As the world watched the TV in the early hours of Friday morning, we saw the catastrophic damage in Sendai Japan. This instantly reminded me of the Great Hanshin Quake that shocked Kobe in January of 1995. I clearly recall the movement in currency that took place over the next few months.
When natural disasters strike, there is a definable impact on financial markets because they force reactions from investors and governments.
Most will immediately focus their analysis on the Japanese Markets in light of this current and expanding crisis, but the repercussions are global as Japanese supply chains strangle production processes all over the U.S. and Europe and as Japanese consumers stop spending on non-essentials like European fashion. More importantly, how does this 9.0 quake in Japan and the resulting tsunami shake up and wash over Americas Treasury market?
Lets consider …
Japan is getting ready to embark on one of the largest rebuilding efforts it has seen since the end of World War II. The country is going to have to replaceeverything from bridges and roads to seaports, airports and runways, highways, train tracks, shopping centers, housing, power stations, schools, utility and cell phone towers, hospitals, production plants, parking garages, post offices, whole communities the list would take pages to print out.
This undertaking is going to cost tens, actually, more like hundreds of billions of U.S. dollars to complete.
Because Japan is one of the worlds wealthiest nations, it is very fortunate. Plus, the citizenry is extremely patriotic. This means Japan has the necessary wealth to accomplish the task Mother Nature has forced upon this island nation, and it has a citizenship willing to sacrifice its own savings to rebuild Sendai, Minami-sanriku, Fukushima and the others.
Japan now has a singular focus. Japan now has little interest in playing in U.S. Treasury and equity markets because of this domestic emergency.
As Japans government, companies and citizens raise cash to fund the rebuilding, it seems extremely likely that Japan will sell off U.S. debt and U.S. equities.
That will cause profound effects in America.
If Japan moves away from the Treasury Market
…Then What?
Japan is the 2nd largest holder of U.S. debt in the world. It is estimated that Japan owns $3 trillion of U.S. securities, both stocks and bonds and $886 billion of U.S. Treasuries. Over the last year Japan has bought an average of $10 billion worth of Treasuries each month.
It is not easy to replace the second-largest consumer of bonds, notes and Treasury bills. Not many countries have deep enough pockets to step in with that kind of financial capability.
China already owns more U.S. debt than it needs or wants. In fact, China has been reducing the amount of U.S. debt it consumes and has focused on putting its cash into other currencies and gold out of a sense of financial caution. There are some Middle East nations that could pick up some excess. The problem is they have their own uprisings to quiet. They are throwing mountains of cash at protestors to overturn the dissent and at security personnel to quiet the protestors.
The U.S. Will Have Little Choice But to
Raise Interest Rates
Most likely, Japan will all but disappear from the Treasury market. China and a few others will take up some of the slack. The Fed, which is supposed to end its QE II campaign in June, will most likely extend the balance of its $600 billion buying program over several more months.
The willpower doesnt seem to exist in Washington for the Fed to increase the size of QE II, and that means there will be some serious shortfall. And shortfalls are not a good thing for the U.S. government. The U.S. government has a certain amount of debt it must sell every month to fund all of its bloated spending commitments.
With a world that is already overstuffed with American Dollars, there is only one way to bring buyers to the table and that is with Higher yields.
With this in mind, we can see that the Great Sendai Quake will cause after-shocks that ripple some 6,600 miles away in Washington, DC, where the Treasury Department will have to pay more to access the money it needs to fund Americas overgrown spending demands.
That is going to make it much more expensive for America to fund its obligations.
We have no idea what the consequence of that will ultimately be. Congress could agree to QE III! The Fed cant cut rates any lower, so rising interest rates here could only be mildly inflationary. Congress could be more open to to raising tax rates.
But what about stocks? Japan owns more than $1 trillion in U.S. stocks. This is equal to about 6% of the total value of the New York Stock Exchange. If Japan sells off any sizable amount of their holdings, that will clearly put downward pressure on American equities.
Let History be Our Guide…
These arent just random considerations. What Im laying out here has precedent in the 1995 Kobe quake. Times are slightly different, yes. Japan and America are in far worse shape financially. Interest rate cycles are at a different point. But one fact – the only fact that matters – remains identical: Japan has a national crisis that it must address.
In 95, the Japanese repatriated mountains of cash to pay for the rebuilding effort. As a result, the Japanese yen surged in value, rising about 25% against the dollar between January and April 1995. Meanwhile, Japans stock market sank about 20% during the same period as retail and institutional investors pulled out of stocks to repair damage to their own lives or to buy Japanese bonds to help the government repair Kobe.
And now, its happening again in the wake of the Sendai quake. Japanese stocks are tanking and the yen is rising against global currencies. Partly this is a reflection of fear and panic related to a potential nuclear mishap and the governments warning that nuclear fallout remains a real risk.
But part of it also reflects a country, citizens and government alike, raising cash for the spending needs they clearly see as critical. Insurers are bringing yen home and selling securities globally because they know a flood of claims is coming.
For investors, these moments offer risks and rewards.
The risks: Being short the Japanese yen and long most of the Japanese stock market, at least in the short run. Over the next few months, the yen will continue to strengthen as the repatriation effort goes on, and stocks will suffer as the sell off continues. Worse, the risk of nuclear tragedy is so pronounced in the investor mindset right now that any substantive release of radiation will cause another down leg in Japanese stocks and another upsurge in the yen, which has become a safe-haven currency of sorts.
So, avoid being short the yen at the moment. And avoid the temptation to buy Japanese shares on the cheap.
Also, dont play in U.S. Treasuries. They are strengthening at the moment on the fear trade, but, if Japan does leave the market, Treasury yields will nudge higher – and Treasury prices will fall. A safer bet is simply to park your idle cash in a money-market account since they are the first to react to any rise in interest rates or better still to purchase currencies on the short term that will outperform your current holdings.
The opportunities: are the exact opposite of the risks. The Japanese economy is fundamentally flawed and the yen is ultimately a reflection of that. Plus, the government is throwing the equivalent of billions of U.S. dollars into a stabilization effort, and that will work over time to push the yen substantially lower.
The weakening yen, in turn, will benefit Japans exporters, who historically fare well when the yen is falling.
So, if you see the yen break below 80 to the dollar and move well into the 70s, it will be time to reverse course and short the yen again. And it will be time to buy the exporters – companies like Honda, Takeda Pharmaceuticals, Komatsu, and Canon.
Just look back at Kobe. After the brief period of yen strength/stock weakness, the trend reversed. The yen plunged and Japanese stocks gained 50% the following 12 months.
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