Japan’s ‘Frankenstein’ Turns On The No. 3 Economy

Who knew global investors were this easy? Even Bank of Japan Governor Haruhiko Kuroda must be asking as markets bet he’s suddenly becoming Tokyo’s version of Jerome Powell.

All Kuroda did, after all, was make the tiniest of gestures he possibly could on the BOJ’s ultraloose policies. His team shifted its yield curve stance to allow 10-year bond yields to rise to around 0.5%, double the previous upper limit.

What hasn’t changed in Tokyo, though, are the underlying economic conditions which don’t scream “raise rates, please!” Wages continue to flatline even as Japan imports the fastest inflation in 40 years. Japan’s export-reliant model is predicated on a stimulus exchange rate. So the idea that the BOJ is going to be tightening anytime soon, or even “tapering” in a significant way, ignores the bigger picture.

And then there’s Tokyo’s “Frankenstein” problem.

The monster now turning on the third-biggest economy is actually 23 years in the making. It started with the BOJ’s 1999 decision to slash interest rates to zero. It staggered forward in the 2000-2001 period when the BOJ pioneered quantitative easing.

For the next 21 years or so, a succession of BOJ leaders managed to keep a tight leash on the beast created in its monetary laboratory. Then something changed in 2021, as Federal Reserve officials in Washington began hiking rates.

The dollar’s relentless rally was a game-changer. The widening gap with the U.S. and Japan sent the yen 30% lower in a matter of weeks. It was a moment where the BOJ lost all control.

That can be seen in how quickly the yen’s plunge had economists like Jim O’Neill, formerly of Goldman Sachs, warning the move could trigger another 1997-like Asian financial crisis. O’Neill said that if the yen kept falling, Beijing “will see this as an unfair competitive advantage so the parallels to the Asian financial crisis are perfectly obvious. China would not want this devaluing of currencies to threaten their economy.”

Now, the BOJ is losing control in the other direction. In recent weeks, the Japanese government bond market showed grave signs of stress as traders tested the BOJ’s tolerance for higher borrowing costs. With the Fed engaged in its most aggressive tightening cycle since the 1990s, traders are understandably testing the BOJ’s resolve.

Kuroda’s team called their bluff this week. But only just barely. The thing about widening the range of BOJ policy moves is that Kuroda’s team could just as easily think it has greater latitude to ease. Opening the monetary spigot further is equally as plausible as the BOJ tapering in the months ahead if Tokyo’s Frankenstein has anything to say about it.

The problem is the linchpin role Japanese government bonds play in the economy. They are the main assets held by banks, exporters, local governments, pension and insurance funds, universities, endowments, universities, the sprawling postal system and rapidly growing ranks of retirees. This creates something of a “mutually assured destruction” dynamic that dissuades virtually anyone from selling debt.

The closer JGB yields get to 1% and above, the more virtually every one of Japan’s 126 million people get hurt. The closer yields get toward 2%, the more difficulty Tokyo will have controlling the developed world’s most indebted economy, with a debt burden of as much as 265% of gross domestic product by some measures. Along with acting as a powerful headwind for the economy in 2023 and beyond, that pressure will lead to a whole-of-government shakeup in terms of big-picture strategy.

For decades, shorting JGBs, along with betting on a break in the Hong Kong dollar peg, has been the ultimate “widowmaker” trade. Hedge fund after hedge fund tried and failed. Now, though, the gap between U.S. and Japanese yields has speculators wondering if the pressure cooker dynamic in Tokyo’s debt market is about to go awry.

A collapse in the JGB market would shoulder check world markets. It would be the last thing a China struggling to revive growth and a U.S. grappling with recession risks needs.

It also would be a big blow to the Modern Monetary Theory craze of recent years. Kuroda’s team scoffs at suggestions Japan engaged in MMT strategies as it hoarded more than half of all outstanding JGBs and became the largest holder of Tokyo stocks via exchange-traded funds.

The BOJ’s modest tweak this week was the bare minimum Kuroda could do to let markets know that it’s on top of things. It was the monetary equivalent of liking a tweet or sharing a Facebook post. What it does not signal is that Kuroda is about to rival Federal Reserve Chairman Powell’s rate hike cycle. Or that Kuroda is suddenly channeling Paul Volcker, the uber hawkish 1970-1980s Fed leader.

The biggest worry for Kuroda, who steps down in March, is that Tokyo’s financial Frankenstein becomes even harder to control. Keeping it moored will be job No. 1 for his successor. And risks abound.

But Tokyo isn’t about to embark on a global-slamming tightening cycle that tramples Japan’s entire economy. The nation is still grappling with the fallout from big rate hikes in the late 1980s and early 1990s. The same with a period in the mid-2000s when the BOJ raised rates twice and quickly reverted back to zero when the recession began.

Thing is, the monster the BOJ and its enablers in government after government created is now calling the shots. The last thing Tokyo can afford is letting it get out of control by way of rate hikes. If you think the BOJ has the courage to mess with this Frankenstein, you haven’t been paying attention.