Japan bears bet on Abe victory followed by yen disaster

Hideyuki Sano

An election sweep for Japanese Prime Minister Shinzo Abe this weekend looks like a safe bet, but some are betting that the consequences for Japan could be calamitous - a collapse in the yen and uncontrolled inflation.

The continuation of 'Abenomics', a program of money printing and debt-funded spending to lift Japan from two decades of deflation and stagnation, is, they say, not just failing, but heading for disaster.

"The endgame of this could be an inflationary depression," said Arne Espe, vice president of mutual fund portfolios at USAA in San Antonio, Texas.

For Espe, it could nevertheless be a profitable endgame.

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While the yen tumbles, stocks would be boosted by the flood of cheap liquidity and their value as a hedge against inflation, so he has bought futures contracts on the Nikkei stock index while shorting yen futures in his $175 million USAA Flexible Income Fund.

A central goal of Abenomics has been to weaken the yen, which had been boosted by Japan's trade surplus up until 2011 since the currency floated in 1973, but has made Japanese exporters increasingly uncompetitive.

The yen, now at 120 to the dollar, has already lost about a third of its value in the past two years under Abe.

Companies in Reuters surveys largely say the rising cost of imported materials is already outweighing the benefits to exporters, but Espe believes it could fall to between 200 and 300 to the dollar within the next few years, a further fall of 40 to 60 percent.

Why Japan needs more than a weak yen

Abe and his supporters say his policies have created jobs, boosted asset prices and helped to bring Japan out of perennial deflation. But the economy contracted in three of the last four quarters, with little growth in exports and weak consumption, despite the stimulus, which includes the central bank buying assets worth more than 10 percent of the economy.

The danger, detractors say, is that Japan's government has become so dependent on the central bank printing money that it has no choice but to continue.

Point of no return?

The Bank of Japan is buying more government bonds than the government issues, helping drive down bond yields.

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The 10-year government bond yield hit a low of 0.4 percent on Wednesday, not far from a record low of 0.315 percent last year.

With public debt reaching 245 percent of GDP this year, even a small rise in bond yields could threaten government finances.

"If interest rates were allowed to rise, it would not be too long until interest-rate expenses consumed an unmanageable portion of your tax revenues," said John Mauldin, chairman of Mauldin Economics, based in Dallas, Texas.

"Therefore, it is clear to me, at least, that the BOJ and the Ministry of Finance will not allow interest rates to rise," said Mauldin, who also expects the yen to fall to 200.

Abe's decision to delay a planned sales tax hike to 2017 makes it almost impossible to meet what had been the government's fiscal target for 2020 - to balance its budget excluding expenses on debt.

That means Japan's debt burden will keep growing at least until 2020, and the BOJ will have to keep buying bonds, said Takeshi Fujimaki, a trader turned opposition lawmaker.

"The BOJ has to keep printing, so the value of the yen should fall. And when that happens, inflation will spike. But the BOJ cannot stop inflation. It no longer has a brake," he said.

Fujimaki, who came to fame in the late 1990s on his call that Japanese government bond yields would fall below 2 percent, said the yen has nowhere to go but down.

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"When you have such a big load of debt, you have two choices - raising taxes sharply or creating inflation. The fact that (Abe) delayed a sales tax hike means he took the second route, creating inflation," he said.

Signs of an increase in long-term bets against the yen are visible in the options market, where investors are buying yen puts, or the right to sell the yen at a pre-fixed "strike price."

Mauldin said he bought yen puts at strike prices around 130 to 150 yen earlier this year. "I have structured a 10-year options trade that would pay for half my mortgage if the yen does indeed get to 200," he said.

The appeal of such yen puts is visible in the price, which has surged since late October, when BOJ Governor Haruhiko Kuroda surprised markets with additional easing.

The relative price of five-year yen puts against dollar puts, called risk reversals spread, rose to the most expensive levels on record this month.