Nikkei’s 7% plunge, last Thursday, and the way it happened, gives us a glimpse into how the next crisis will play. As we know, any market crash is always preceded by warning signs : the subprime crisis exploded on September 15, 2008, with the Lehman Brothers bankruptcy, but there had been warning signs as early as the 2007 spring (New Century Financial’s bankruptcy and many mortgage houses going under).
Japan is ahead of Europe and the US because it has been in crisis for a longer period (the bursting of the stock market and real estate bubbles dates back to 1990) and it has used the same methods to try and get out of it (with debt and money printing). We all know that it doesn’t work, of course, but Shinzo Abe, the new Prime Minister elected on December 26, 2012, has decided to go ahead with this policy, but full steam ahead, this time!
But Shinzo Abe went overboard with it, and here’s how the crisis developed : the stock market goes up, but at an unrealistic rythm (+50% between January and the end of April!); this « free » money shed by the central bank is put in the Nikkei by the banks, for some quick profits; some of those holding State bonds want to join the party, so they sell their bonds and turn to the stock market. As a result, the bond prices fall and, thus, their yield increases (the bond’s coupon is fixed, so it becomes proportionally more important in relation to its price). But these falling prices for bonds put great pressure on insurers and japanese banks, which are loaded up to their necks with these public debt products, so they are exposed to gigantic losses. On the other hand, if yields go up, Tokyo would have to raise the interest rates at which it refinances itself, which is impossible because the servicing of the public debt is already eating up almost half of its revenues! As a consequence, the central bank quickly intervenes and buys some bonds to appease the market. And, in this over-heating atmosphere, bad news comes out (slowing growth in China, in this case, but it could have been anything else) and, bang, the Nikkei loses 7%. Since then, things have been see-sawing back and forth, but one can say that, within four months, Abe’s mirage seems to have already dissipated.
Add to this the fall of the yen (losing 16% to the dollar since the start of the year!), which helps a little for exporting goods, but does a lot for importing goods. This creates inflationary pressure and, if confirmed, it would pull down the price of bonds and the State would have to hike interest rates to refinance...
This is the kind of crisis we could be facing, but at a much larger scale and with the authorities losing control of the situation. Tying together the bond and stock markets, both in bubble territory, thus very unstable, creating imbalance, and then the central bank kicking the can down the road, the currency falling, the return of inflation... We’ll have to keep close tabs on what the apprentice-sorcerer in power in Japan is doing.