Japan financial tsunami barreling for the US

Since I started publishing the TrendCompass newsletters in January 2020, I have periodically revisited a number of themes that seemed relevant to the crawling, creeping crisis of the Western world, and which will shape the unravelling on that crisis. They include the economic and fiscal crisis in Japan and other G7 nations, the approaching bonds Armageddon, the energy crisis, the commodities supercycle, inflation, AI bubble, the disintegration of British and EU economies and more.

At present, it appears that all these crises are accelerating simultaneously. Already in March of 2010, I published the article, “Japan: the Harbinger of (bad) things to come,” opening with the sentence, “Large and gathering imbalances brewing in the Japanese economy threaten to generate a tsunami-like fallout that could soak most of the global economy.” Recall, Japan has been the pioneer among G7 nations in zero interest rates policy (since 1999) and quantitative easing (since 2001), which have both contributed to those “large and gathering imbalances.”

In the 8 March 2022 TrendCompass report, while the yen was trading around 115 to the US dollar, I wrote that the “yen will burn to a crisp over the coming years.” Four+ years (and numerous interventions) later, it takes 159.2 yen to buy one dollar, the weakest it’s been in 40 years, which is amplifying Japan’s rampant inflationary pressures. If the oil prices continue to rise, which seems likely; and if the yen continues to fall, which also seems likely, Japan could find itself in a disastrous double jeopardy.

Namely, Japan has to import about 3 million barrels of crude oil per day which, at current prices, is well in excess of $250 million/day, settled in US dollars. The higher the oil price goes, the greater Japan’s demand for US dollars, and the greater the downward pressure on the yen. The lower the yen, and the higher the prices of oil and other imported goods, the more inflation Japan imports via its US dollar oil purchases.

Ordinarily, when they wish to strengthen their currency, central bankers raise interest rates. That would make Japanese financial assets more attractive to global investors, which would boost the demand for and purchases of yen. But the Bank of Japan (BOJ) can hardly afford to do that, given that it would bankrupt the Japanese government, which is leading the developed world in terms of debt-to-GDP, which currently stands at around 240%.

Raising interest rates would also crash Japan’s financial markets and with it, Japan’s pension funds. When the BOJ raised the interest rates by only 0.25% on 31 July 2024, the Nikkei collapsed by -12.4% - its worst one-day crash since the Kobe earthquake in 1987. Currently, Japan’s debt to GDP stands at around 240%.

The answer, probably, is yes, but not this week. Given that raising interest rates is unpalatable, Japan had the option of selling its $1.1+ hoard of US Treasuries and using the proceeds to buy and prop up the yen. In fact, Japan’s Finance Minister Satsuki Katayama was anxious enough about her government’s fiscal position that on 10 Juy she explicitly encouraged Japanese households and pension funds, “to increase their investments in Japanese financial assets.”

But selling US investments to buy Japanese assets would put further pressure on US intrerest rates, putting a squeeze on the US Government which is already in a massive fiscal bind. In fact, the US Government can be so sensitive about foreign governments selling their Treasury debt that they can regard it as an act of war. Accordingly, Ms. Katayama quickly backpedalled from her cunning plan. Instead, the US and Japan together coordinated an intervention to support the yen and relieve Japan’s inflationary pressure.

In late July the US coordinated market operations with Japan to support the yen, which have been somewhat successful: they knocked the yen back up from its 40-year low of 164 yen to the dollar to below 156. Since then, however, the yen fell back to just under 160 yen/USD where it is trading today.

Even when governments do it, currency rate manipulations ultimately fail: they buy a temporary respite from the accelerating collapse, but they cannot reverse the decline as they leave the structural causes of the financial imbalances intact. In the end, I believe that the yen will indeed burn to a crisp (as will the euro and the British pound) and that Japan will ultimately drag the United States with it.

Unfortunately, predicting the timing of all these events is out of the question. Note, my original article about Japan being the harbinger of bad things to come is over 16 years old, and its predictions are yet to unfold in full. US/Japanese joint yen rescue operation may not be over yet. Further efforts to boost the yen could be successful, especially if they trigger large-scale short covering in the markets.

Namely, global investors and traders have accumulated the largest short position on record against the yen. Panicked short-covering could give another boost to the yen in the near term, but in the end, the predictable disintegration of Japan’s fiscal and economic position are now all but inevitable.

Reiterating my earlier prediction with relation to this crisis, we can make three predictions about Japan’s economy:

1. We’ll see a period of stagflation (inflation + recession) and the inflation part could ultimately morph into a hyperinflation;

2. Interest rates will continue to rise and the price of Japanese Government Bonds will collapse. I believe that the unravelling could resemble what Germany had experienced 100 years ago (see below);

3. The Nikkei could continue to rally (for now) - As currency and debt turn worthless, equities tend to go vertical as we saw in many cases through history, including Venezuela, Zimbabwe, Argentina, Israel and the Weimar Republic too:

Thus, as Japan’s inflation accelerates, the Nikkei cold continue to soar. However, the nominal gains in stocks will be more than offset by their losses in yen, still leaving investors with close to total losses in real terms. The reason why even real assets turn worthless is that inflation indiscriminately annihilates the purchasing power in an economy. When everyone’s purchasing power converges on zero, we really get the great reset: owning nothing minus being happy.

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With Friday’s closing prices we have the following changes for the Key Markets portfolio: