richard koo
Fung Global Institute
In his latest piece, Nomura economist Richard Koo examines the recent crash in the Japanese stock market, which has tumbled 15% since just May 22.
"The prevailing view is that we are finally seeing a reaction to this excessively rapid move, and if so this is a healthy correction," he begins. "The reality, however, may be somewhat more complicated."
Koo argues that the primary driver of the big upward move in the Japanese Nikkei 225 so far has been hedge funds outside of Japan who were previously betting against the euro.
Then, last September, when the ECB introduced a new monetary stimulus program that undermined the fear in the market that the euro could collapse, those international hedge funds had to find something else to bet against.
Koo writes (emphasis added):
Late last year, the Abe government announced that aggressive monetary accommodation would be one of the pillars of its three-pronged economic policy. Overseas investors responded by closing out their positions in the euro and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher.
I suspect that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible. Had they understood this, they would not have behaved in the way they did. 
Japanese investors, Koo asserts, did understand this. That's why they didn't join in when international hedge funds started buying up Japanese stocks in size (emphasis added):
Whereas overseas investors responded to Abenomics by selling the yen and buying Japanese stocks, Japanese institutional investors initially refused to join in, choosing instead to stay in the bond market.
Because of that decision, long-term interest rates did not rise. That reassured investors inside and outside Japan who were selling the yen and buying Japanese equities, giving added impetus to the trend.
However, Japanese investors' initial aversion to the long Nikkei trade couldn't last forever.
"Even though the moves in the equity and forex markets were led by overseas investors with little knowledge of Japan," says Koo, "the resulting improvement in sentiment and the extensive media coverage of inflation prospects forced domestic institutional investors to begin selling their bonds as a hedge."
That selling caused yields and volatility to rise in the Japanese government bond market, which spooked investors and arguably sparked the big unwind in the Nikkei trade.
But why should rising bond yields be such a bad thing for the "Abenomics" story of experimental economic stimulus in Japan that international investors have placed their faith in by running up Japanese stocks? After all, higher yields reflect rising inflation, which is one of the main goals of Abenomics.
The problem, according to Koo, is that a rise in inflation before the Japanese economy starts to recover is bad news:
The Bank of Japan began buying longer-term JGBs on 4 April with the goal of pushing yields down across the curve. The outcome of those purchases, however, has been exactly the opposite of what Governor Haruhiko Kuroda intended, with long-term bond yields moving higher in response.
Domestic mortgage rates have increased for two consecutive months as a result. This is clearly an unfavorable rise in rates driven by concerns of inflation, as opposed to a favorable rise prompted by a recovery in the real economy and progress in achieving full employment.
The more the market senses the BOJ’s determination to generate inflation at any cost, the more interest rates—and particularly longer-term rates—will rise, adversely impacting not only Japan’s economy but also the financial positions of banks and the government...
Since there is no increase in bank earnings from additional lending activity and no increase in tax revenues from a recovering economy, the financial positions of banks and the government deteriorate in direct proportion to the rise in long-term interest rates.
In other words, rising rates aren't bad if they reflect a strengthening economy, because the losses banks will sustain in their bond portfolios will be offset by increased revenues owing to a stronger economy in general.
Again, though, Koo does not think that is the scenario unfolding in Japan right now:
Only 22% of people surveyed by the Nikkei felt Japan’s economy is actually recovering (27 May 2013), suggesting relatively few have benefited from Abenomics’ honeymoon thus far.
Moreover, an increase in long-term rates at a time when 78% of the population is not personally experiencing a recovery is most likely a “bad” rise in rates, and the authorities need to address it very carefully, keeping a close eye on private demand for funds. 
All of this means that the big upward thrust in Japanese equities that began late last year has likely come to an end, at least for now.
"The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher," says Koo. "This means further gains in equities will require stronger corporate earnings and a recovery in the economy."