| Hayman Capital founder Kyle Bass. Photo: (Bloomberg News) |
Kyle Bass, founder of the $2 billion hedge fund firm Hayman Capital Management in Dallas, is not particularly impressed with so-called Abenomics. Bass, 44, has been predicting a default and economic implosion in Japan for more than three years, and he thinks that Japanese Prime Minister Shinzo Abe’s measures to spur economic growth in the country, introduced earlier this year, are a day late and several trillion yen short. Bass’s fundamental case for Japan’s insolvency is simple: Its debt burden is a staggering one quadrillion yen and steadily rising, while its economy has hardly grown since 1989. Bass set up the Japan Macro Opportunities Fund in 2010 to bet against Japanese government bonds, but so far the big payoff has been slow to arrive. Bass has made correct doomsday calls before, however. He earned a return of more than 500 percent shorting the subprime mortgage market in 2007 (in a fund co-managed with Mark Hart’s Corriente Advisors) and also profited from a wager against Greek bonds.
Abe’s attempts to juice Japan’s economy have included a huge boost in fiscal stimulus, an accelerated pace of monetary easing and structural reforms to make Japan more competitive — and they have worked, triggering higher economic growth, a rising stock market and higher inflation. After Haruhiko Kuroda took the reins as governor of the Bank of Japan in March 2013, the pace of monetary easing was further accelerated under a policy of qualitative and quantitative easing, or QQE, aimed at raising inflation in Japan to 2 percent. The yen, which was 78.92 to the dollar a year ago, fell about 31 percent to 103.19 in May, recovering since then only modestly since to 98.58 on October 15. Bass recently spoke with Alpha via telephone to discuss why he’s still bearish on Japan despite the early successes of Abenomics.
Alpha: Economic growth in Japan rose 2.8 percent in the second quarter, while inflation rose 0.7 percent year over year. Has this affected your outlook for Japan?
Bass: Think about the paradox that Abe faces. I term it the rational investor paradox. When I was over there meeting with many of the largest bondholders in Japan, they all, to a certain extent, believe that Abenomics will work and it will generate CPI inflation somewhere from plus 1 to plus 2 percent. If you own a Japanese government bond with a nominal yield of 70 or 80 basis points, that means you’re going from a pretty significant positive yield to a negative real yield.
So, what’s your rational response if you believe the government is telling you that they are going to intentionally weaken the currency to intentionally drive a cost-plus-inflation number? If you’re rational, you’re going to sell some or all of your bonds and buy equities in Japan, or even foreign equities, so you get the benefit of the currency depreciation. Every bondholder I met with had already sold somewhere between 10 and 27 percent of their bonds in the June quarter.
So here’s the problem. Think about this from a macro perspective. The Bank of Japan and Kuroda are set to buy 60 trillion yen of bonds in the next two years and effectively double the monetary base in doing so. Their fiscal deficit is running about 10.5 percent of GDP, or roughly 50 trillion yen. So what do they have left? They have 10 trillion yen a year in a kind of cushion to stabilize the marketplace. That is nowhere near enough.
So, what initially was known as the shock-and-awe plan to double the monetary base and buy 60 trillion yen of bonds two years in a row in my opinion is woefully inadequate if they are going to stabilize rates. And if you look at their purchasing patterns since the June announcement, they are far ahead of the pace that they said they would be at already. Therefore, they are going to have to announce a supplemental program to keep rates stabilized.
How much more in government bonds do you think the Bank of Japan will need to buy?
First of all, they drew a bright red line, and they told you how many they were going to buy. If you’re going to project confidence to the marketplace, it can’t be a red line. It needs to be a gray line. Maybe there doesn’t need to be a line. Basically, what they need to do is make the program open-ended and say, we will buy whatever we need to buy to stabilize the marketplace or to keep yields within a certain framework. That would project more confidence to JGB owners than drawing a bright red line and having people much smarter than we are understand that that’s nowhere near enough.
How are you invested in Japan?
We’ve invested primarily through the currency and secondarily through the rates. So we’ve done pretty well in Japan so far.
What do you think will happen next?
Just do some back-of-the-envelope math. Say 16 percent of Japan’s GDP is earned from exports. You’re trying to generate 2 percent CPI inflation. That means that the yen needs to be at 118 to the dollar by end of 2014. [It stood at 98.58 yen to the dollar on October 15.] Our principal position is betting with the government of Japan that they will be able to weaken their currency vis-à-vis the dollar. Our secondary positioning is making sure that if they lose control of rates — and we mean not just have rates widen a little bit, if they lose control of rates — our portfolio is adequately hedged for such a global systemic problem.
As a hedge strategy it’s almost like writing your homeowners insurance check. You hope the homeowners insurance company never writes a check back. The rest of our portfolio will do well if we’re wrong about the rates. But if we’re right about the rates, the rest of our portfolio will do poorly. And so will everyone else’s.
What is your advice to investors in Japan right now?
If you’re an investor in Japan and you’re 100 percent yen-based, No. 1 is to get out of the yen. Go into some global basket of currencies. You don’t have to choose the dollar. If you’re trying to preserve the purchasing power of your savings, what your government is telling you is that they are going to intentionally weaken your currency pretty significantly in hopes of attaining their goals.
What if you own Japanese government bonds?
I wouldn’t sleep at night. Why would you ever own the debt of a sovereign nation that has 24 times their central government tax revenue in debt? They have a quadrillion yen of debt. You should get out and never look back. It’s a gift horse. The Bank of Japan is offering to take you out and make you whole, and you should hit that bid.
Yet you say that while government bondholders are taking steps to liquidate, they are keeping the vast majority of their government bonds.
I think that the key is 96 percent of their debt is internally held, and 95 of the 96 percent is held by institutions, which is the Government Pension Investment Fund, the Japan Post Bank, the banking sector and the Lifecos. I met with some of the biggest banks in Japan, who told me they were selling their bonds because they were being rational.
It’s funny. In Japan I had the same phenomenon happen when I talked to these people that I had in the U.S. when I was raising money for our subprime fund in 2006. I would travel all over the U.S., and everywhere I went, they would explicitly agree with my assumption that U.S. housing had moved too far and that it was set for a significant pullback of 20 or 30 percent in price. And in the same breath they would say, but it’s not going to happen here. It’s going to happen everywhere else in the U.S. except where I live and where I have a house.
No one wants to believe that it can happen to them. They want to believe it can only happen to others. And everyone I met with in Japan was telling me they are so far ahead of the market. They are the only ones operating this way and that everybody else is slow and they’ll come to the same conclusion later. But everyone I met with said the same thing.
Do you still think that Japan is going to implode at some point?
Well, there are two things to think about. If they did nothing — if Abe didn’t embark upon Abenomics and they didn’t go on the current path they are on, they would implode under the weight of their own debt. Given the fact that they are now engaging in CPI inflation at all costs and trying to make this go the other way, I think they’ll explode, if they are successful. It’s just semantics, but you have to think about how it works.
What we’re saying is that no matter which way they go, whether they persist with excessive deflation or if they achieve CPI inflation, it’s a bad outcome. Look, if they get to 2 percent CPI inflation, where is the ten-year yield going to go? If nominal yield goes to 2 percent — that’s a zero in real inflation. But it’ll probably go to 3 to have a 1 percent real [rate of inflation]. And then if it goes to 3, they’re out of business.
What can investors do to avoid the fallout, and what is the time line?
What you’re asking is, how do you time the end of a seven-year debt supercycle with any precision? What we can give you is as many leading indicators as we can. We can follow it very carefully. And right now we’re not seeing any signs of stress. There’s an interesting kind of corollary to think about — and it’s Greece. Greece didn’t have a new bond issue flop. It didn’t have a maturity that didn’t get paid. You woke up one day, and the Greek ten-year bond had busted out 100 basis points. It went right from 4 to 5, and you thought, huh, I just lost 7 percent. And you think, I wonder what’s wrong? I’d better go look into this. The next day you woke up, and it was out another 100 basis points. What set it off? Nothing set it off. It was just a change in the qualitative belief of the participants. And then two months later, it was over. You’d already lost 60 percent of your money.
If and when the default occurs, how will the Japanese rebuild their economy?
There are some mechanisms that are involved in defaults and complete implosions of economies. Look at the [so-called] tequila crisis in Mexico in 1994 and 1995. Basically what happens is that currencies overdiscount the high rates in the future and therefore they overshoot to the downside, and the currency overshooting vis-à-vis other world currencies will make Japan infinitely more competitive. There’s a self-correcting mechanism. At some point in time, the loss of purchasing power abates, and they become hypercompetitive again. The problem is that between now and then you have to wipe out a lot of debt. A lot of the existing debt stock has to go away.
