTD, so they are suspects. Their debt-GDP ratios are 87%, 50%, 82%, and 52%, respectively, compared to 255% for Japan. One also has to wonder if yields in the US (debt/GDP=122%) would be much higher if not for reduced demand for Japanese bonds and the expectation of rate cuts later this year that could make US treasuries bought today go up in value.

In a world of tariff-siloed economies, maybe heavily-indebted, mercantilist Japan doesn't look as much like a safe haven. Mexico and SK have low debt-to-GDP. Meanwhile, Brazil and India are about to launch BRICSpay to divorce themselves from dependency on USD-denominated international systems and presumably reduce their odds of being squeezed by events in that sphere.

The Japanese carry trade, where yen are borrowed, sold for USD, and invested in treasuries at higher interest rates than the loans, may have run low on lenders willing to loan at low rates against increasingly-risky US treasuries.

Moods could shift about the probability of US rate cuts if tariffs raise inflation and extend the FOMC's pause on rate cuts. Imports are about 14% of US GDP, so if those costs go up an average of, say, 10%, then that's roughly a +1.4% increase in spending/costs, not accounting for retail markups on the higher amounts. Plug in your own numbers and do your own calculations, but it seems CPI in the 3rd and 4th quarters will be zooming up above 3% unless there is a complete policy reversal. Recessionary conditions by then seem unlikely, so will the FOMC vote to cut rates in the face of rising inflation?

While we speculate, Japanese stocks look like maybe they shouldn't be up +7.63% over the past month. An EWJ put or bear spread is interesting at the moment, on the thesis that banking issues might be about to erupt.

[vand]

Yes.

It's almost as if lending money to a country with 260% debt to GDP and a rapidly collapsing demographic base is becoming a less than stellar proposition.

[reeshau]

Yes.

It's almost as if lending money to a country with 260% debt to GDP and a rapidly collapsing demographic base is becoming a less than stellar proposition.

Yes, a great deal of my hope that the US will wake up to its situation is that Japan will likely be the first lemming over the cliff.  I don't wish that kind of economic trouble on anyone, but there are a host of countries who might take their situation to heart.

[ChpBstrd]

Yes.

It's almost as if lending money to a country with 260% debt to GDP and a rapidly collapsing demographic base is becoming a less than stellar proposition.

Yes, a great deal of my hope that the US will wake up to its situation is that Japan will likely be the first lemming over the cliff.  I don't wish that kind of economic trouble on anyone, but there are a host of countries who might take their situation to heart.

I don't think demographics suddenly sunk Japanese bonds. The fact that exports comprise 21.8% of their GDP and evidence that the world is moving toward protectionism and siloed economies is sinking Japan.

Without the carry trade to make the yen attractive, the BOJ will need to keep rates higher than in the past. Those higher rates will hit GDP at the same time tariffs reduce demand for Japanese exports. And as we've experienced in the US, raising rates on oneself greatly increases the burden of having a national debt. 2x that for Japan.

So investors are looking at a different type of convexity: How badly does the debt/GDP ratio go up if Japan's export-heavy GDP shrinks at the same time their interest costs go up?

[habanero]

30y japanese govvies fx hedged to USD offers a yield of around 7.2-7.3%, so a pickup of over 200 bps over 30y USTs so quite juicy for non-japanese investors (FX hedged on a 3m month basis, that is, not until maturity)

[MustacheAndaHalf]

We should be extremely worried about Japan's debt to GDP ratio of 195%.  Oh, wait - that a decade ago, in 2015.  Point being Japan's debt has been very high for some time, and is not a recent situation.
https://www.macrotrends.net/global-metrics/countries/jpn/japan/debt-to-gdp-ratio

I heard that Japan's government owns most of their debt.  There's probably some corrupt self-dealing there, with the government setting lower yields so it doesn't have to make larger payments.  I've also heard that Japanese tend to have multicurrency accounts, and move their yen into other currencies that pay better yields.  An odd situation, but it seems to work for Japan.

In 2020, Japan's debt went from 198% of GDP to 216%.  Covid stress tested their borrowing, and no banking crisis occurred.  Are there specific indicators that this time Japan has a more serious problem than during Covid?

[habanero]

We should be extremely worried about Japan's debt to GDP ratio of 195%.  Oh, wait - that a decade ago, in 2015.  Point being Japan's debt has been very high for some time, and is not a recent situation.
https://www.macrotrends.net/global-metrics/countries/jpn/japan/debt-to-gdp-ratio

I heard that Japan's government owns most of their debt.  There's probably some corrupt self-dealing there, with the government setting lower yields so it doesn't have to make larger payments.  I've also heard that Japanese tend to have multicurrency accounts, and move their yen into other currencies that pay better yields.  An odd situation, but it seems to work for Japan.

In 2020, Japan's debt went from 198% of GDP to 216%.  Covid stress tested their borrowing, and no banking crisis occurred.  Are there specific indicators that this time Japan has a more serious problem than during Covid?

The list of hedge funds and ohers who have tried shorting japanese goverment bonds over the last decade is apparantly endless. At least its worked now for those who came late to the game. The japanese central bank bought up a lot of the government debt (aka QE), almost half the debt outstanding is owned by Bank of Japan. Historically at least, japanese government debt has been largly a domestic affair - its been common for reatil investors to buy bonds as an integral part of their savings so there has been good demand regardless of yield levels over the years so th bond market has to a large extent been sheltered from whats going on in the world markets and yields have stayed stubboringly low until recently.

As a fun fact I remember reading a comment from a JGB trader some years ago that during a whole trading day the benchmark 10y bond did not trade a single time in the interbank market;)

[BicycleB]

Very interesting discussion!

I'm aware of Japan's low interest bonds supported by traditions and systems within the country, for decades - but not familiar with recent changes, or competent to evaluate default risk. It seems like a structure with its own character, that will either stand or collapse.

I hope for the Japanese people's sake that it stands!

At some point, to me it seems like an automaker (maybe Mitsubishi) will sink from Chinese competition and Japan's failure to build EVs, causing a new problem for the Japanese economy. And of course, though demographic change is slow, its pressure is indeed building. So who knows?

[sonofsven]

Very interesting discussion!

I'm aware of Japan's low interest bonds supported by traditions and systems within the country, for decades - but not familiar with recent changes, or competent to evaluate default risk. It seems like a structure with its own character, that will either stand or collapse.

I hope for the Japanese people's sake that it stands!

At some point, to me it seems like an automaker (maybe Mitsubishi) will sink from Chinese competition and Japan's failure to build EVs, causing a new problem for the Japanese economy. And of course, though demographic change is slow, its pressure is indeed building. So who knows?

Speaking of demographics, I saw videos recently of Australians who were priced out of the AUS  housing market and were buying inexpensive abandoned houses in Japan ("Akiya"), and fixing them up.
Doubt it's enough to stem the generational tide, but it's a start.

[ChpBstrd]

In 2020, Japan's debt went from 198% of GDP to 216%.  Covid stress tested their borrowing, and no banking crisis occurred.  Are there specific indicators that this time Japan has a more serious problem than during Covid?

Good question. Where's the red line where everything starts breaking down? Japan's debt-to-GDP keeps rising, and if it continues there will eventually/someday be a spike in yields and downgrades. I can't say where that line is, but I know it is somewhere and I know Japan is close to it. These things tend to unravel quickly rather than showing early signs. See the UK, 2022.


The thing which changed recently is a sudden uptick in interest rates. Four years ago, banks were accepting 0.9% from Japanese 10y treasuries. Today the yield is 1.52% and rising fast. That may not sound like much, but bond convexity is a beast. According to an online calculator, a 1,000 yen (I know that's less than the price of french fries, just picking an even number for illustration) 10-year bond bought at 0.9% coupon is only worth 964.69 if four years have past and rates have increased to 1.52%.

That 3.5% loss is not what concerns me. I'm wondering if Japanese 10y yields are heading toward and beyond 5%, more in line with the U.S. That would definitely sink some banks. How do we know? Because the exact same thing happened in the U.S. three years ago and it sank some banks.

In that 5% scenario, if it occurs by next year, the now-5-year bonds with a 0.9% coupon would be worth 820.92, a loss of -17.9%.

And this illustration using 10-year bonds from four years ago doesn't even address all the 20 year and 30 year bonds which were sold to banks back then. If a 30y bond sold in mid-2021 with a yield of 0.67% suddenly entered an environment where the rate was 3% - like it is now - that bond would be worth 651.62, a loss of 34.8%. If the 30y rate hits 5%, it will have lost more than half its market value.

More importantly, if such a thing happened, it would strain the ability of Japan to pay interest on such a huge debt without running the money printer. Thus, higher rates justify even higher rates because the risk keeps accumulating in a vicious spiral. To me, it seems like all the prerequisites are in place for such an event to happen. The reduction in international trade due to tariffs could lead to flight from the yen or lower liquidity for Japanese government bonds, setting off the dynamite.

[MustacheAndaHalf]

In 2020, Japan's debt went from 198% of GDP to 216%.  Covid stress tested their borrowing, and no banking crisis occurred.  Are there specific indicators that this time Japan has a more serious problem than during Covid?

Good question. Where's the red line where everything starts breaking down? Japan's debt-to-GDP keeps rising, and if it continues there will eventually/someday be a spike in yields and downgrades. I can't say where that line is, but I know it is somewhere and I know Japan is close to it.
...
That 3.5% loss is not what concerns me. I'm wondering if Japanese 10y yields are heading toward and beyond 5%, more in line with the U.S. That would definitely sink some banks. How do we know? Because the exact same thing happened in the U.S. three years ago and it sank some banks.

In that 5% scenario, if it occurs by next year, the now-5-year bonds with a 0.9% coupon would be worth 820.92, a loss of -17.9%.

Excess stimulus for Covid-19 lead to 2022 inflation spiking to 9%, which caught the Fed off guard ("transitory"), and resulted in rapid increases in bond yields (via the Fed raising the Fed funds rate).  This resulted in one bank, Silicon Valley bank, to be found insolvent by the FDIC.  It was insolvent on a Thursday, and by the following Monday, its doors were reopened with FDIC money backing its assets.  I think fears of contagion were widespread then, but the "crisis" meant the FDIC bought $20 billion in treasuries and held them, making the bank's customers whole.  No losses, except for the government holding lower yielding bonds to maturity.
https://thehill.com/business/3920600-fdic-spent-20-billion-to-handle-silicon-valley-bank-collapse/

For the past two months (Mar/Apr), Japan's inflation rate has been 3.6%.  if that can break Japan's banking system, why didn't it happen in January (4.0%) or February (3.7%)?
https://tradingeconomics.com/japan/inflation-cpi

Not only was 2022 not a banking crisis, but Japan's inflation isn't comparable to that of the U.S. in 2022.  I doubt 3.6% inflation for 5 months triggers a crisis in Japan.

[vand]

Inflation is currently 3.6% in Japan.

If they though deflation was undesirable wait until they get a load of the alternative.

[41_swish]

How can Japan have such an insane debt to GDP ratio? I know the U.S.'s is bad, but that one seems insane.

[tooqk4u22]

Japan's net debt is closer to 155% and part of the reason its gross debt has risen so much is due to floating bonds to cover its version of social security obligations without depleting the funds in reserve, which are invested in higher risk assets other than Japan's debt.   

The rest is simply due to zero growth economy for what is basically forever combined with a rapidly aging population (30% over 65 and increasing), below replacement birthrate and no immigration.   

Not unlike the US, 125% debt to GDP, 78% net debt to GDP but the US has benefited from above average growth and TBD on other variables (18% of population over 65 and increasing), below replacement birthrate, and immigration was an offset (until it wasn't recently)

The US has a similar trajectory but has a larger and more diversified economy, it can also flip a switch and increase immigration which has an additional benefit of increasing the birth rate.   Middle income people with all their trappings and need for two jobs and childcare make having children too expensive and less desirable. 

Bottom line, Japan needs to increase economic activity, births and/or immigration.   

This really is a problem in most developed countries.

[reeshau]

Like I said above, they are the first lemming to go over the cliff.  They are the worst in all the metrics people are worried about in their own countries.  Maybe Japan Inc. will find a way out of it.  But their issues are cultural ones as much as structural ones, and unlikely to change.