Japan's Downgrade is Bearish For U.S. Treasuries

The recent rally in U.S. Treasuries has many of us wondering when the trend is going to end. One party disruptor may be Japan, a major foreign creditor holding some $900B of U.S. Treasury debt, second only to China, who holds ~ $1.15T. Japan may yet decide to liquidate some of its holdings to divert capital to post-tsunami rebuilding efforts or to invest in higher yielding debt or other investments elsewhere.

Japan's recent sovereign credit rating downgrades are perhaps warranted, but a tad nonsensical in comparison with a lack of an actual downgrade of U.S. sovereign credit. Though Japan's government debt/GDP approaches ~220% of GDP, the U.S. debt/GDP at ~100% of GDP is growing at a much faster rate and does not account for unfunded obligations that will easily exceed projected tax revenues.

The Yen carry trade that financed arbitrage-fancy T-bond purchases is not as lucrative as it once was, given the persistent strengthening of the Yen (USD/JPY is now trading again below 80). Given the U.S. debt profile, sitting on long-term U.S. debt has growing risks unless hedged. The Bank of Japan could see a sale of Treasuries and a purchase of higher yielding debt from other countries with stronger currencies as a prudent move as Treasuries continue to push higher on what I call a technical rally.

(Major foreign holders of Treasury securities are tracked by the Treasury here: http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt.)

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.