Is It Time To revisit the “widow maker” and Short JGB’s once more?

No doubt Kyle Bass (arch Japan bear and well known hedgie) and many other hedge fund managers over the last 15 years would answer the question in the title of this article with a resounding “No!” Not for no reason is the short JGB trade known as “the widowmaker”…

With everyone it seems anticipating a prolonged BOJ intervention program and thus a perpetual bid for JGB’s by the BoJ, many fear that finding bonds to cover any short positions could become virtually impossible. However, in an interesting piece of research released a few days ago, Barclays Research pointed out what they perceive to be a massive disconnect between the fundamentals and the current pricing of Japanese bonds and which, they reason, cannot last forever. Let us take a closer look at their observations…

Kyle Bass

Barclays believes that the current macroeconomic policy and the latest economic data are not reflected in the long end of the Japanese yield curve. In other words, the massive reflation policies being pursued by the BoJ under the economic program known as ‘Abenomics’ is not currently reflected in certain parts of the yield curve, in particular the 5yr + part and where yields present something of a conundrum. The peculiar position is that IF the Abenomics policies are successful, then yields at the long end are presently too depressed and must, by default, rise. Thus a unique opportunity to short bonds is now presented.

The forward rate 5yr benchmark yield has in fact been declining since 2004. What with the massive purchase of government bonds by the BOJ in recent years, this has contributed to a generalised advance in bond prices (and hence the opposite effect on bond yields). At the same time, this massive buying has also helped contribute towards pushing consumer prices higher and further, policy is set on a further increase in the CPI towards 2%.

The latest data reveal that notwithstanding the recent new consumer tax rise, the Japanese economy is now improving. After more than 20 years of stop-start deflation, the bold Abenomics policies implemented so far have in fact succeeded in pushing prices above the key 1% level and the unemployment rate down to 3.6%. While the Japanese central bank’s intervention is depressing short-term bond yields, it should in fact be pushing the long end of the curve higher as improved economic conditions mixed with rising inflation expectations logically has a positive impact on long-term yields (that is raises them).

What with the unemployment rate currently sitting at just 3.6%, the supply side of the labour market is becoming tighter and which means it is more exposed to wage pressures which, economic theory dictates, translates into inflation pressures for the near future. At the same time, many analysts expect the BOJ to extend the current 60-70 trillion p.a yen QE package at the next meeting scheduled for the end of this month and which will so create further inflation pressures.

Remember the principal goal behind the Abenomics policies is aimed at reflating the Japanese economy and currently they appear unwavering in pursuing this goal. With forward rates on a declining trend for almost 10 years now, and, amazingly, at a level below those seen during the worst of the deflationary period, Barclays just may be onto something here. At some point the market will have to catch up with the fundamentals and even if some, so badly burned of old, believe it to be too risky to short JGB, it at least may be a good idea to stop buying them. It is a trade opportunity we are watching closely…