The Time To Short Japanese Government Bonds Is Now

Includes: JGBD, JGBS-OLD
by: Shubhendu Pathak

The Japanese saved, and the rest of the world consumed

Japan ran a trade surplus with the rest of the world for more than two decades before 2011. The BOJ bought the dollars earned by the Japanese exporters and used those dollars to buy the U.S. treasuries; hence the enormous $1.13 trillion holding of the "asset". The Japanese saver, who in effect holds this asset, is now aging, retiring, becoming a net consumer and locking horns with the mighty consumer of the U.S.

Surpluses become deficits when net savers become net consumers; the post Tsunami strengthening of the Yen in 2011 only accelerated the shift that would have occurred eventually. However, the government is now trying its best to reverse this shift by devaluing the Yen in order to spur exports. Nations don't export for the sake of exporting; they export to be able to import products that are produced more efficiently elsewhere. Running high surpluses for decades to pile up "IOUs" does not make economic sense.

The Japanese saved, and the Japanese consumed

The government debt is now well above 230% of GDP, and it takes about half of the tax revenues just to service it. Despite the expanding monetary base and government spending, inflation remained negative for majority of the period since 1995.

This was one thing that was going in favor of the Japanese saver suffering from a stagnating economy. The Japanese savers were becoming wealthier in real terms even with their low yielding fixed income assets. Thanks to the increasing labor productivity which, according to OECD, grew by 1.5% every year since 1990. Should one give credit to the government for building a world class infrastructure for this increasing productivity and the resulting deflation? Probably not.

The infrastructure spending should have resulted in higher revenues and a budget surplus at some point but that does not seem to be the case. Budget deficit is currently at 7% of GDP. Clearly infrastructure was not the only government spending during this period. There were promises made and "fulfilled" by ambitious politicians in Japan that allowed some Japanese to consume at the expense of the other; it is not a surprise that social security and debt service were two major line items of the 2013 budget and past several budgets.

Japanese savers are ready to consume, but who is going to produce?

With the government determined to increase inflation, the hard earned savings of the Japanese are in danger. The BOJ recently caved in to the pressure from the newly elected Prime Minister to set the target rate of inflation at 2%. Masaaki Shirakawa, Governor of the BOJ, who has been resisting a decrease in interbank lending rate is stepping down in March. The interest that banks are currently earning on their excess reserves is likely to be scrapped after the new Governor takes over.

Should one buy the JGB expecting that the banks will use their excess reserves to bid up their price? Perhaps in the short term, as was seen post Mr. Shirakawa's announcement to step down on February 5; bond yields went down following the announcement. So the information is now priced in.

But who would hold a 10 year bond with a yield less than 1% when inflation is more than 2%? And it is not going to remain at 2%. Remember the Yen does not have the "safety valve" of being the reserve currency, a status that the U.S. dollar has been enjoying since 1944. If you flood the market with Yen, there is no China sitting out there to absorb the paper.

Japan's primary debtor, the U.S., itself runs a trade deficit of $6 billion a month with Japan and more than $40 billion a month with the rest of the world. The question is who is going to save and produce when both the debtor and the creditor become net consumers? All that the government and foreign debtors have to offer to the Japanese saver is paper and the stage is set for high inflation and eventually a high interest rate environment.

Tail risk is that the BOJ will not increase the interest rates even in a high inflation scenario. Takahiro Mitani, president of the Japanese public pension fund which holds about $750 billion in local bonds, is already considering a move away from the JGB. Clearly Mr. Mitani is not betting on that tail risk. It would be surprising if the fund is not followed by other investors as it is now perhaps the best time to short the JGB.

Investors outside of Japan can short the JGB by buying inverse JGB ETNs; levered if they want to assume more risk. PowerShares DB Inverse JGB Futures ETN (NYSEARCA:JGBS-OLD) and PowerShares DB 3x Inverse JGB Futures ETN (NYSEARCA:JGBD) are two good options. Another indirect strategy that the Japanese can use is to buy a house with a fixed interest rate mortgage. Such an investment will play out very well in the tail risk scenario. The downside to this strategy is that at some point when the inflation becomes unbearable the BOJ might decide to increase the interest rates, as Paul Volcker did in the U.S. in early 1980s. In such a scenario servicing even a low fixed interest rate loan might become painful as the Yen will be in short supply.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.