December 20, 2012 1:02 pm

Has Japan’s bond market made its last widow?

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Shinzo Abe’s poll victory means the last bastion of hard money has fallen, writes Peter Tasker

The trade is known as the widow-maker because it has been financially fatal for so long. Generations of gunslinger macro traders have met their nemesis by shorting Japanese government bonds. They walk in cool and confident, armed with PowerPoint presentations. They leave town horizontal, soaked in red ink.

The rationale was always compelling – why should Japan have such absurdly low bond yields when its debt to gross domestic product ratio is among the highest in the world, government spending is roughly twice tax revenues and the population is rapidly ageing? Yet the result was always the same. At whatever yield the call was made – 3 per cent in 1996, 2 per cent in 2002, 1 per cent in 2011 – it always fell further, and the bet lost money.

Back in the day a neophyte investment analyst was sometimes dispatched to the trading desk to demand an explanation. The standard response was a sarcastic “more buyers than sellers”.

That is the best explanation of what has been going on in the Japanese bond market for the past 15 years. It also describes what has been happening in global bond markets since 2008, when the world started turning Japanese.

Private sector deleveraging, distrust of risk assets, loss of faith in growth, broken banks – these have all contributed to the surge in demand for government paper.

The eurozone turmoil appeared to offer an alternative narrative – that excess debt led to sovereign debt crises – but this was illusory since Greece, Spain and the others are not sovereigns. Wherever governments have retained control over their currency, markets have shrugged off deficits, rating downgrades and the prognostications of doomsters.

Following the Japanese template, bond yields have fallen even as debt levels have risen. This has been so in the developed world and in the developing world; in countries that have current-account surpluses such as Germany, and those perpetually in deficit such as the US and UK.

In reality, bond markets are reflecting economic fundamentals. Risk-free rates should approximate nominal GDP growth, which has been in sharp decline globally. With governments caught between stimulus and austerity, and monetary policy achieving little traction, bonds have looked the safest bet.

The great investment question for 2013 is whether change is in the air and the deflation trade is over.

In Japan, the election victory of Shinzo Abe means the last bastion of hard money has fallen. The next governor of the Bank of Japan, to be appointed in the spring, will be a dove. A shift towards inflation targeting is likely. There will also be less enthusiasm for driving the economy off a fiscal cliff, as Yoshihiko Noda, the outgoing prime minister, risked with planned tax rises.

Globally, the move to soft money is gathering impetus – as seen in the US Federal Reserve’s move to tie monetary policy to unemployment and by favourable talk of nominal GDP targeting by the Bank of England’s governor-designate.

Will this be enough to change the “more buyers than sellers” paradigm? In the first instance, probably not – greater central bank activism will mean greater purchases of government bonds by those banks in the short term.

But in the medium term it is likely that governments will succeed in generating higher inflationary expectations. The aftermath of the global financial crisis shows that once radical options can quickly become mainstream policies. If current policies do not produce results, new ideas are waiting in the wings – such as the outright cancellation of bonds held on central bank balance sheets.

In fact, consecutive waves of quantitative easing have already succeeded in lifting inflationary expectations as measured by the bond markets’ break-even rates. The US rate has risen from negative in the aftermath of the Lehman shock to the average levels of 2000 to 2008. Even in Japan, five-year inflationary expectations have risen well above the bond yield. Almost everywhere, investors in government bonds are facing negative real yields – an unnatural and combustible situation.

In Japan this could be the widow-maker’s last ride. If so, the repercussions will be felt more widely. World bond markets have had it too good for too long.

The writer is a Tokyo-based analyst at Arcus Research

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