MW-33 -- Just a JGB Hiccup

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 33
Tuesday, June 24, 2003

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Viewpoint: Just a JGB Hiccup

The Bottom Line:

o Money Watch, like others, believes that the JGB market is a
major bubble that will eventually burst. But this bubble is
not ready to burst yet, and if it does, it will be over the
dead bodies of the Koizumi administration, the BOJ and even
the LDP.

o The Japanese government is simply not prepared to pursue a
serious reflation effort, nor to deal with the potential
crisis-like complications that a serious reflation effort
would have on the JGB market. For one, Japan's banks are still
dangerously short of real capital, with 11 major banks
depending on deferred tax assets for 70 percent of their
capital, according to Teikoku Data Bank.

o While 17 straight trading days with volume of over 1 billion
shares suggests that the current equity rally may have legs,
Money Watch's working assumption is that the secular trends --
bull market in bonds, bear market in stocks -- have not
changed. This conjecture is all the more credible if one's
working assumption for the US equities market is that the
rally there is similar to the first large rebound seen in the
Japanese market in 1995-1996 following the Japanese market's
crash in 1990. That was a very nice rally, but not enough to
dispel the bear.

o Traditionally, Japan's domestic pension funds have been trend
followers, piling into equities long after the rally has begun
and usually helping to form the top in prices for the rally.
This time, it may be different, especially given the
debilitating losses of the past three years. Take away (or
simply significantly reduce) foreign buying, and the current
rally in Japanese equities will not only die on the vine, its
downfall will be precipitated by profit-taking from domestic
pension funds.

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Just a JGB Hiccup

Money Watch has observed, along with many others, that the Japanese
government bond (JGB) market is in the midst of a bubble of historical
proportions, and that it is essentially a train wreck waiting to
happen. At the same time, being the cynical but practical market
observers that we are, we also recognize the fact that cash-rich
domestic institutions find JGBs the lesser of many evils as at least a
store of value, and that JGB yields are but a symptom of the massive
and deep structural problems Japan faces in dealing with the Heisei

In addition, Money Watch still believes that the Koizumi
administration, the new Bank of Japan governor and even the Liberal
Democratic Party are not prepared to fully commit to the scale of
resources required for a serious reflation effort, nor are they
prepared to risk the possibility of a financial crisis should such
actions cause a serious backup in interest rates. In this regard, the
Bank of Japan remains committed to preventing a rout in the JGB market
by continuing to be the single largest buyer of JGBs.

While ostensibly committed to fighting deflation, the Koizumi
administration (and most likely its successors) will do everything in
its power to make any anti-deflation measure as bond-market neutral as
possible. It is within this context that we view the recent hiccup
in the JGB market and the latest rally in Japanese equities.

Yields on the 10-year government bond briefly hit new historic lows
last week (at around 0.430 percent) and then promptly began backing
up, hitting 0.73 percent for the first time in two months. Since the
new fiscal year began on April 1, the decline in lending amid
deflation at first encouraged city banks to aggressively invest in
government bonds. Thus the bond market at first dismissed the stock
market rally, even as foreign investors were net buyers of 94 billion
of Japanese equities from the start of the fiscal year in April.
Impervious to the foreign buying, domestic institutions and other
Japanese equity players continued selling until the week ending June
13. Then domestic institutions began throwing some money toward the
equity market, being net buyers to the tune of 600 million during the
week as daily trading volumes in the stock market continued to trend
extremely high, with consistent 1 billion-plus trading volumes for the
past 17 days.

What spooked JGB market participants last week was apparent evidence
that Japanese banks were selling ahead of April-June quarterly
earnings reports and ostensibly locking in on gains made from April.
The sell-off in JGBs last week essentially erased gains made in the
JGB market for the fiscal year to date. There was also talk of foreign
investors selling JGBs and perhaps trying to repatriate the funds back
into dollars. This conjecture spooked the currency market.

But the real drivers of Japan's JGB yields have been risk aversion and
the view that Japan's economy is stuck in a low-interest deflationary
rut. The Japan equity market rebound and weaker JGBs have been a
mirror reflection of US market moves. Given the apparent shift in
deflationary concerns and perceived financial system risk of late
(from a "March crisis" mindset to just gloomy), investors naturally
have taken profits, but this does not mean a secular shift out of
bonds into equities is under way, as some have suggested. If the
Nikkei 225 were to near 10,000, domestic institutions would have to
re-consider their planned asset allocations for fiscal 2003, which
currently favor bonds over equities. That could prolong what Money
Watch considers to be a short-term rally in a bear market for
equities, and a short-term correction in a bull market for JGBs, but
would not change the basic direction of a bear market in stocks and a
bull market in bonds. These secular trends will continue to persist
until: a) either the Japanese government makes a serious commitment to
do whatever it takes to reflate Japan's economy; or b) the growing
government debt burden and/or financial system collapses in a crisis.

Japanese officials and economists say the reversal in bond yields from
"over-bought" levels is a good thing for the economy, because demand
for bonds had been "too strong." Taro Aso, an LDP old-guard spokesman,
welcomed the sell-off because yields were too low, in his view. The
markets and the government are sanguine about the backup because no
one really believes that a backup of some 30bps in bond yields will
increase government borrowing costs by much. That's because yields are
still below levels on Dec. 24, when the government announced its
budget for this fiscal year. Yields on benchmark bonds were at 0.935
percent when borrowing costs were estimated for the year beginning
April 1.

Moreover, while the life insurers would suffer valuation losses on
bond portfolios, a backup in JGB yields would ostensibly help their
inverse yield gap (the negative gap between promised returns on
insurance policies and actual investment returns) as they tend to be
long-term holders of JGBs. However, with JGB yields still below 1
percent, the inverse yield gap remains over 200-300 basis points, and
selling JGBs for the life insurers would merely mean forfeiting future

But a Finance Ministry panel of government bond investors agreed
during a meeting on Friday that the uptick in rates was temporary.
Money Watch seconds that opinion.

One could also view the JGB market reversal last week as reflecting a
shift to a less bearish view of financial sector risk now that the
government has stepped in to rescue Resona Bank with public money. But
the bank stocks sold off along with the JGB sell-off. The banks'
exposure to JGBs is different than the life insurers. The banks have
been depending on interest income and trading profits in JGBs to help
shore up operating income, and this has been essentially their only
source of operating profit.

At the same time, Teikoku Data Bank estimates that the same deferred
tax assets (DTAs) that tripped up Resona account for no less than 47
percent of stated capital at 126 major and regional banks. Moreover,
11 major banks depend on DTAs for 70 percent of their capital. Indeed,
at Chuo Mitsui, Ashikaga and Kinki Osaka banks, DTAs actually exceed
shareholder equity. Thus Japan's banking woes were by no means
completely solved with the capital infusion of Resona. Indeed, the
Financial Services Agency (FSA) is in the process of submitting a new
law to allow the government to proactively inject capital into banks
before they suffer a capital shortage.

The law ostensibly would be in effect for two to four years, but the
proposal is not expected to be submitted to the Diet before an
extraordinary Diet session this fall.

The resurgence in demand for bonds on Friday confirmed the outlook of
cynics (Money Watch included) who said the bond market's recent
sell-off doesn't mean an end to the secular rally in bonds, but merely
caps the run which had pushed the 10-year JGB yields to a record low
of 0.43 percent last week from a peak of 1.57 percent in January 2002.
Entrenched deflation means the Bank of Japan's quantitative easing
policy, which targets short-term interest rates at zero and is partly
responsible for the bubble-like conditions in the JGB market, won't be
changing dramatically anytime soon. Moreover, with Japan's economy and
policy still snared in a zero-interest-rate trap, investors should be
worrying more about zero or minus interest rates than a sustainable
and sharp move in bond yields to the upside.

The recent stock rally has Welfare Pension Fund returns in the plus
column for the first time since a brief positive return hiatus in
the second half of 2001. Over the past three years, however, their
exposure to domestic equities has been an albatross, producing
shrinking assets. Indeed, these funds are currently trying to reduce
their exposure to risk assets. Given the poor economic environment and
little prospect of a significant improvement, these funds are
abandoning their 5.5 percent projected return haircuts for more modest
required returns. While the average exposure to equities is just under
30 percent, the recent rally has not changed their tendency to reduce
this level of exposure.

Indeed, some of these funds are asking their asset-management
companies if there would be a problem with selling equities and
raising cash positions. Historically, there has been a tendency for
these funds to become sellers of equity once their investment returns
begin to rise. Funds that would be subject to reduced equity
weightings would be the ones of corporations that have decided not to
return the Welfare Pension Fund portion they manage back to the
government (daiko henjo). Generally, the portion represented by the
Welfare Pension Fund for a corporation is roughly one-half of total
pension assets. There are already 500 companies that plan to return
their Welfare Pension Funds back to the government, and up to half of
all funds are eventually expected to return these funds.

Given daily trading volumes of more than one billion, higher potential
selling trends would not be that serious a problem in terms of the
supply-demand balance for equities. However, this level of trading is
predicated on very active buying by foreign investors, and the whole
supply-demand applecart is upset if foreign investor buying ceases, or
if domestic investors, instead of going along for the ride with the
foreign investors, decide to capture recent gains and to take the
money off the table.

The current rally in Japanese equities has the hallmarks of an
excess-liquidity driven move. It remains vulnerable to further shifts
in foreign investor perceptions and to the temptation by domestic
pension funds to take the money and run. Thus Money Watch's working
assumption is that it remains basically a short-term rally which is
not supported by a fundamental shift in either the medium-term
economic prognosis for Japan or in Japan's equity risk premium. This
conjecture is all the more valid if one's operating assumption is that
the current US rally in equities is but the first significant rally in
a bear market that the US has seen since the secular peak in 2000,
much like the Japanese market rally in a bear market that was seen in
Japan between 1995 and 1996.

-- Darrel Whitten

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Written by Darrel Whitten

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