Spiking interest rates in Japan threaten to undermine, and possibly end, the recovery being engendered by Abenomics.
That could reverse gains not only in Tokyo stocks, but in stock markets world-wide which have benefited from Japanese liquidity.
While a rebound in activity has allowed the Bank of Japan to upgrade its assessment of conditions for a fifth straight month, bond yields have risen sharply in extremely volatile conditions.
Yields on 10-year Japanese government bonds have risen to 0.88 percent, nearly triple their April 5 low of 0.315 percent, just after the BOJ introduced its latest easing campaign, part of Prime Minister Shinzo Abe's overall policy of Abenomics, including stimulative monetary and fiscal policy and economic reforms.
"I don't think the recent rise in yields is having a big impact on the economy," Bank of Japan governor Haruhiko Kuroda said on Wednesday after a two-day BOJ policy meeting.
"We will continue to monitor market moves and respond with flexibility in the pace and maturities of bond purchases and in market operations."
So why are rates rising even as the Bank of Japan is buying huge amounts of bonds?
In large part this is because the BOJ has been successful in convincing investors that it is deadly serious about engendering 2 percent inflation, a goal it has vowed to reach.
"The implication is that the JGB market could plunge and send interest rates sharply higher in a short period of time if people actually start to believe that Mr. Kuroda will use any and all means available to create inflation," Nomura economist Richard Koo said in a note to clients.
"Once inflation concerns start to emerge the BOJ will be unable to restrain a rise in yields no matter how many bonds it buys."
That is both the promise and the problem with extraordinary monetary policy: market effects can move much more quickly than any recovery in the real economy. So far Japan has mostly been the beneficiary of market moves. The yen has fallen rapidly, theoretically giving its exporters an advantage, at least in profitability. And Japanese stocks have soared, engendering hopes of a wealth effect which would boost consumer spending and corporate investment.
JAPAN UNUSUALLY VULNERABLE
If interest rates spike, however, Japan will face a number of very serious sequencing problems.
In the normal order of things inflation follows a recovery, rather than preceding it, as it threatens to do in Japan. If inflation comes first, it means the government is hit with rising debt service costs before the increased tax revenues of a stronger economy begin to roll in. With Japan having government debt of well over two times the size of is economy, the costs would mount quickly. That might get in the way of planned government stimulus and, as rates spike, could ultimately be self-reinforcing, with rises in rates causing yet more rises in rates.
This, in essence, is the Japanese bond crisis thesis in a nutshell - the big bet that many hedge funds have made, and lost money on, in recent years. There is a real possibility of significant amounts of money piling in to a short Japanese government bonds bet if the spike continues.
A rate spike would also gum up the credit market in Japan. Not only might people who planned to borrow and invest decide not to as rates rise, banks themselves will be hard hit. After all, banks in Japan are hugely exposed to fixed income generally and government bonds in specific. As prices of those bonds tumble, they may refrain from lending and might even need new capital.
All of this could easily undo any progress in Japan, and indeed if things got bad enough, prompt policy to be rolled back or even reversed.
This should matter to you even if you haven't got a single yen of Japan exposure. It is no accident that the advent of Abenomics has come alongside the most recent, and giddy, period of stock market gains in the past six months.
Japan, and the BOJ, are a significant source of stimulus for the global economy, both indirectly, and directly. That is even before we think about the destabilizing effect that a Japanese bond market or banking crisis would have on the rest of the world.
To be sure, none of this is pre-ordained. The BOJ has been clumsy in how it operated in the bond market, which is itself a bit of a creaky place after decades of on-off deflation, and is ill-suited to heavy volumes. Both of these issues can and probably will be resolved without great cost.
Still, a near tripling of interest rates in weeks in a highly indebted country is a warning signal investors must heed.
(James Saft is a Reuters columnist. The opinions expressed are his own)
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)