Shinkansen Edition

Malt Liquidity 76

I was never much of a speed runner, but I couldn’t resist trying to hammer out a full post on the speed rail from Osaka to Tokyo. So lock in some Pryda and enjoy!

No-Mura, Kuroda-San

Last time, we talked about the main policy goals of the (US) central bank:

To control inflation, there’s two primary tools — raising and lowering interest rates, and quantitative easing/tightening. Raising interest rates incentivizes saving and reducing spending, while lowering rates incentivizes investment and capital allocation to seek returns… QE/QT is about the purchase and sale of (primarily) treasury securities between the Fed and major banks to increase/reduce the outstanding monetary supply to facilitate/slow down lending and backstop bond market liquidity.

We have also talked a bit about how the Bank of Japan takes it one step further

In March, [Mr. Kuroda] doubled the BOJ’s annual ceiling for its purchases of exchange-traded funds to the equivalent of $115 billion. That was the month the stock market began surging after a pandemic-induced dip. It closed Thursday at a 29-year high, up 60% from this year’s low.

… the market value of its holdings stood at the equivalent of nearly $400 billion as of Sept. 30, which represented an unrealized profit of $56 billion over what it paid.

and noted how there is an issue

When the wealth creation mechanism becomes the source of wealth itself, it rests on the faith that the currency has some innate, tangible value that cannot be replaced with a denomination of any other kind. Japan in particular has had the relative homogeneity and cultural reinforcement over the past couple of decades for this to have at least existed though it hasn’t encouraged natural growth particularly successfully.

I generally consider ZIRP to be the equivalent of financial heroin — as we saw throughout the 2010s, particularly toward the end, financiers from Silicon Valley to SoftBank and companies everywhere in between ruthlessly exploited cheap debt to blast cash every which way in hopes of acquiring dominant market share. Of course, as any seasoned viewer of Requiem for a Dream or The Basketball Diaries would have an inkling of, weaning yourself off a heroin habit is a harrowing task, and for an economy, to do the same with financial heroin is no different. Of particular concern is how to exit these positions:

For large equity positions, the same rule applies to valuing your position as it does for private equity positions. Your paper P/L assumes that there is enough liquidity at the current level for you to sell your position with zero slippage - this, naturally, is not the case. In the case of WeWork for example, Softbank found themselves at the top of a castle in the air with the $47 billion valuation their own purchases had assigned the company (and then proceeded to try and pawn that pile of shit on the public markets) - to cash out on the 11-12% profit the BoJ has made without losing any money on the execution, somehow 6% of the total market would need to eat this trade, a practical impossibility. But it’s even worse - when a central bank is buying, naturally, investors note that an institution with unlimited funds can endlessly purchase. Thus you will get a lot of piggy-backing, which purportedly was the intention of this program. However, who would buy if the central bank is selling?

In the past week, while much attention was paid to the BoJ’s announcement on bond yields:

The Bank of Japan said it would let the yield on the 10-year Japanese government bond, which it has kept under its control since 2016, rise as high as 0.5% from a previous cap of 0.25%.

a different headline caught my interest:

The BOJ held 535.62 trillion yen ($3.92 trillion) in Japanese government bonds by market value at the end of September, excluding treasury discount bills, according to its Flow of Funds Accounts report published Monday [Dec 19, 2022 ~ed].

This represented 50.3% of the outstanding balance of nearly 1.07 quadrillion yen -- up from 49.6% at the end of June.

The figure came to around 10% a decade earlier.

While the market naturally reacted to the admittedly seismic shift in policy tone, I’m a bit perplexed at the contradictions between the policies highlighted by the headlines. The BoJ’s goals here, apart from controlling inflation in line with a 2% target, are twofold — one is to backstop bond market liquidity, obviously, and the other is to stabilize the JPY, which has been shorted to oblivion this year. The yield curve move is an obvious admission of the fact that, when the world’s deepest government debt market is paying a much higher yield than yours, you have to incentivize some non-central bank purchasing of your debt. Indeed:

…the BoJ’s decision was based in part on a bond market survey conducted in November that showed market conditions were deteriorating to the worst level in 15 years. The central bank now owns more than half of outstanding bonds. On some days, no bond trades take place at all — a sharp contrast with other major bond markets in the US and Europe where billions change hands every day.

The contradiction lies in the fact that bond purchases and rising rates are contradictory policies relative to the overall goal to maintain an inflation target. However, with Japanese bond market liquidity so utterly iceberged, tapering is impossible in its current state. Thus, yields must rise to stimulate trading so, eventually, maybe, the BoJ can begin to consider halting bond purchases, though whether they would ever do so remains to be seen. I shudder at the thought of how to downsize a position in a market when you hold the majority of the holdings — it’s the FTX FTT problem but on a government-sized scale (though, admittedly, Japan debt is not bullshit fake internet money.) Truthfully, I’m not sure a position of this size can ever be liquidated, especially if future-issued debt is at a higher yield than currently-held debt.

The differences between Japanese market behavior and American market behavior in low rates environments is fascinating to me, and will be delved into in the Year in Review to follow. Truly, the American ingenuity in exploiting every angle possible to milk the government drip of artificially subsidized debt to manipulate market returns knew no bounds, and, predictably, all these assets came crashing down once reality struck as rates rose. However, Japanese market behavior is notably more conservative. The nature of Japanese business culture itself is almost inverse that of their American counterparts, as the novel financialization of sophisticated parties and the maneuverability of individuals and their risk-taking is comparatively non-existent. Instead, Japan serves as a sort of live-test as to what happens when debt continues to grow at a sweltering pace in a low- (or post-) growth economy, which is why so much time is devoted to observing an otherwise tepid, boring market. A question I ask myself, to which I have no real answer, is what happens when growth genuinely stops? How does the financial system predicated on future cash flows paying off debt-based growth spending continue to churn? For 250+ years, the answer has been brushed off with the statement “Don’t bet against America.” In the next year, where we are likely to see low (if any) growth, this answer seems more and more like an intellectual cop-out, and we’ll further explore it as the financial landscape continues to adapt to rates becoming somewhat normalized. While the economy might wean itself off of financial heroin, the track marks remain.