April 4, 2013
By: Tres Knippa, Member, Chicago Mercantile Exchange
Spiral of Japanese Bonds

Good afternoon from the floor of the CME in Chicago.  As the world focuses on the boy fool in South Korea, I have my work cut out for me trying to digest all the news coming out of the Bank of Japan.  Today is the day.  The Bank of Japan is in session, and the yen trading world  wants to know: WHAT WILL BANK OF JAPAN GOVERNOR KURODA DO?

I guess the real question is not what he will do, but HOW MUCH bond buying will he do?  Don’t forget something here, the BOJ is buying bonds because they HAVE to.  In my opinion, the coming round of inflation is (apart from foolish) the natural result of the bond buying the BOJ is doing out of necessity.  Inflation is typically the negative consequence of central bank activities and not the stated policy goal.  I think this whole bond buying charade is the Japanese policy makers giving in to the idea that their backs are against the wall.

I want to address a question I get regularly regarding what will happen as pressure mounts on the Japanese Government Bond market:

“If the Japanese can print their own currency and buy its own bonds, then why can’t bonds stay at lofty levels forever?”

There is one theory that suggests that as long a the Japanese can print its own currency, then a break in the bond market CANNOT happen.  This idea is commonly known as Modern Monetary Theory, and most things I have read on the subject seems to fly directly into the face of the entire thesis outlined in “This Time is Different”, by Reinhart and Rogoff.  The MMT idea suggests that a sovereign nation can come to a fork in the road and choose a bond crisis or a currency crisis.  I disagree.

I wrote an article I posted on Seeking Alpha outlining my “two-tiered theory” of bond pricing.  What is a bond?  A bond is an IOU.  Bond buyers lend money to the government and they get a security and a promise of repayment at a later date.  If bond prices eventually come under pressure, the MMT crowd says the BOJ will just buy them and support the market forever.

Ask yourself this question: If the government already has the money, then why would it buy back the IOU?  This makes no sense.  What bonds will the BOJ buy?  New issuance.  This is where the fun starts.  It is my opinion that you could see two completely different rates on bonds when the break happens.  New issuance will carry a rate of near zero and go right onto the balance sheet of the BOJ.  The secondary market will trade based on what the institutional bond buyers in Japan can get for the inventory.  The institutions are all long as as much as they can handle.  The Current Account balance suggests things are bad and getting worse.  Who is left to buy?  I do not think this ends well at all.