The accelerating collapse of Japanese economy will foreshadow the unravelling of the European, British and ultimately even American crises. It is time to pay attention as the crisis presents major risks – but also opportunities.

Things were discernible long ago…

Way back in March of 2010 I published an article titled, “Japan: the Harbinger of (bad) things to come,” opening with the sentence, “Large and gathering imbalances brewing in the Japanese economy threaten to generate a tsunami-like fallout that could soak most of the global economy.” At that time it would have been impossible to predict the current circumstances, but even back then it was clear that the policy makers took a wrong turn. In 2010, Japan was well in its 10th year of Quantitative Easing (QE), shoveling money from Bank of Japan’s (BOJ) printing presses at every economic problem. Ever since, QE has been the central bankers’ favorite solution to pretty much every problem.

Japan’s predicament was discernible for all with eyes to see. From my 2010 article: the “eroding household wealth in Japan has stalled demand for JGBs [Japanese Government Bonds]. This has contributed to a sharp rise in the ratio of government revenues generated from bond issuance to that generated by tax collection, from about 50% in 2007 to 90% in 2009. … With the government deficit running at over 40% of expenditure and Japan’s savers buying less government debt, who will finance Japan’s deficit in the future? The JGBs yield of 1.5% would need to triple before it could attract international bond investors.

Seriously, who still remembers JGBs at 1.5%?

BOJ pulls out all the stops

The problems have only worsened over the past 12 years and after several rounds of ever bigger all-that-it-takes QE programs and stimulus measures, the BOJ has had to pull out all the stops and resort to buying unlimited amounts of Japanese Government Bonds. That was announced in February 2022. Not only that, the BOJ capped the interest yield at 0.25% to avoid inflating the domestic borrowing costs.

Well, if you conjure unlimited amounts of currency from thin air to finance government’s runaway deficit spending and you keep the interest rates suppressed below market levels, you are certain to blow up the currency. On 8 March this year, when the yen was trading around 115 to the US dollar I wrote in my daily TrendCompass report that the “yen will burn to a crisp over the coming years.” I also discussed that point in a podcast with Tom Luongo. Incidentally, that podcast has aged rather well considering everything that’s happened during the past six months.

Yen will burn to a crisp

We are now past 145 yen to the dollar, a new 24-year low and I’m afraid that we can expect thay trend to continue. Although I wouldn’t know how exactly to define a “crisp,” the yen is now only where it was in 1998. We can think of that time as the ‘good old days,’ before the BOJ even started its hare-brained QE arson. Since then, Japan’s central bank has painted itself into a corner: it’s got no option but to continue QE; it can’t raise interest rates, and while we can predict that the BOJ try to defend the yen’s exchange rate, talk tough and bluster about, we can also predict that their efforts will ultimately fail.

What happens next

Broadly speaking, we can make three predictions about Japan’s economy:

  1. We’ll see a period of stagflation (inflation + recession) and the inflation part could ultimately morph into a hyperinflation;
  2. Interest rates will continue to rise and the price of Japanese Government Bonds will collapse. I believe that the unravelling could resemble what Germany had experienced 100 years ago (see below);
  3. The Nikkei will rally

As currency and debt turn worthless, equities tend to go vertical as we saw in many cases through history, including Venezuela, Zimbabwe, Argentina, Israel and the Weimar Republic too:

Thus, as Japan’s inflation accelerates, the Nikkei will likely also go vertical. However, the nominal gains in yen will still leave investors with close to total losses in real terms. When Weimar inflation unwound in 1922, the total market capitalization of Daimler Benz was equal to the price of 327 of their cars. I suspect they must have had that many cars on their production lots and in their dealerships around Europe, so the company itself would be close to worthless.

Real estate prices also collapsed in real terms: villas in the upscale neighbourhoods at the outskirts of Berlin could be bought for 100 US dollars (which were still gold-backed at the time). The reason why even real assets turn worthless is that inflation indiscriminately annihilates the purchasing power in an economy. It really is a great reset.

Why all this matters

In a recent podcast on Geopolitics and Empire, Doug Casey said something that may seem obvious, but it is extremely important. He said that, going into the coming apocalypse, the most important thing everyone should try to do is, preserve one’s wealth to the best extent possible. In this sense, the way Japan’s crisis evolves will prove relevant for most nations in the west; as goes Japan, so will the UK and the EU go. Ultimately, even the United States is sliding down the same slippery slope.

Profiting from the approaching apocalypse may seem questionable from the moral point of view, but I’m not sure what, if anything, is the virtue in letting yourself be swept away by a raging flood. Understanding the forces that are coming to bear on us is not a matter of profiting, but of self-preservation. You’ll be of no use to anyone else unless you can assure your own economic survival. Accordingly, the rest of our discussion is about practical solutions and some of the ways to weather the storm.

Predicting the endgame vs. navigating the events as they unfold

Well, it’s one thing to predict the endgame – quite another to sail through the storm intact. Markets aren’t always “rational” in ways we’d expect. While Japan’s troubles have been discernible for many years, the markets reacted in ways that may seem counter-intuitive:

  • Interest rates on Japanese Government Bonds did not rise as government finances deteriorated; au contraire, they steadily declined and in 2016 and 2019 the JGBs even traded at negative yields;
  • The yen did not fall of a cliff along with BOJ’s quantitative easing; 12 years into QE it appreciated to an all-time high of less than 75 yen to the US dollar (2012).
  • The Nikkei vaulted from the low of 7,500 in 2009 to nearly 30,000 in 2021.

Makes sense? If it does, please let me know. For my part, I can’t work out how to predict market events and much of what’s happened since my 2010 article has been more or less of a surprise. Fortunately, life has taught me to expect surprises. Over 25 years ago, when I started my career as a market analyst I quickly made peace with the fact that I couldn’t predict tomorrow’s events, let alone what might happen a month or five years from now, so I gave up trading around forecasts entirely.

I did notice however, that large-scale price events (LSPEs) tended to unfold over time as trends, spanning weeks, months or even years. I also found that such LSPEs represent far and away the greatest source of risk and opportunity for traders. Rather than trying to predict things, I decided to figure out how to navigate trends instead.

Trends: it’s a question of confidence

The difficulty with trends is that they’re only obvious in hind sight. But the question of whether today’s fluctuations constitute a trend or not, has to be solved in the real time, since we can only make decision in the present, not in the past. But that question can’t be reduced to a simple yes or no answer. Rather, it is a matter of judgment we might form with some degree of confidence.

When we observe a price chart of some security, we might be more or less confident that what we see is a trend. When prices are at or near peak values, we can be near-certain that we’re looking at is a trend. But most of the time our judgment will fluctuate between certainty and utter ambivalence: between one and zero.

Basically, that’s how we work out whether some market is trending or not: we scan a price chart, and our brain does some kind of trigonometry that ultimately forms our judgment and confidence. With that in mind, we sought to produce the trend confidence function artificially. We did so by creating a neural network of mathematical algorithms that could emulate human judgment:

For our purposes it was sufficient to approximate human judgment. The important part, and the critical advantage of this approach is that it produces a numerically exact value of trend confidence, which would be impossible for a living person. A numerical trend confidence function in turn enables us to determine the optimal level of confidence that justifies taking speculative risk. This too would be impossible for a human trader to do.

The chart below shows the average confidence function of the 12 strategies we use for YEN/USD in our Major Markets portfolio along with the resulting directional exposure and trading performance:

Again, these results are based only on price inputs, ignoring all other information from the outside world. Mathematical algorithms don’t care whether the price fluctuations “make sense” or not.

Markets move in trends

We completed our model in 1999 and named it I-System. In all, I-System has been reliable at doing what it was built to do and it’s navigated effectively the recent YEN/USD rally also. But the situation will continue to evolve, offering further risks and opportunities.

Japanese, British, European and American crises may be discernible, but predicting the securities price trajectories is quite out of the question. Any investor’s best bet is to rely on high quality systematic trend following models. I-System TrendCompass is a good place to start; we track more than 200 financial and commodities markets with no dilution in focus or quality of analysis. One month’s trial is always free of charge. For professional investors we also provide a variety of high quality turn-key portfolio solutions as a more reliable, more effective and far cheaper alternative to in-house research teams. Find out more at I-System Trend Following.

Sign up for a 1-month free trial of I-System TrendCompass!

One of the best trend following newsletters on the market, I-System TrendCompass delivers consistent, dependable and effective decision support daily, based on I-System trend following strategies covering over 200 key financial and commodities markets with no dilution in quality or focus.

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