Japan’s stock exchange is booming. The Nikkei is up more than 3% this morning, and has just reached a new 52-week high.
Toyota, Sony and Honda exporters are on a roll. Investors are cheering the new trade agreement with the US, and the expected resignation by Prime Minister Shigeru Shiba.
Look a little closer, and you’ll see that the signs have a different meaning. One that says the rally is built on sand.
The Japanese economy is not entering a new phase of confidence. It’s entering a phase of increased risk. The bond market is the first to notice.
Is Japan losing its bond market control?
The warning signs are obvious. On July 23, the government conducted a bond auction for 40 years. It was the lowest in 14 years.
Bloomberg reports that the bid-tocover ratio, which measures the demand, was at 2,127, the lowest level since 2011. The yields soared to a record high of 3.375%.
But this was no surprise. Investors have been avoiding the long end of Japanese Government Bonds (JGB) for several months.
Early in the week, the yields on the 30-year bonds had already risen to 3.20%.
The curve is steepening rapidly. The market is asking for higher premiums in order to lend to Japan on a long-term basis.
Once reliable domestic buyers, such as life insurers and pension funds are now pulling back.
The Ministry of Finance responded by reducing the issuance of long-bonds, but it hasn’t really helped.
It’s not just a technical issue. It’s not just technical. Bond traders are pricing future instability.
The market is asking the basic question: Who will be in control, and how much will they spend?
Why Japan’s political turmoil is important now
Shigeru Ishiba, Prime Minister of Japan, suffered a humiliating electoral defeat. Local media reported that he planned to resign a few days later.
Ishiba has denied these reports. However, it is clear that in a country that prides itself on its quiet continuity, something has changed.
The defeat of his coalition has empowered the opposition parties to push for aggressive tax cuts, spending and spending.
Sanseito – a populist party that uses Trump-style messages – jumped from 1 to 15 seats.
The Democratic Party for the People is calling on the Bank of Japan (BoJ) to return to easy-money. Fiscal expansion has suddenly become fashionable.
The LDP (Japan’s ruling party) is scrambling for a new leader. The candidates couldn’t be more different.
Sanae Takaichi visits the controversial Yasukuni Shrine and supports a looser policy.
Shinjiro is young, but unpredictable. Harvard-educated Yoshimasa Haashi represents continuity, but lacks spark.
The outcome is crucial. Not only for politics, but also for the markets. Investors are watching Japan to see if it will take a steady approach or veer towards populist territory, further damaging confidence.
Has the trade agreement changed anything?
On July 22, the US and Japan announced an agreement to expand trade.
Instead of the 25% tariffs expected, the US settled on 15%. Japan also promised to invest $550 billion in the US.
The day was a great one for stocks. The Nikkei and Topix both jumped over 3% to new 52-week highs. The yen briefly strengthened before fading.
This was not a turning-point, but a relief rally. Investors had already priced in a worse outcome. What they got was better.
The fundamental problems are not yet solved.
Export margins will continue to be affected. The bond market has not been calmed by the equities boom.
Can the Bank of Japan afford a standstill?
The Bank of Japan is already tightening. The Bank of Japan has already begun to tighten.
The rate was raised in January of this year and another increase is expected to take place by the autumn. July passed without any action.
Shinichi Uchida, the Deputy Governor of Japan, delivered a conservative address. He said that inflation was higher than expected.
He warned of the dangers. He requested patience. He did not give a clear direction.
The BOJ is in a bind. Raising rates could lead to a more severe bond sell-off. Stay loose and the yen may fall as inflation expectations rise.
The markets now control the narrative, not the BOJ.
Traders pay more attention to the long end of a curve than to policy statements. Yields speak louder than policy statements.
Why is this rally not lasting?
When this happens, you have to decide who is telling the truth. You have to decide which asset class is telling the truth.
Currently, the equities market is telling a tale of short-term relief, while bonds are telling of a long-term breakdown.
But Japan’s economy is still facing a 250% debt-to-GDP ratio, weak wages and declining real incomes. There are also demographic tailwinds fading and a shrinking workforce. Political instability with no clear successor, and a bond-market that is losing its base at home.
This moment of calm won’t last unless the next Japanese prime minister restores fiscal credibilty quickly. The political vacuum in which Japan’s economy is currently located has not yet been priced in.
Investors who are long-term have already taken a step back. They demand higher yields. More compensation. Less trust.
This week’s market activity has a deeper meaning.
It doesn’t matter who wins the LDP, but whether Japan as a whole still deserves to be rewarded for its debt.
This post Japan’s stock market is booming, but its economy says that it may be short-lived. It may be modified as new developments unfold.
