When Will the Powers That Be Notice That Japan's Insolvent?

 | Apr 13, 2016 | 4:00 PM EDT
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The idea that Japan may be on a trajectory toward sovereign insolvency is beginning to get consideration by the mainstream financial media, as is most evident in the Barron's article today, "The Endgame for Japan's Pyramid Scheme?"

That article expanded on the subject as it was presented two days earlier in The Telegraph.

There is nothing new about the contention that Japan is on an insolvency trajectory, or even that it may already be terminally insolvent. I've discussed the issue in numerous columns for the past several years.  

The idea of a Japanese sovereign insolvency, however, has never been considered seriously by any government or financial sector leaders in the world -- at least publicly.

The conventional belief has always been that the Japanese economy would eventually return to growth somehow, which would also bring with it a level of inflation that would allow the sovereign debt to shrink as a percentage of GDP and its servicing as a percentage of tax receipts.

As a result, there's never been serious consideration by governments and financial industry leaders as to what a Japanese sovereign insolvency implies for the global capital markets outside Japan.

There are too many variables and ways of managing an insolvency to consider here; and they all have differing impacts on capital markets and asset classes.

There are some issues we can anticipate, however.

The first is that as capital market participants' awareness of the insolvency trajectory for Japan increases, consideration for how it could impact other global assets will increase and along with it volatility across all of them.

Financial crises have traditionally followed a pattern of starting in the debt markets and then expanding to impact equities broadly, then banks specifically, and finally real estate.

It is logical that the same will occur this time.

As that process plays out, there will be a capital flight away from financial assets and to hard assets, which will propel all commodities higher but most probably have the biggest impact on precious metals, especially gold.

I'm not anticipating that this process is imminent, as awareness concerning the reality of Japan's sovereign debt issues is really just beginning to get real consideration by government and financial sector leaders.

I think it's important, however, for investors to be aware of what the trajectory of awareness implies for capital market action ahead of time.

As awareness of Japanese insolvency grows, the concern will shift toward when that will occur, what the capital market cues will be that it is imminent, and how the Japanese will absorb the necessary losses.

It could take many years for a crisis requiring insolvency and resolution to occur, but it could also start at any time.

It is also possible the process will occur over many months or even years before insolvency is actualized.

That would be similar to the approximately two years it took following the first surges in subprime residential mortgage defaults to metastasize into the bankruptcy of Lehman Brothers.

It's also possible, though, that the process could be almost instantaneous. That is, at some point the market, outside of the Bank of Japan, for Japanese government bonds crashes.

In such a scenario, it is probable that all of the world's asset exchanges and banks will be closed and transactions denied.

It would also be very difficult to determine the probability of such from capital market action and indicators.

However, it is probable that there will be market indications as the degree of awareness of the situation by capital owners increases.

That would also comport with the adage that going bankrupt occurs gradually and then suddenly.

Two indicators to easily monitor for increasing concerns by capital owners are the performance of DB Japanese Government Bond Futures ETN (JGBL) and the CurrencyShares Japanese Yen ETF (FXY).

As concerns about a Japanese sovereign insolvency increase, unless the Japanese government announces a plan to address the issue before a crisis erupts, capital owners globally will likely increase the percentage of their wealth held in hard assets, especially gold and gold miners.

That, too, could be considered a cue to the unspoken concerns capital owners have about the potential fallout from a Japanese insolvency.  

Most importantly right now, though, is to be aware that Japan is terminally insolvent and that the primary first issue is when it will be actualized, not if.

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