The ‘third' rail runs alongside train tracks to provide electric power. In the UK it carries 750 volts which, combined with a high current, is enough to kill you should you touch it. In political parlance, ‘touching the third rail' occurs when a politician grapples with an issue so charged and intractable that no matter their good intentions, it results in their immediate immolation, says Chris Clothier, manager of CG Asset Management's Real Return Fund.
For the last 30 years or so finance has had its own third rail; shorting Japanese Government Bonds (JGBs). Each generation of macro-investors has been tempted into the trade and each received, if not actual death, then certainly a nasty shock. Investors are, once again, convinced that this time is different. Unusually for us, we think they are probably right.
Japan has a long history of quantitative easing, dating back to 2001. The program was, by contemporary standards, pretty modest until 2012 when it began rapidly accelerating. The Bank of Japan's (BoJ) balance sheet grew from 30% of GDP in 2011 to around 130% today.
In 2016 the BoJ introduced yield curve control (YCC) which set short term interest rates at -0.1% and 10-year yields at around 0%. At the time they wrote that the bank would "continue expanding the monetary base until the year-on-year (YoY) rate of increase in the observed CPI […] exceeds the price stability target of 2 percent and stays above the target in a stable manner".
Fast forward to today, YoY inflation in Japan is 4.3% and the Japanese Trade Union Confederation is asking for a 5% increase in wages from this year's Shuntō (union-employer wage negotiations), the highest since 1995. Fast Retailing, the parent company of fashion retailer Uniqlo has said it will increase starting graduate salaries by 18% and those of store managers by 36%.
Against this backdrop it seems that the requirements for abandoning YCC will be met. Sure enough, the BoJ shocked markets in December by shifting the upper bound from 25bps to 50bps for 10-year bonds.
Sensing blood, the market has begun to aggressively challenge the BoJ. Over a 3-day period in December the BoJ spent over JPY12 tn (c.£ 75 bn) in an attempt to cap yields. If the BoJ carried on this rate of purchases it would increase its holdings of JGBs by 160% of GDP within 12 months!
Examples of stress in the rates market abound. The yield curve has a pronounced kink as yields have risen significantly either side of the 10-year mark. 10-year interest rate swaps, having moved in lockstep with government bonds over 2021, are now about 50bps higher than bond yields.
In its January meeting the BoJ has reaffirmed commitment to YCC. Nevertheless, it seems likely that the BoJ will eventually abandon it: either because it concludes that it has met its policy objectives; or under pressure from financial markets. What will be the consequences?
The most obvious channel is the currency markets. Since its nadir in October, the Yen has appreciated 10% against the dollar. It could have much further to go. The Yen is still startlingly cheap. We understand that wages are higher for Chinese manufacturing workers than Japanese in some areas and it is cheaper to hire a junior software engineer in Tokyo than Vietnam. On some PPP measures, the Yen is still 50% below its fair value against the dollar.
A change of policy would cause Japanese government bond values to fall, however we judge the risks to index linked government bonds to be acceptable, given that break-evens are less than 1%. Taken as a whole - currency attractions but bond risks - we are comfortable holding 6.5% of our portfolio in Japanese index linked.
Perhaps the greater risk to investors of a change in the stance of the BoJ lies outside Japan. Japan has a huge stock of savings. Faced with nugatory returns at home, Japanese investors have invested heavily overseas.
Also, the Yen is probably the largest funding currency for carry trades: borrowing cheaply in one currency and investing the proceeds in a higher yielding currency. Rising Japanese rates could cause a huge repatriation of capital to Japan sending shocks through global equity and bond markets.
By Chris Clothier, manager of CG Asset Management's Real Return Fund.
