As the obsession with the "falling dollar" continues we have been scouring the globe for a catalyst to stop the decline. Last week, Fitch warned Japan that if government spending is not curtailed it faced a ratings downgrade.

Japanese debt as a percentage of GDP is already the highest in the G7 at over 180%, and the IMF estimates it could rise to 227%. The risk is that a debt downgrade could cause borrowing costs to rise and curb investment. The new Japanese government is in a tricky predicament, as government spending is part of the plan to lift Japan out of recession.

The plight of Japan is not unknown among the financial markets, but in the last week fear has begun to permeate the markets. Credit default swaps on Japanese government bonds (JGBs) have almost doubled. The implication is that market participants see an increased risk that Japan could default on its debt.

To be clear, we view the chances of a Japanese default to be remote at best. However, credit default swaps can push markets into a negative feedback loop. As the CDS market increases,investors demand higher interest to compensate for the increased perception of risk. These higher interest rates circle back and indicate to the CDS market that investors are concerned about risk; in
turn, CDS increase and the whole cycle begins again.

The best examples of the dire outcome of this negative feedback loop can be found by looking at Bear Stearns and Lehman Brothers. As the CDS market climbed, investors either required more capital or simply withdrew funds, ultimately bankrupting both companies.

While the chances of the Japanese government going bankrupt are slim, it is not without precedent. Recall that only 13 months ago
Icelandic rates climbed so much that the country could not service its debt.

We present these examples not as a prediction for Japan, but simply as an example of what can happen when market perception turns into reality.

Disclosures: Short FXY