Sovereign debt meets Japanese yen, and releases a triple-whammy of pain!

You may recall my Money and Markets column, “Why the yen could be today’s best currency trade.” Today I want to give you an update on why I believe we are very close to a long-term peak in the value of the Japanese yen. Or to put it another way a major long-term multi-year bottom in the U.S. dollar.

Let’s first go back to the 1980s when Japan was poised for what many believed was inevitable economic domination. The country was in the midst of a huge credit bubble — valuations were off the charts.

For example, in 1989 the Tokyo Imperial Palace was said to be worth more than all the real estate in California! The country’s trade balance was soaring against the world, especially the United States. Japanese companies were gobbling up real assets throughout the globe.

Here in the U.S. the premiere properties acquired were Pebble Beach Golf Course and Rockefeller Center. Americans were concerned, very concerned about this “foreign invasion.” And Japan bashing was in vogue.

During the early 1980s the U.S. dollar was in a major bull market. Despite the real value of the dollar and other fiat currency values inflating away, the dollar staged a rally of almost 50 percent from its low in 1980. Paul Volcker’s tough love administered by a massive hike in interest rates, was the catalyst of this multi-year rally.

With Japan the big dog on the block and its trade surplus soaring, U.S. manufacturers and other trade groups began applying pressure for a dollar devaluation — the dollar was “too high.” So the major global powers jumped into action to rectify this terrible wrong.

The United States, the United Kingdom, France, West Germany, and Japan got together at the Plaza Hotel in New York and agreed that the dollar was too high. The Plaza Accord or Plaza Agreement was signed on September 22, 1985. In short, the countries agreed to allow their respective central banks to intervene in the foreign currency market through a coordinated effort to push the U.S. dollar down.

Though at the time billed as a dollar problem, the implicit rationale for the Plaza Accord seemed a defense against Japan’s rising trade surplus. Thus it was more of a “push up the value of the yen” agreement.

Many, rightfully, believed Japan’s aggressive export-dominated trade policy took advantage of relatively open markets in the West by producing increasingly high-value goods and morphing up the consumer value chain. But at the same time it continuously found a way to stop or delay Western goods from making it to Japanese consumers.

As I said, the Plaza Accord worked in pushing up the value of the yen. But it did little to solve the trade balance problem. Japan’s trade surplus remained strong even as the yen soared.

In the chart below I have compared Japan’s trade surplus on a monthly basis with the yen’s value from 1983 through June 2012. I noted the Plaza Accord and the official Credit Crunch start by the red vertical lines. Think of them as bookends on the massive rally in the yen.

Click the chart for a larger view.

Here is where it starts to get interesting if, like me, you believe the USD/JPY is close to a major long-term bottom …

The way I see it, the real trigger that changed the dynamics for Japan’s seemingly unending trade surplus was the Credit Crunch. That’s because the Credit Crunch brought an end to Japan’s long string of trade surpluses!

I also believe it triggered the beginning of the end of the Asian export model as we know it. I see three major reasons, which are interrelated and self-reinforcing:

First, it marked the end of an era of unlimited global liquidity …

Second, it triggered a secular change in global consumption …

And third, more specifically …

Approximately 90 percent of Japanese debt is held by Japanese investors.

Over the years, huge pools of savings and massive current account surpluses have provided plenty of money to fund the Japanese government’s growing need for funds — as tax revenues were increasingly scarce given Japan’s low growth deflationary economy.

But now, Japan faces a daunting prospect thanks to the Credit Crunch. No longer is it generating the current account surplus it needs. Consumer demographics and low growth have pushed the consumer savings pool sharply lower — heading toward zero.

And companies domestically have been using their savings pools to recover from the Tsunami and plug the holes from falling demand for their exports. Therefore, the Japanese government is at risk of a funding shortage — at least internally. And this is very dangerous.

Here’s why …

Japan has a government debt-to-GDP ratio of around 215 percent. The interest cost to fund this debt is huge. Plus the yearly funding needed to maintain government services is massive. Add them up and you get a mismatch between government revenues and spending. It’s called a budget deficit, and here in the U.S. we know firsthand how that works.

Next, take a look at the chart below. Presently the yield on the benchmark 20-year Japanese government bond (JGB) is 1.7 percent. In fact it has hovered around this level since 1998.

20-year Japanese Government Bond Yield
vs. the USD-Japanese yen 1990-today

Click the chart for a larger view.

If Japan does not have the internal funding available to handle its needs, it will have to look to international investors for this funding.

So Japan is faced with a triple-whammy of pain:

1. Rising funding needs,
2. Falling internal sources of funding,
3. Rising funding costs because foreign investors will expect a much higher yield than 1.7 percent to account for the risk of holding Japanese debt.

Because Japan is facing this triple-whammy with an already astronomical debt load, this mix of problems will likely lead to a vicious self-feeding spiral. Then higher interest rates will lead to higher funding costs and falling bond prices will lead to dumping of bonds, which leads to higher yields to entice new buyers.

I believe we are seeing the outlines of what might eventually become a Japanese government bond default as the sovereign debt problem visits Tokyo. My suspicion is that once the markets are finished attaching the euro-zone bonds, they will train their guns on Japan.

To sum it up, a change in the global economy and the outlines of a sovereign bond crisis in Japan suggest to me that we must be very close to a major trend change for the Japanese yen.

Best wishes,

Jack