It has been quite a week for the ‘ugly sister’ of the debt markets, Japanese government bonds.
As noted on Wednesday, these usually dull and often ignored instruments have come out dancing — largely due to a surge of shorting interest touched off by Greenlight Capital’s David Einhorn, who told a New York value investing conference in late October that Japan was “past the point of no return” and signalled it was time to squeeze JGBs — big time.
Combined with signals from the Japanese government that it might have to vastly boost its debt issuance to fund ambitious spending plans, the result was a spike in JGB yields combined with frenzied activity in the market — and ultimately a warning from Fitch Ratings this week that Japan risked a sovereign debt downgrade.
As William Pesek observed in a column for Bloomberg, Einhorn was “betting on a phenomenon many tried to time for a decade: a meltdown in a bond market with irrationally low yields”.
Since then, JGBs have been going through some strange gyrations, with yields surging, then settling. On top of that, this week’s auction of 5-year JGBs was an unforeseen success — and was followed on Friday by an unexpected recovery as bond prices rose and yields declined along with Japanese stock prices.
As Bloomberg reported the 5-year auction attracted bids for 3.7 times the amount on offer, higher than the so-called bid-to-cover ratio of 2.17 times at the previous sales on Oct 15, which was the lowest since September 2003. The result prompted some analysts to call an end to the latest round of a bear market in the bonds.
Indeed, with big institutions already starting to close their books, it’s clear that end-of-year derisking is now a bigger priority than making a quick buck.
As RuiXue Xu, JGB analyst at RBS in Tokyo, observed in a note:
It only took two days for the 10yr yields to claw back nearly half of the rises over the past one month, from the high of 1.485% on November 10 to the low of 1.24% on October 6. The smooth 5yr auction helped ease the worries that banks may continue slacking their buying and provided a trigger to attract other domestic buyers.
According to Jonathan Allum, KBC’s ever-eloquent Japan strategist:
We should all be happy that the JGB market enjoyed its strongest bounce for 11 months and yields are now back to 1.37%, the level at which they started the month. But we are not, largely because we never are happy these days, but also because the fall in yields is due to rising fears of deflation whereas the preceding rise was all about credit concerns.
So where does all this this leave investors? As one seasoned Tokyo hedgie remarked:
“I’ve just been told that the success of the mega JGB 5Y auction is a negative for equities as it demonstrates flight from risk. Prior to this I was told any failure of the auction would have been negative for equities, demonstrating rising sovereign risk. Priceless stuff.”
But, the FT’s Lindsay Whipp and Gillian Tett note on Friday in a thought-provoking rundown on the peculiarities of the current JGB market: While domestic investors — who account for more than 95 per cent of total JGB purchases — have maintained a sanguine view of the market, a striking divide has opened up with the “swaptions” sector (for options giving the buyer the right to enter into a swap agreement at a later date), where volatility has soared.
Consequently, they note:
… the swings in the swaptions sector and its apparent dislocation with the cash market is thought to reflect the fact that large non-Japanese macro funds have recently entered this sphere, to short the JGB market and thus turn Einhorn’s comments into a tangible trading bet.
Quite how long this pattern will continue remains unclear. But in the meantime, the JGB tale is now attracting growing interest from international policy makers and investors – not least because it might be a foretaste of what could await governments in countries such as the UK, as these also grapple with rising debt levels and potential political uncertainty.
As with the current JGB hype — in the words of one particularly plugged-in trader, the issues (Japan’s fiscal problems etc) could be “real or imagined but what has clearly happened is that the short trade got too crowded”. It might be that new investors are just now realising the JGB problems, but that doesn’t mean they haven’t been there for a long time, he says, continuing:
Too many guys got sucked in after Einhorn put his trade on and then talked his book, and I think he took profits soon after (covered his shorts) as everyone else put on the trade. Those newer, lower-quality shorts are now getting stopped out. Look on Friday, it’s moved higher again.
There have been JGB bears for years and years, but they usually get squeezed out at some point like now. So this time around, it was very interesting because all of a sudden there were a bunch of NEW bears that the rates guys had never seen, they weren’t bond or Japan specialists but equity or macro guys who put the trade on with gusto. So all the fixed income guys sat up a few weeks ago and said “whoa who are these new shorts” and quite rightly, they wondered why now, since there is no new “news” for Japanese bonds and all the negatives are well known for professionals in the bond market.
And finally, this observation from another savvy JGB watcher:Certain investment banks were shopping around trade ideas that revolved around the almost certain explosion higher in Japanese rates thanks to an ever growing public debt/GDP ratio (approaching 200 per cent). It’s inevitable that rates must go higher with so much issuance, right? (Note the parallel with the US, too). Well the only people who disagree are Japanese domestics that take every opportunity to hoover up bonds.
In the JGB market since January there have been five short squeezes including the current one, he adds, noting: “You can’t teach an old dog new tricks and it seems some foreigners trading Japan have the same issue.”
And to end with some “down-home sagacity”, he concludes:There are two golden rules in life: don’t get involved in land wars in Asia and don’t fight Japanese domestics on rates.
Related links:
More fun with JGBs, more headaches for Japan – FT Alphaville
Japan bonds gain the most since June – Bloomberg
Japan, Einhorn and ‘tontine’ fantasies – FT Alphaville
Japan’s sovereign debt crisis looms – FTfm