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Author Topic: Japan - How would Kyle Bass answer this...  (Read 2346 times)
Melbustus
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November 19, 2012, 05:16:45 AM
 #1

So, anyone familiar with Kyle Bass knows his position on Japan; in short, they're fully entering their endgame of a full-fledged sovereign bond crises. JGB yields will rise. The gov cannot afford even a 1% rise in rates, so when yields move at all, Japan's sleeping bond market will ignite *very* suddenly.

He makes a very solid argument, overall, and I tend to see things his way. Two extremely interesting facts appear in his latest letter to investors:
1) For the first time in 2011, sales of adult diapers in Japan exceeded sales of baby diapers. Japan has a big demographic problem.
2) The Bank of Japan is now buying fully 56% of the bonds the government issues. They are clearly willing to monetize all of it.

But, while I concur that Japan will face some sort of a crises eventually, the counter-argument that a sovereign issuing and re-paying their own debt in their own fiat currency can never experience a bond crises because they can simply monetize 100% of the debt, bears some investigation.

So here's the question:
If the BoJ is willing to simply buy every single new JGB issue, for whatever price they determine, why couldn't they just price it to leave the yield on new issues under 1% (or even at 0 exactly)...forever? Sure, there'll certainly be a Yen crises of sorts since the BoJ is simply printing exactly Japan's fiscal deficit amount in this scenario and dumping it into the economy, but that doesn't mean rates on JGBs will move, since (in this scenario) the BoJ is the ONLY player on the demand side of the new issuance.

Furthermore, if you never get big yield rises in the primary bond market, you never get the hugely non-linear feedback loop that leads to hyperinflation. Surely the above scenario leads to nasty inflation, but I don't see a bond crises as inevitable. There just wouldn't *be* any real bond market, at least not for new issues. As far as secondary market, maybe things could get interesting there, but without the gov being forced into the feedback loop via high rates on new issues, the situation is not obvious.

Kyle Bass is no fool. What am I missing in the above?

 

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November 19, 2012, 05:36:55 AM
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Isn't Japan's debt something like 230% of GDP?  Lets assume it is and like most sovreigns it is in a mixture of outstanding maturities.  Lets also assume the weighted average is 4.5 years so 18% comes due each year.  Roughly 41% of GDP comes due every year.  Japan current year deficits are 9% of GDP so to avoid rising interest rate the Central bank would need to increase the money supply by roughly 50% of GDP annually.   Now most countries have a very low velocity right now (US is ~1).  If Japan is like the rest of the world you are essentially talking about 50% increase the money supply year over year.

I would call that hyperinflation wouldn't you?
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November 19, 2012, 06:46:27 AM
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Yes, I would agree that 50%/yr increase in the money supply is hyperinflation! Yikes. If your analysis is correct, then the money supply inflation is already in excess of 25%/yr (since the BoJ is buying more than half of new JGB issues already).

So clearly the Yen is toast by that analysis... But still - BoJ *can* technically keep yields on JGBs low in this scenario. Which is only relevant to the extend that people betting against Japan are doing so via interest rate swaps (not that I know anything about such instruments beyond the fact that it's a bet on the yield movement).

But wait a sec - after 4.5yrs of this, BoJ will have monetized the entirety of their existing national debt. At that point, they will only have to continually finance the ongoing deficit with new printing... So 9%/yr instead of 50%/yr.

This amounts to more than doubling the money-base over 4.5yrs, and then increasing it at ~10%/yr forever after that.



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November 22, 2012, 05:10:36 AM
 #4

I believe Bass is betting both on interest rate rise and on currency devaluation.  I don't know which instruments he uses for this though, if somebody has the answer, feel free to share.

I think 50% inflation for several years would severely impact the psychology of the population and lead to hyperinflation.
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November 30, 2012, 11:52:00 PM
 #5

I believe Bass is betting both on interest rate rise and on currency devaluation.
...
I think 50% inflation for several years would severely impact the psychology of the population and lead to hyperinflation.


Yes, he is indeed betting on a JGB rate rise and Yen devaluation, according to his statements and investor letters. It's the interest rate rise specifically that I don't really see the mechanism for, given the extent to which the BoJ has demonstrated willingness to simply buy all the bonds.

It's inevitable that the Yen gets massively devalued. That's pretty obvious. However, I still don't clearly see how that necessarily impacts JGB rates, as stated above. What's exactly is the mechanism? Furthermore, 50% base-money inflation for a few years, *without massive bond yield spikes* could absolutely be absorbed by an economy, especially a structurally deflating economy. It's the exponential feedback loop that high bond rates create which causes true hyperinflation.

So I don't think my original question has been answered yet. What's the mechanism that's going to spike rates? What's Kyle Bass's answer to that? Again - I'm sure there's a good answer; Kyle is no slouch.

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December 01, 2012, 12:16:24 AM
 #6

I think you misunderstood my point.  The central bank CAN't print that much money, not without causing massive economic chaos.  Think about multi-year financing (like for construction).  What interest rate do you put on a 30yr mortgage when inflation could be 50% annually.  The simplistic answer is just make it a comfortable risk premium like say 5% in real terms making the rate 55%.  However 50% is just a wild ass guestimate.  What if inflation is 70% for a decade and the borrow decides to pay the note off with increasingly worthless currency they are flooded with?  Oops you (as the lender) took massive risk and lost 50% of your principal (in real terms).  The reverse is also true.  Someone with a 50% mortgage would be betting their income will be rising 50% in nominal terms.  What if the central bank tightens.  Suddenly the interest payment overwhelm the borrower.   Now apply that kind of chaos to all aspects of society from public works (can you imagine floating a muni-bond in a 50% inflation environment) to retirement (try not to outlive your savings.  You only got $20 trillion yen?  Hope you don't live too long).

Simply put no modern economy is going to function with that level of monetary expansion.


TL/DR version:
Premise 1 - Interest rates will rise unless central bank continues to ease
Premise 2 - Japan debt is so high relative to GDP and there is so little outside demand for its debt that to ease would require 50%+ annual monetary expansion
Premise 3-  The central bank will be unable to monetize all Japan's debt.

Thus rate will rise as that supply comes flooding into limited demand.  Higher rate = higher demand and an equilibrium will be reached.


Longer term I see only three possible "outs" for Japan
A) Integrate.  Ditch 5,000+ years of xenophobia, open ports to (young) immigrants in an attempt to get some meaningful gowth in real (adjusted for inflation) terms.  The bad news is old habits are hard to break.
B) Implode.  Become the Greece of Asia.  The bad news is the limited natural resources and bad demographics mean the road out is going to be bad.  Maybe they emerge as Vietnam 2.0 in three or so decades.
C) Expand.  War looked like a good idea in 1939 maybe it will again in 20x9.  Restore the pan-pacific empire via military expansion.  Natural resources, wealth, land is available for those able to take it.  The bad news is China has a four decade head start and hasn't quite forgotten the atrocities of the last world war.

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December 01, 2012, 12:55:03 AM
 #7


Yes, he is indeed betting on a JGB rate rise and Yen devaluation, according to his statements and investor letters. It's the interest rate rise specifically that I don't really see the mechanism for, given the extent to which the BoJ has demonstrated willingness to simply buy all the bonds.

It's inevitable that the Yen gets massively devalued. That's pretty obvious. However, I still don't clearly see how that necessarily impacts JGB rates, as stated above. What's exactly is the mechanism? Furthermore, 50% base-money inflation for a few years, *without massive bond yield spikes* could absolutely be absorbed by an economy, especially a structurally deflating economy. It's the exponential feedback loop that high bond rates create which causes true hyperinflation.

So I don't think my original question has been answered yet. What's the mechanism that's going to spike rates? What's Kyle Bass's answer to that? Again - I'm sure there's a good answer; Kyle is no slouch.

You are right that the BoJ could buy up all bonds, and interest rates would not be affected, so it does not necessarily impact the JGB rates.  But then the BoJ would have to print up a lot more base money to buy these newly issued bonds.
I don't know the numbers, but as japan has been deflating for many years now, I would guess that corporate and household debt is low compared to base money.  While you can keep inflating money, you can't keep deflating the money supply. If all loans are paid off or defaulted on, you just get the base money (correct me if I am wrong).  
Therefore, I think it is a reasonable assumption to make that if the BoJ keeps printing large amounts of money, this base money inflation will translate into higher price inflation (once monetary inflation forces overcome balance sheet reduction deflationary forces).
If interest rates are kept constant, this will make JGBs terrible investments (little yield in an inflationary environment), so the public will sell them, and the BoJ will have to buy all of it up.  This would increase money supply drastically.  I had a quick look at the numbers, and if I am using the correct ones, this would add roughly 500% to the monetary base.  Hyperinflation much?

This could happen.  Alternatively, if the BoJ feels that inflation is getting out of control, they could let interest rates rise, which would however bankrupt the government.  So (unless they grow out of their problems), either they will hyperinflate their currency, or they will default on their bonds.  Bass is taking both bets (so he is betting against them growing out of their problems, or against them maintaining the status quo for a prolonged period).
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December 01, 2012, 01:22:16 AM
 #8

...

If interest rates are kept constant, this will make JGBs terrible investments (little yield in an inflationary environment), so the public will sell them, and the BoJ will have to buy all of it up.  This would increase money supply drastically.  I had a quick look at the numbers, and if I am using the correct ones, this would add roughly 500% to the monetary base.  Hyperinflation much?

This could happen.  Alternatively, if the BoJ feels that inflation is getting out of control, they could let interest rates rise, which would however bankrupt the government.  So (unless they grow out of their problems), either they will hyperinflate their currency, or they will default on their bonds.  Bass is taking both bets (so he is betting against them growing out of their problems, or against them maintaining the status quo for a prolonged period).


Yes, agreed that they'll have to end up jacking up the money supply by about 500%. But my point is that if they do that without letting bond rates float, there'll be no feedback-loop that requires exponential printing; instead, a period of high linear printing is required. Yes, 500% money supply inflation is horrible, but doing so over a number of years, and then following up with 10%/yr to cover ongoing deficits is not hyperinflation. So the Yen will depreciate A LOT, but not like the disaster scenario many are predicting. And I still don't see any mechanism for JGB yield increases assuming the BoJ is committed to large-inflation (which it has to be, and has indicated strongly with their dozen rounds of QE over the last decade).

So the question still stands: Why is Bass betting on higher rates? What does he think the mechanism is? I do not think he thinks the BoJ will fail to buy the debt. In his own investor letter he points out that the BoJ is currently buying 56% of new issues. So it's clear to him they're willing to be the entire market...

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December 01, 2012, 02:24:41 AM
 #9

I think you misunderstood my point.  The central bank CAN't print that much money, not without causing massive economic chaos.  Think about multi-year financing (like for construction).  What interest rate do you put on a 30yr mortgage when inflation could be 50% annually.  The simplistic answer is just make it a comfortable risk premium like say 5% in real terms making the rate 55%.  However 50% is just a wild ass guestimate.  What if inflation is 70% for a decade and the borrow decides to pay the note off with increasingly worthless currency they are flooded with?  Oops you (as the lender) took massive risk and lost 50% of your principal (in real terms).  The reverse is also true.  Someone with a 50% mortgage would be betting their income will be rising 50% in nominal terms.  What if the central bank tightens.  Suddenly the interest payment overwhelm the borrower.   Now apply that kind of chaos to all aspects of society from public works (can you imagine floating a muni-bond in a 50% inflation environment) to retirement (try not to outlive your savings.  You only got $20 trillion yen?  Hope you don't live too long).

Simply put no modern economy is going to function with that level of monetary expansion.


TL/DR version:
Premise 1 - Interest rates will rise unless central bank continues to ease
Premise 2 - Japan debt is so high relative to GDP and there is so little outside demand for its debt that to ease would require 50%+ annual monetary expansion
Premise 3-  The central bank will be unable to monetize all Japan's debt.

Thus rate will rise as that supply comes flooding into limited demand.  Higher rate = higher demand and an equilibrium will be reached.


Longer term I see only three possible "outs" for Japan
A) Integrate.  Ditch 5,000+ years of xenophobia, open ports to (young) immigrants in an attempt to get some meaningful gowth in real (adjusted for inflation) terms.  The bad news is old habits are hard to break.
B) Implode.  Become the Greece of Asia.  The bad news is the limited natural resources and bad demographics mean the road out is going to be bad.  Maybe they emerge as Vietnam 2.0 in three or so decades.
C) Expand.  War looked like a good idea in 1939 maybe it will again in 20x9.  Restore the pan-pacific empire via military expansion.  Natural resources, wealth, land is available for those able to take it.  The bad news is China has a four decade head start and hasn't quite forgotten the atrocities of the last world war.




I generally agree with your analysis, except that the 50% inflation (if it came to that - they may be able to roll everything over into new money more gradually) would only necessarily last 4.5yrs (by your estimation of avg maturity on existing debt). After that, they need to print 10%/yr to finance ongoing deficits, and would have a national debt of 0.

So, my key point, is that without the exponential feedback loop of high interest rates, the necessary amount of printing is credibly limited. Sure, 50%/yr is awful, even for a few years. But in a deflating economy, that could be more easily absorbed without tremendous dislocation. Heck, didn't the Fed increase their balance sheet by $2.7T over the course of a few months? That's at least 20% of our money base at the time...

So, this would yield a fourth out for Japan:
D) Perpetual Stagflation. Inflation of 10-15% for decades. Small to zero growth as the population dynamics get worse for a few decades.

Again, am I missing an interest rate mechanism?

And even if I'm wrong that case D is possible, they *have* to try it. The other "outs" are worse (except for A, but that's a tough one for a lot of reasons).

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December 01, 2012, 05:38:51 AM
 #10

Yes, agreed that they'll have to end up jacking up the money supply by about 500%. But my point is that if they do that without letting bond rates float, there'll be no feedback-loop that requires exponential printing; instead, a period of high linear printing is required. Yes, 500% money supply inflation is horrible, but doing so over a number of years, and then following up with 10%/yr to cover ongoing deficits is not hyperinflation. So the Yen will depreciate A LOT, but not like the disaster scenario many are predicting. And I still don't see any mechanism for JGB yield increases assuming the BoJ is committed to large-inflation (which it has to be, and has indicated strongly with their dozen rounds of QE over the last decade).

Maybe you are right, maybe they will just have big inflation for a number of years.
On the other hand, no government ever choses hyperinflation, it's just that when inflation gets too bad, people start to inform themselves and realise the shaky belief-basis that fiat currency value relies on.  If enough people decide they don't want that risk and get rid of their cash as soon as they can, you have hyperinflation, no matter what central banks decide.

So the question still stands: Why is Bass betting on higher rates? What does he think the mechanism is? I do not think he thinks the BoJ will fail to buy the debt. In his own investor letter he points out that the BoJ is currently buying 56% of new issues. So it's clear to him they're willing to be the entire market...

Consider it a hedge against the Yen depreciation trade.
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December 01, 2012, 07:02:26 AM
 #11


Maybe you are right, maybe they will just have big inflation for a number of years.
On the other hand, no government ever choses hyperinflation...


No government that owes debt in its own currency has ever hyper-inflated, either....because they can always keep rates down; eg, no exponential feedback loop.


So the question still stands: Why is Bass betting on higher rates? What does he think the mechanism is? I do not think he thinks the BoJ will fail to buy the debt. In his own investor letter he points out that the BoJ is currently buying 56% of new issues. So it's clear to him they're willing to be the entire market...

Consider it a hedge against the Yen depreciation trade.

That wouldn't be a hedge; I think you meant something along the lines of "Consider it another way to get profitable exposure to a collapse in Japan". In that case, perhaps... Though I would still fully expect him to have a viable answer as to the exact mechanism that he sees potentially triggering a substantial rise in yields. From what I can tell, he always fully connects the dots in his thinking.

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December 01, 2012, 02:42:33 PM
Last edit: December 04, 2012, 08:20:56 PM by Spaceman_Spiff
 #12

No government that owes debt in its own currency has ever hyper-inflated, either....because they can always keep rates down; eg, no exponential feedback loop.

Bernanke also said that US housing never went down on a nation-wide basis, look how that turned out...  Your argument is more rational however, as it excludes a mechanism (and relies on the history of all countries, instead of one), but I still do not see it as a foolproof protection against hyperinflation.  If enough people lose confidence, money velocity will keep accelerating, and you'll have hyperinflation.  

Consider it a hedge against the Yen depreciation trade.

That wouldn't be a hedge; I think you meant something along the lines of "Consider it another way to get profitable exposure to a collapse in Japan". In that case, perhaps...

Yes, that was what I meant.
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