The surprise victory of Sanae Takaichi as the new leader of the Japan LDP, which will allow her to become the next Prime Minister of Japan, has been welcomed by stock traders with such a loud cheer of joy that overheated Japan stocks marked one of the biggest daily jumps in Japan indexes in recent years on Monday. Not surprisingly, the reaction of FX and government bond traders was the complete opposite with the JPY immediately racing lower, and now trading already at ~152.50 against the USD, while JGB yields spiked with the 30 years trading almost at ~3.40% – not only an all-time high level, but a level no one but few (like myself) could hardly imagine it could be achieved until not long ago.
Why wasn’t this market reaction a surprise at all? Sanae Takaichi promised to revive Abenomics with high fiscal spending, cheap borrowing, tax cuts, and direct cash payments to households during her electoral campaign. In a nutshell, she “bought” support promising free money left, right, and center. The small problem is that Japan cannot afford to resume a helicopter money type of policy when the only way to pay for it is for the Bank of Japan to continue monetizing its ballooning public debt, already the highest in the world compared to Japan’s GDP (even beyond Venezuela).
The current situation Japan is going through is not very different from what happened 3 years ago in the UK when Liz Truss became, very briefly, the country’s Prime Minister. This was her economic agenda at that time:
- Implement immediate tax cuts, including scrapping the planned corporation tax rise (from 19% to 25%) and reversing the National Insurance increase.
- Introduce a “mini-budget” to boost growth through deregulation and supply-side reforms, rejecting “orthodox” fiscal caution.
- Address the cost-of-living crisis with temporary relief measures, like suspending green energy levies on bills.
- Tackle soaring energy bills by supporting domestic energy production, including lifting the moratorium on fracking.
- Provide immediate relief for households struggling with rising costs (though details were vague beyond tax cuts).
However, unlike Japan stocks, UK equities weren’t so buoyant when Liz Truss became Prime Minister, and as soon as her agenda started to make its way through parliament, stocks started tanking. What was the trigger of the turmoil? UK Government bond traders reacted to her economic policies that would have caused a sharp increase in UK debt and public deficits by dumping bonds and sending yields sharply higher. Ultimately, this triggered a chain reaction of margin calls and liquidations of leveraged positions in UK pension firms and insurances that required a Bank of England bailout (“Bank of England says pension funds were hours from disaster before it intervened“).
On Tuesday, Japan was very close to such a situation where long-term yields were about to skyrocket out of control, but the BOJ did not wait to intervene to calm the situation. While JGB 30y yields were trading at 3.38% in the market, the Japanese government auctioned 30y government bonds that cleared at 3.248% compared to 3.264% of the previous auction. This is a massive gap and the only way for this to happen, an incredible market distortion, was the BOJ buying 100% of all new bonds being auctioned. In order to achieve this, the BOJ had to print JPY out of thin air, with the currency quickly losing 2 big figures in the market against other major currencies. Unlike the Liz Truss case, here we see the BOJ intervening in the market even before Takaichi officially becomes Prime Minister. Needless to say, this is quite a bad omen.
Back in 2022, Liz Truss’s government barely lasted a month, less than a head of lettuce, an English tabloid set her government against (The Lettuce Outlasts Liz Truss). How long can Sanae Takaichi last when the Japanese market is already wobbling so much?
If once in charge of the government, she U-turns on all her promises that required a rumbling printing press to be financed, then we are back to the situation that has proven daunting for her predecessor, Ishiba. In this case, Japan’s stocks will crash since free money won’t be expected to flood the markets anymore. If, once in charge, she keeps her promises, it will be very hard for the BOJ to hold markets together. Even if the BOJ keeps implementing Yield Curve Control as it is already doing, without admitting it officially, though, the JPY will quickly depreciate towards 160 against the USD, and that’s the area where an outright FX intervention in the markets will be needed. That will set Japan markets in the exact same situation of 2024 that preceded the stocks flash crash on Monday, the 5th of August, and that I correctly anticipated the week before in “A TRAVELER GUIDE TO NAVIGATE THE BANK OF JAPAN MESS” and “IN JAPAN IT WILL BE A MESSY MONDAY, BUT NOT A BLACK ONE (YET)“. Outright interventions in the FX market can be very dangerous because they create a significant shift from equilibrium; if not handled carefully, they can trigger a domino effect similar to what happened one year ago when the global JPY carry trade was about to implode. Furthermore, as I explained long ago in “A PEEK INTO THE FUTURE: USD/JPY ROAD TO 300“, these interventions can only achieve short-term relief while worsening the situation in the medium and long term. In a nutshell, when the value of JPY isn’t longer justified by the strength of its economy but by the total amount of its foreign reserves, trimming the value of its foreign reserves while the JPY printing press keeps rumbling will ultimately push the JPY to devalue no matter what. This is basic math: in the numerator, we have the total Japanese money supply circulating, while in the denominator, we have the fixed amount of total foreign reserves. Consequently, if the numerator continues to rise while the denominator remains stable, or decreases in case of outright selling of reserves in the open market, ultimately the JPY FX is forced to devalue.
Because the JPY carry trade is critical to the global financial system, similar to what happened one year ago, other Central Banks will surely support the BOJ and coordinate to devalue their currency. For example, the BOE injected more than GBP 80 billion of liquidity in the market through short-term repo operations since the 5th of August last year, while in the US, the “cash on the sidelines” represented by the amount of FED Reverse Repurchase Agreements has been drained all the way down to only ~USD 4.6 billion now left.
But once again, this short-term relief caused by forcing a market distortion will ultimately compound the problems in the medium and long term.
What we can surely conclude until now is that Japan’s stocks’ bullish reaction was totally wrong. Takaichi won’t be able to print vast amounts of money as she promised if she wants to remain in charge, and if she sticks to her promises, it won’t take long for markets to start “punishing” her, similar to what they did with Liz Truss 3 years ago. In any case, as I have been warning for such a long time, Japan’s fate is sealed, and there is no other way out but to implement draconian restructuring policies to take it out of the hole it is currently stuck in and sinking deeper and deeper into. So far, there is no politician willing to do so, but Japanese people won’t be able to endure this insane situation for much longer since inflation is raging and the purchasing power of their ample cash savings in JPY is evaporating at an appalling speed. Sooner or later, the pain is going to be too much to endure, and people will have to come to terms with the fact that the can cannot be kicked down the road any further, and it will become critical to save the whole future of the Japanese economic system.
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