"Japan is about to 'detonate' a 'debt bomb' and will be forced to massively devalue its currency. Japan's $14 trillion bond market is heading for a crash." -- Kyle Bass, hedge fund manager.
Known as the "widow maker," one of the more defined asymmetric trades of recent years has been shorting Japanese Government Bonds (JGB). This has been laid out well by Kyle Bass in this interview at the University of Virginia. Of particular interest is his discussion of Japan starting at minute 3:30. Bass argues that Japan is already in a crisis and that the likely election of Shinzo Abe on Dec. 16 will set off a chain of events that will result in a devaluation of the Yen and send JGB yields skyrocketing.
"Abe is defined by his desire for growth. 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, which would be likely to break new ground in quantitative easing by buying foreign bonds.
"Japan is entering its final 'checkmate' phase of the chess game. We think Abe's a shoo-in. And he said he's going to do everything possible to get to 3 percent inflation. He doesn't even know what he wishes for, because if he gets there, he detonates his debt bomb. When there's a press release put on the BOJ's website from the MOF, the BOJ and the government - that's analogous to Bernanke, Geithner and Hillary Clinton issuing a joint press release saying 'we're going to end deflation.' This is how it begins to happen. Their backs are against the wall. They have a full crisis. They absolutely have to change the manner in which they deal with their currency. If and when the dominoes fall, I just hope the U.S. doesn't collapse first. All my money is bet that it won't. That's my biggest fear. That I'm wrong about the chronology of events. But I'm convinced what the ultimate outcome is."
Other key points:
- Japan is already running a $100 billion trade deficit. You have a balance of trade that's literally being rewritten and falling off a cliff and their GDP is now tracking -3.5, -4 percent.
- The country's GDP has been hit by a Chinese boycott stemming from the Diayou/Senkuku islands dispute. Japanese corporations have large Chinese exposures and several of the largest electronics companies in the world -- Sharp, Sony and Panasonic -- now have financial difficulties (WSJ: Japanese Electronics Behemoths Speak of Dire Times).
- You have a secular decline in the population happening. The retirement age is 65, and the peak years for Japan births were 1947-1951. The situation in Japan is unsustainable and the government is looking to cut pension payments by 2.5% from October 2013 to April 2015 in line with falls in the Consumer Price Index. Bloomberg reports that Japan's public pension fund, which is the world's largest, has been selling off domestic government bonds as the number of people eligible for retirement payments increases. "Payouts are getting bigger than insurance revenue, so we need to sell Japanese government bonds to raise cash," a source told Bloomberg. It would appear the Ponzi has reached its tipping point. Japan's population is aging, and baby boomers born in the wake of World War II are beginning to reach the pension-eligible age of 65. That's putting GPIF under pressure to sell JGBs so it can cover the increase in payouts. The fund needs to raise about 8.87 trillion yen this fiscal year. GPIF is historically one of the biggest buyers of Japanese debt and held 71.9 trillion yen.
- The JGB is already buying two-thirds of the bonds today. The Bank of Japan, just reported that in the quarter ending Sept. 30, the Japanese central bank reported an operating loss of ¥183.4 billion, and a net loss of ¥232.9 billion.
- Fiscally Japan already spends a third of its tax revenues on interest payments. Their debt is 25 times their revenues.
- Ten-year JGB yields virtually nothing at around three-quarters of a percent.
The question now is what will happen when and if Japanese households panic? Japanese households held 1,515 trillion yen in assets at the end of June 2012. Even if they don't panic, will Japanese investors be quite so keen on a 0.75% yield in a 2 or 3% inflationary environment? They may be already rendering their verdict even before Abe's doves arrive.
"It's a case of retail JGBs not having enough yield," Naomi Fink, head of Japan strategy at Jefferies Japan Ltd., told Bloomberg. "Households are accumulating cash and using financial investments to diversify into higher yields and JGBs don't really provide this ... Individual investors are holding cash rather than bonds and other financial assets."
Another question is where will Mrs. Watanabe run to when inflation is no longer constrained by the previously inflated Yen? There are already signs of literal cash hoarding. If Japanese banks, which are heavily exposed to JGB, get even more shaky, it could accelerate into a bank run. In the past, Mrs. Watanabe has been a carry trader, borrowing in yen to purchase higher yielding currencies, such as the Brazilian Reis, Aussie Dollar and Turkish Lira. Of late, Japanese investors have been selling gold, but that could change if the Yen swoons and inflation picks up. She has also moved away from the BR Reis, which was a previous favorite.
Unless the fictitious capital represented by 14 trillion in JGB is quickly destroyed and goes to money heaven, the Japanese investor class will be running all over looking for a safety valve. Therefore, the JGB yield should be carefully monitored because once rates start spiking, Japan's government will be overwhelmed by a fully sprung debt trap -- fiscally Japan already spends a third of its tax revenues on interest payments -- and huge losses in JGB assets will be incurred. If the bond yield rises to 2%, the interest expense alone will surpass the total expected tax revenue of 42.3 trillion yen. This will have game-changing ramifications globally.
For those wishing to try this trade, the sequence to playing the end-game is to consider to what degree Mrs. Watanabe can get out the burning house before her wealth, held in fictitiously priced Japanese assets, is destroyed. The process will likely occur simultaneously, as the capital flight becomes the causa proxima of the JGB-Yen bust. But as financial institutions collapse, a large portion of these assets will go to money heaven. The various trades to utilize would be in two sets. The first set is to short yen/short JGB. The JGB trades as a mini-future in Singapore. The other set would be the carry trade currencies mentioned above and perhaps gold. Gold has been a side show for Japanese retail. My preferred trade in gold is cheap, out-of-the-money calls one month out in the futures or GLD as the implied volatility at 12 is at record lows.
The trade mechanics for U.S. retail investors playing a Japan bust are not simple because the main pairs are in other troublesome currencies, but some can be laid out. In terms of currencies, I'm not interested in bonds, as I believe we are witnessing a central-bank infected global bond bubble, especially in the major developed nations. I don't anticipate Mrs. Watanabe will run into the USD or euro. Forex trading in the past has been limited to primary currencies, but CitiFx has opened up some new pairs, including the ones Mrs. Watanabe favors. Of mention (along with current interest rate carry levels) are JPY (o.1%) / Australia 3.25%, Turkey 5.75%, New Zealand (2.5%), Poland (4.5%) and Norway (1.5%). These are all relatively solvent countries for now. The Aussie is a crowded long currently.
Sadly, Brazil, Russia, India and China are not available in Forex trading. Even though the Hong Kong Dollar (0.5%)/ JPY is not much of a carry, this pair is interesting because some like Kyle Bass and Bill Ackman (presentation on this concept) are using this as an asymmetric trade, thinking Hong Kong may end its USD peg. Speculators would have to use USD futures in the BR Reis or employ various ETFs like BZF (Brazil currency) and ICN (Indian currency), but those trade in a USD pair -- not yen.
In viewing how this general trade is situated right now, it should be noted that speculators have gotten heavily short the yen against the U.S. dollar. Judging from this market action, the myth of the yen as a "safe haven" is at last being challenged. This can be problematic as a position like this has the potential of being squeezed in part because the myth of the U.S. as a safe haven may be similarly challenged and soon enough. That's why Bass called this the most difficult environment of his career. So the idea may be to avoid both of these currencies and the euro. If you end up taking the short yen against the USD, use futures puts as they are very cheap. So far, the yen has already been quite weak (and inflationary), but this has yet to translate into JGB weakness. But for timing purposes, the useful set up to short Yen might be to use the USD convergence overhead (perhaps in conjunction with a fiscal cliff reality check), then short yen and go long various carry trades mentioned. This topic will be spotlighted in my Actionable service. Links to that site are on my profile information.