There was a time not that long ago when Japan was the only major economy with a zero interest rate.

Sixteen years ago as the new new millennium was being ushered in, most countries were dealing with an unbelievable economic boom. The dot com bubble was in full swing and Federal Reserve Chairman was raising the Fed Funds level up to 6.5% to snuff out the massive speculation that had enveloped the stock market.

Yet it was during this crazy time that Japan entered a balance sheet recession. In March of 1999 the Bank of Japan lowered their overnight rate to the unprecedented level of 0% and it has since spent 12 of the last 16 years firmly stuck there.

When Japan first made the move to a zero interest rate, all the Milton Friedman monetarists predicted runaway inflation. Surely setting overnight rates at such an unheard low level would create rampant price increases.

But what almost everyone failed to realize was that Japan had entered what economist Richard Koo labelled a “Balance Sheet Recession.” The 1980’s Japanese bubble had created so much debt, the private sector was unwilling to borrow – at any price! As Japan lowered their interest rate, borrowers simply said thank you very much for the reduction in the cost of carry, and continued to pay down debt. There was zero desire to take out new debt. The velocity of money in the Japanese economy plummeted as credit contracted.

Milton Friedman’s famous idiom “inflation is always and everywhere, a monetary phenomenon” was born from an era of stable monetary velocity. A collapse in the velocity was never contemplated as a response to absurdly low interest rates. Yet this is exactly what happened in Japan. Instead of inflation rearing its ugly head, deflation set in.

But it took traders years to figure this out. During this period every smart Alec macro manager lost princely sums shorting JGBs (Japanese Government Bonds) assuming inflation was just around the corner. This trade was so popular, and such a perpetual loser, it was dubbed the Macro Widow Maker. John Mauldin even joked that you couldn’t call yourself a macro trader until you had lost a fortune trading JGBs.

Now a days these minuscule yields don’t seem that unusual, but spending almost the last two decades under a 2% yield for the 10 year has been truly mind blowing.

In a lot of ways, the Japanese are simply a decade ahead of everyone else. Their demographics deteriorated earlier than all the Western countries. They had a massive credit bubble in the 1980s that eclipsed even the US mid-2000’s real estate bubble. Faced with an aging society and a collapsed credit bubble, Japan entered the “balance sheet recession” ten years before it was even contemplated in the US.

I distinctly remember discussing Japan with one of my good friends who told me Japan was different, and a zero rate could never happen in the US. Well, after the 2008 credit crisis, the major developed economies all did the impossible, and followed Japan in their ZIRP (zero interest rate policy).

Japan was also the first to engage in quantitative easing. They have flirted with many different forms and sizes. Throughout the past two decades, they almost wrote the book on the policy. Although they have had QE for most of this period, it has always been not quite enough to stop the constant dis-inflation and even outright deflation.

The latest Japanese Prime Minister was elected on a platform of finally squashing the relentless pattern of lower prices. Prime Minister Abe put in place a series of policies that was labelled Abeconmics, designed to break the back of deflation. There was a series of programs and reforms, but the main weapon was an absolutely breath taking amount of Quantitative Easing.

It is difficult to understand how much “printing” the Bank of Japan has done over the past few years. Think about it this way; the US economy is a $18 trillion dollar economy with a Fed balance sheet a little more than $4.5 trillion. The US Central Bank’s balance sheet is approximately 25% of GDP. The Japanese economy is a 488 trillion Yen economy but the Bank of Japan’s balance sheet is 385 billion Yen! Their balance sheet is almost 80% of the GDP!

It is no wonder that this all of this balance sheet expansion has sent the Japanese Yen into the toilet:

Although there are plenty of naysayers who claim Prime Minister Abe’s program have made things worse, I disagree. The Japanese were engulfed in a massive deflationary vicious circle. A failure to act would have seen their economy collapse.

I am a big believer we have entered into an era of competitive devaluations. As shown in the experience of the 1920s, countries that devalued early were much better off than the ones who tried to stick it out. Bar fight rules apply when it comes to currency wars – hit first, and hit hard.

The Japanese have hit hard with their crazy aggressive QE program. In the process they have driven their currency down to levels that make Japan stupid cheap.

Have a look at the big famed Big Mac index:

Japan has gone from being one of the most expensive places in the world, to one of the cheapest.

One of my favourite bond manager M&G Investments recently made this comment:

Japan is CHEAP. The yen is 25%+ undervalued. A dry martini in a posh hotel cocktail bar overlooking the Imperial Palace (who’s modest grounds were valued at more than the whole of California’s real estate market back in the day, yadda yadda) was £4. Visit Japan asap.

I understand why QE can fail to produce inflation. If the decline in the velocity of money is greater than the expansion of the Central Bank’s balance sheet, then there is no expansion of the money supply.

But what if the velocity eventually rebounds? What if in the mean time the Central Bank’s balance sheet has tripled in size? And what if you can short 10 year sovereign bonds at 25 basis points?

I think those that have proclaimed QE a failure have just not been patient enough. Japan entered the ZIRP era first, I suspect they will be the first to truly leave it (I don’t buy the US has fully left it yet).

I think QE works, you just need to do an uncomfortable amount. Japan has done that, and I suspect before it through, they will get their much hoped for inflation. All of these pessimists will be surprised at the wonders a cheap currency can do for an economy. The Japanese economy is going to fly in the coming the years. In fact, I suspect their real problem will be that they get way too much inflation, not the other way round.

In the mean time, I think this recent JGB rally offers an excellent point to get short.

We will look back at this period and be amazed anyone thought lending to the Japanese government with their massive debt and insanely aggressive monetary policies at 25 basis points for 10 years was a good idea. I am shorting JGBs with both fists. Everyone has forgotten about this trade, but I still have all the wounds from my previous attempts and I want to make sure I get some payback. Try it enough times, even I might get it right…

Thanks for reading,

Kevin Muir

the MacroTourist

PS:  For those of you who aren’t futures traders and are interested in shorting JGBs – have a look at the JGBS inverse DB notes.  Be careful as they are thin.  And for those of you who are more bold, have a look at the JGBD which is the 3x inverse.  Just be extra careful on those as the nature of leveraged ETFs is that you get chewed up with volatility.