Japan is one of the hottest trades in the world right now.
We hear it over and over from Wall Street strategists: Investors are betting that the yen, which has dropped 17.5 per cent against the U.S. dollar just since September – still has plenty of room to run.
Photo: Bloomberg, Business Insider
The consensus view among economists and analysts is that a weaker yen, driven by recently-elected Prime Minister Shinzo Abe’s stimulative fiscal and monetary policies, will be great for the Japanese economy. They represent a fighting chance to overcome deflation for the first time in a long time.
Ryutaro Kono, the top Japan economist at BNP Paribas, takes a decidedly different view on “Abenomics,” as these new policies have been dubbed.
Kono writes in a note to clients, “Fiscal expansion only boosts growth while it is happening. When its effects fade, what remains is likely to be a sluggish economy with high inflation, coupled with public debt so swollen that the probability of a fiscal crisis soars.”
Here is the roadmap to how “Abenomics” in 2013 translates to fiscal crisis in 2015, according to Kono (emphasis added):
Democratic societies tend to want quick results, but there is no formula for and instant boost to trend growth. Lacking the patience for structural reform, economies can become dependent on near-sighted policies. Because of this political-economic reality, we think monetisation will be the choice of the Japanese government and are making it our base-case scenario.
We have, therefore, adjusted our forecasts. In addition to the large fiscal stimulus package just announced (2% of GDP), we expect the government to implement stimulus measures of a similar magnitude in Q1 2014 and again in Q2 2015. Based on this assumption, we have revised our growth forecasts to 0.8% in 2013 (0.2% previously), 1.0% in 2014 (0.0%) and 1.1% in 2015, meaning that the economy will continue to outperform its trend growth rate (roughly 0.25%). While the nominal growth rate will also rise, the BoJ’s easing should ensure that the long-term interest rate only sees mild increases in 2013 and 2014. Because of this, risk-asset prices will likely continue to rally. The economy, in other words, will take on bubble-like aspects.
With the frictional unemployment rate at around 3.5% and the current unemployment rate at 4.2%, there is actually not much slack left in the economy. Based on our new growth forecast, the year-end jobless rate is set to hit 3.7% in 2013, 3.6% in 2014 and 3.4% in 2015. Because of entrenched deflationary expectations, there will probably be only limited rise in inflation initially, despite a narrowing output gap. But we expect inflation to start to pick up once the economy reaches full employment in H2 2015. Consequently, our year-end inflation forecasts (excluding impact of consumption-tax hikes) are 0.4% in 2013, 0.8% in 2014 and 1.6% in 2015.
Upward pressure on long-term rates should also intensify alongside accelerating inflation. However, at this juncture, the BoJ would probably not be able to tighten policy, because it would be concerned about the possibility of causing a bond-market crash that could lead to financial instability (given the huge volume of JGBs held by domestic financial institutions). When the central bank becomes deeply incorporated into the government’s debt management, price stability is sacrificed for the sake of financial-system stability. But the BoJ won’t be able to neutralise this upward pressure for long, and the long-term interest rate should also start to climb in the latter part of 2015, increasing the risk of a fiscal crisis. Our year-end forecasts for the 10-year bond yield are 1.20% in 2013, 1.60% in 2014 and 2.90% in 2015.
In other words, Kono is now forecasting that Japanese government bond yields will soar in 2015. Given their steady march lower in recent years, that would certainly be a twist.