Never short a Japanese government bond — no matter what you think of the country’s debt-to-GDP ratios, demographics, savings and the like. The JGB market can stay irrational longer than you can stay solvent etc. So swaption it, instead.
Here’s Bank of America Merrill Lynch’s Bin Gao on why:
Given the level of debt that Japan faces, at some point, rates inevitably need to rise when the demographics will not produce enough savings to support the bonds and out of concern about the country’s ability to continue servicing the debt. Although the rates have been consistently low, it still strikes investors as too expensive to simply go short the bond. Thus, swaptions have been a more favorite instrument, especially those of deep-in-the-money payers. The thinking goes that once rates start rising due to debt-service troubles, the sky will be the limit for rates and the little premium that is paid now will be nothing compared to the potential payoff generated in that scenario.
The rates will likely rise… We are less hopeful that this is the time to put on such a trade hoping for Japan to become the next Greece or Ireland. That does not mean rates would not rise in Japan. We actually believe they will, for different reasons, driven by demand/supply imbalances due to an improved global outlook. In a couple of pieces … we have discussed why banks, being the main support for JGBs, may not have enough cash to support the market in the coming year. Critical in this equation is the capex spending, cutting into deposit growth or boosting lending growth, leaving less capital for JGBs.
… but they will not grow explosively. For one thing, rate rises due to any improvement in the fundamentals should not lead to a heightened concern about default – so the upside for rates should be capped. On the other hand, if rates do rise significantly due to negative reasons (forced bank selling due to loss on JGB books in a weak economy with continued deflation), we will likely see a more active Bank of Japan, sidelined so far, whose balance sheet will afford it to come to the market and push the rates back down again to provide better support for the economy.
So in the meantime, we’ve got plenty of JGB volatility to look forward to, according to BofAML. For instance, you’ve got continued political instability — which feeds into stimulus policies and the JGB market. But also … earnings season at the banks:
Coming around the corner is the fiscal year-end. Banks, as the major buyers of JGBs over the last two years, are sitting on big positions with both yield and yield volatility around 50% higher for the last three months (mid-November to mid-February) than in the three previous months (mid-August to mid-November). The loss and the higher risk have cut significantly banks’ capability for taking more risks. Mega banks holding of JGBs, instead of falling, actually increased from November to December by 3 trn yen, making the risk even higher.
The yield on the benchmark 10-year JGB is at a 10-month high on Wednesday.
Related links:
Japan’s savings rate about to go negative, Goldman says - FT Alphaville
‘A new era of Treasury price volatility’ - FT Alphaville
Clock ticks on Japan’s low debt yields – FT Analysis
Domesticating the debt - FT Alphaville