Why would a hedge fund manager be interested in adult diapers? They are a clue to what growing numbers of hedge funds are now seeing as the next big trade: the bursting of Japan’s bond bubble.
This year, sales of adult diapers in Japan eclipsed sales of infant ones for the first time; a neat statistic that captures the huge demographic challenge the country faces – one big factor of several that bears believe are behind a crisis set to break in the coming months.
“What did Bernie Madoff’s titanic Ponzi scheme teach the world?” asks Kyle Bass, a Dallas-based hedge fund manager who has garnered a wide following for his contrarian – sometimes borderline apocalyptic – views, in his letter to investors this month.
“A key takeaway should have been that you can make outlandish promises for the future as long as you maintain one key ingredient: more victims entering the scheme than exiting.”
His point is simple: social security costs in Japan have been rising steadily. The retirement age is 65. And the peak years for Japan’s birth rate were the four from 1947.
Japan is finally facing its reckoning, Mr Bass says, driven by insuperable demographic forces and triggered by a worsening current account– which has for the first time slipped into deficit – after years of widening debt to gross domestic product and falling government revenues.
And yet, we have been here before. Betting against Japan has been a persistent hedge fund favourite.
David Einhorn, founder of Greenlight Capital, for example, has been short Japan one way or another since 2009, and shorting the yen has been a failed trade for many of the world’s most seasoned macro hedge funds four years running.
As if to underscore the point, Japanese government bond yields reached multi-year lows this week. As SocGen analysts have written, expecting them to rise seems tantamount to “chasing rainbows”.
Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Morgan Stanley, describes an “unshakeable JGB absorption structure”, whereby the gap between loans and deposits at banks is filled by government bonds. Current data suggest the banks have plenty of room to buy more, he says. “We see no indication at all that the desire to buy JGBs on dips is weakening.”
All of which is not deterring new hedge fund bear converts.
“We believe that things really are now set to shift,” says Christopher Rigg, a life-long Japan expert who runs a new dedicated Japan-short fund at UK-based activist Audley Capital. “We think it is all coming together now.”
Mr Rigg’s thesis is more moderate than Mr Bass’s: he says a catalyst for change will be the Japanese elections, set for December 16, which look set to usher in Shinzo Abe, head of the Liberal Democratic party, as prime minister.
“Abe is defined by his desire for growth,” Mr Rigg notes. “It’s quite obvious that he wants the Bank of Japan to be more aggressive.”
With the governor and two deputy governors of the BoJ set to be replaced early next year, an Abe administration could lead to a permanently more dovish BoJ, Mr Rigg says, which would be likely to break new ground in quantitative easing by buying foreign bonds.
Mr Rigg expects such a development could push JGB yields as high as 2 per cent – nowhere near the 6 or 7 per cent catastrophists see but enough to make short sellers huge profits.
“There are some people who look at the debt dynamics of Japan and go ‘oh boy’ – people who think this is a Greek-type situation with yields at 6 per cent. I’m not saying that it can’t happen but we don’t think it will,” he says.
And nor, crucially, do hedge funds need it to in order to make big returns.
Audley tells potential investors in the Japan fund to expect triple-digit percentage gains – based on current futures prices against Japanese debt – if its thesis is proved correct.
It is precisely the asymmetry of the Japan trade, as much as the fundamentals behind it, that is now making it so attractive to hedge funds once more.
“Japan’s situation is such that the question is no longer ‘why bet against it?’ but ‘why not?’” says one portfolio manager at a large global macro firm. The cost of taking out puts on Japanese bonds is negligible. The upside huge.
It might, nevertheless, prove to be a long trade, and one peppered with uncertainties.
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