Abe's killer third arrow is lacking the carry

Just over a week ago Japanese Prime Minister Shinzo Abe fired his "third arrow". The bow string must have been damp.

In fact, after a spectacularly successful initial response to the first two arrows – big fiscal stimulus and massive central bank purchases of bonds – the impact of "Abenomics" has been waning quite rapidly.

The radical and risky program was designed to try to end the quarter of a century of economic winter in Japan by stimulating inflation and growth. A key to the plan was a managed depreciation of the yen. The Bank of Japan’s interventions – about $70 billion a month of bond purchases – were supposed to push up bond prices and force down yields.

There were some early signs of success both in the real Japanese economy, which has been showing its first signs of stirring for decades, and in financial markets.

The yen, which opened the year at less than 84 yen to the US dollar, fell heavily against it and other currencies, with the dollar buying 103.3 yen in the middle of last month. The story was very similar, albeit slightly more pronounced, against the Australian dollar.

The Nikkei soared, rising from around 10,000 at the start of the year to 15,706 on May 22, a surge of 57 per cent.

Then something happened. It was in the middle of May that speculation that the Federal Reserve board in the US might begin "tapering" its own quantitative easing (bond-buying) program earlier than expected that ignited significant volatility in global financial markets (and, with a little help from the Reserve Bank’s last rate cut a little earlier in the month, punctured the Australian dollar).

Abenomics had appeared to provide a very clear signal to investors that the yen would be forced down to improve Japan’s competitiveness and rates would be kept low.

That produced an enormous set of incentives for hedge funds and others to create carry trades predicated on those assumptions holding true. The obvious one was to short the currency and take up long positions in the Nikkei but there were probably many variations based on a weak yen relative to other major currencies and extremely low Japanese interest rates.

When the Nikkei was rocketing along and the yen was tumbling those trades would have been exceptionally profitable. But then the yen started appreciating, the Nikkei falling and Japanese bond yields rising – and the carry traders would have begun scrambling to unwind their positions.

The yen is back to 94 yen to the US dollar (89 to the Australian dollar), the Nikkei (at around the 12,500 level) has lost 20 per cent from its peak and Japanese yields are broadly back to where they were a year ago.

One suspects that has less to do with Abenomics than speculative global capital flows and the switch since the speculation of a change in the Fed’s stance from a risk-off to a risk-on stance by the hedge funds. It is also notable that where the prospect of a weakening yen and lower bond yields should have seen Japanese investors exporting capital instead they appear to have been repatriating it in the face of global financial market volatility, which isn’t helping Abe.

Abenomics was a risky strategy, given that Japan is the developed world’s most indebted nation, with a gross debt-to-GDP ratio close to 250 per cent. Almost all of that debt is held by Japanese individuals and financial institutions, with the International Monetary Fund estimating that government debt accounts for about 25 per cent of the assets of Japan’s banking system.

If for any reason Abenomics doesn’t work (or is too successful and generates too much inflation) and bond yields rise significantly those banks could face major capital losses and Japan could have a self-inflicted financial crisis.

Abe’s "third arrow" was really more of a ranging shot than an attempt at a bulls-eye. He promised earlier this month to loosen business rules, such as those governing the sale of non-prescription drugs, and allow some Japanese cities to lower taxes and regulation.

He has also said he will unveil a more substantial growth strategy and reform agenda later this year.

He might want to bring the timing of that announcement forward and perhaps convince the Bank of Japan that it is going to have to increase and broaden its range of interventions in bond markets if Japan is to reverse the recent trends in its currency, bonds and stocks which threaten to undo the early successes of Abenomics and send the Japanese economy back into the wintry conditions from which it was just starting to emerge. Abe needs the carry traders to return.