A "canary in the coal mine" for Japan's economy and the yen?

[Ahlevah]

The following article caught my eye over the weekend:

Dollar funding costs for Japanese banks dropped considerably after the Bank of Japan last week enhanced its support for Japanese banks, a little-noticed success in the central bank's otherwise underwhelming stimulus.

The Bank of Japan said on Friday it would double the size of one of its dollar lending schemes to $24 billion from the current $12 billion.

The facility was introduced in April 2012 to lend dollars for one year, with a maximum of up to four years after roll-overs.

Friday's unexpected decision reduced the so-called dollar/yen basis swap spreads, or the premium Japanese banks pay to borrow dollars.

Dollar funding costs drop after BOJ doubles up scheme to support Japanese banks | Reuters

In 2014, the spread on dollar/yen swaps was about 15 basis points. Before the Bank of Japan intervened last Friday, it had widened to 77 basis points. After the intervention, it dropped back to 70 basis points. These swaps arrangements allow Japanese banks to purchase dollar-denominated assets without having to sell yen into the FOREX market. What's interesting to me is they are willing to pay a considerable and rising premium to get dollar holders to agree to swap the equivalent dollar-denominated debt for "safe" yen and these foreign holders appear to be taking the bait because when you add the swaps discount to the negative yield of the Japanese debt the dollar holders can still earn a higher return than the equivalent dollar-denominated debt. Of course, the Bank of Japan has access to an unlimited supply of dollars thanks to various swap arrangements it has with the Federal Reserve, but these spreads have been widening in spite of the promise of an unlimited backstop provided by these central banks.

Because these derivatives allow Japanese banks to sidestep the FOREX markets, we don't really know what the true value of the yen is. Foreign ownership of Japanese debt has hit record levels and is rising. Something seems almost perverted about a state of affairs in which the lower into negative territory interest rates on Japanese debt go, the greater the demand for this debt by foreign buyers, thanks to derivative discounts. How this all plays out is anyone's guess, but if these foreign investors ever try to hit the exits at once, we'll have a problem.