Is Shorting This Market 'Easy Money'?

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, FXY, GSJY, HEWJ, HFXJ, HGJP, HJPX, JEQ, JPN, JPNH, JPNL, JPXN, JYN, UDN, USDU, UUP, YCL, YCS
by: Long/Short Investments

Summary

Japan's sovereign debt is at sky-high valuations and catalysts are taking effect to reprice the debt downward.

Catalysts: Increased demand for credit, higher developed world inflation, Federal Reserve tightening, weak yen.

Risks: Inflation may fail to sufficiently pick up, cautious Fed (waiting to learn economic effects of Trump policies, ideologically dovish), excessive BOJ control in market, subject to potential time fatigue.

Thesis

Short longer-duration Japanese government bonds ("JGBs"). Japan (NYSEARCA:EWJ) is facing a highly unsustainable debt situation, credit demand appears to be picking up, inflationary pressures are growing, and any degree of tightening this year from the US Federal Reserve will increase the allure of US-based assets relative to Japanese assets. All of these events are expected to lead to an increase in selling in a very expensive JGB market.

Overview of Japan's Situation

Japan is the most highly indebted country in the world when measured as a percentage of GDP. This figure was about 230% officially at the end of 2015 and likely somewhat higher currently. Most of the debt expansion has been a product of demographics, with low fertility rates, an aging population, and low immigration rates to replenish the labor supply. Japan's average age is approximately 47 (world average is around 30) and around 27% of its population is age 65 or older (OECD average is 17%-18%). Only 1.6% of the population is comprised of international migrants, compared with 12%-13% in other OECD countries.

All of these demographic-related issues have swelled dependency ratios, caused by ever-expanding entitlement spending coupled with a diminishing tax base of working population citizens. Upon the end of Japan's post-war boom in 1989, deflation ensued, and growth has been scarce ever since. Naturally, this has only exacerbated the issue. This combination of deflation, low growth, and escalating central government debt has placed interest rates at sub-1% territory for more than two decades, and the BOJ will continue its highly accommodative monetary policy bias for the foreseeable future.

Ultra-low rates have nonetheless thwarted bank profitability given the minimal yield spread these monetary policies afforded. Accordingly, back on September 21, the BOJ - innovator of many policies (because its ugly economic situation has forced it to) - introduced yield curve pegging. Namely, instead of setting rates at the very front end of the curve (the overnight rate), the BOJ also set a point along the middle of it to steepen the yield curve and engineer more profitable lending in the financial sector.

In this particular case, the 10-year yield was pegged at 0% and could go no higher than 0.10%. This entails that 10-year bonds will trade between 0.00%-0.10%. And until very recently, it appeared this would perhaps be a longstanding artificial peg similar to a fixed exchange rate currency where the BOJ would need to continually sell JGBs to avoid dipping back into negative yield territory.

But beginning in November, global inflation expectations picked up given the expected shift to expansionary fiscal initiatives in the US (24%-25% of the overall world economy), which in turn flowed into other economies as well given the general interconnectedness of the global markets. This has eliminated the need for the BOJ to sell 10-year bonds in order to keep the yield artificially "high" at 0%. Instead, it seems more likely that it will now have to enter the market to buy at 0.10%, as it did just last week when the market tested the BOJ's resolve at this level.

The fact that the market could push yields above 10 bps on the 10-years (before the BOJ inevitably came back in to manage the market) demonstrates that the equilibrium point for the market is higher given there's sufficient demand for credit at rates above this level.

Trade

The idea is to sell JGBs of maturities greater than 10-year duration, as the curve isn't managed above the 10-year point. Or one could find an alternative means of expressing the same thing (shorting JGB futures). Shorting the futures market is also doable within most broker platforms. The nice thing about shorting no-yield or close to no-yield bonds is there is effectively no cost to doing so, outside of borrowing cost and any transaction fees.

A cautionary note is that bonds of greater than 10-year duration are less liquid, so there is always the risk you can't get in or out at the price desired. But given that the BOJ has publicly come out and stated it wants the yield curve to steepen, going short rates on a longer end of the curve is really the only type of trade that makes sense. The 0-10 year portion is fully within the constraints of the BOJ's directive, running from -10 bps (overnight rate) to +10 bps (upper end of the 10-year range).

On the 20-year, each 100-bp rise in yields projects to provide about 15% gains on an unleveraged basis.

What will drive bond yields higher?

1. Increasing demand for credit in the Japanese economy

This is/would be the most fundamental, organic reason. When the market tested the BOJ on how serious it was about buying up 10-years at 0.10%, it got the bank to push back yields into the 8-10 bp range.

2. Higher inflation in the US and EU bleeding into Japan

From July-December 2016, inflation accelerated 130 bps in the US. From October-December, inflation accelerated 120 bps in the euro area taken collectively. Japan's inflation rate increased by 80 bps from September-December. Higher inflation causes some degree of repricing of fixed-rate bonds given it eats into yields.

3. Central bank tightening from the US Federal Reserve

The Fed is likely to underperform on its projections of three 25-bp rate hikes in 2017. (I'd give it a 75% chance it won't do more than two.) I believe it'll go twice - once in two of the three meetings in June, September, and December. Inflation is likely to be around 2% in the US by June, and if Q1 GDP comes back at 2% or better in year-over-year terms, I believe a June rate hike will be forthcoming. But a lot can change in the next few months.

An interest rate rise from the Fed will make US assets look more attractive relative to Japanese assets (higher yields), leading to capital outflows from Japan and an increase its own sovereign debt yields.

4. Weakness in the yen (NYSE:FXY)

The US economy is stronger than that of the Japanese economy, is in tightening mood, and could lead to further price appreciation in the US dollar (NYSEARCA:UUP)(NYSEARCA:UDN) at the expense of the yen.

Moreover, Japan keeps printing money to stimulate inflation. Japan's M2 money supply has grown 19% in the past five years (3.5% annualized), yet actual inflation has only been around 5%-6% (1% annualized). In theory, these should balance out in the long run. But there has been such insufficient demand for this liquidity (hence why rates are negative) and inflation has badly underperformed accordingly.

Currency depreciation is inherently inflationary, as it effectively reduces consumer purchasing power. Inflation creates lower yields in real terms, which may cause investors to require higher returns in nominal terms, pushing prices higher.

Reasons this could fail

1. Inflation fails to pick up

I've written about this quite a bit in the past, even dedicating an entire post to it, but there are several structural headwinds to higher inflation in the global economy. The argument mainly resides in the fact that public debt as a percentage of GDP is so high in the US, EU, and Japan that higher interest rates substantively impact government deficits.

2. The Fed fails to raise rates to the extent of the market's expectations

Either US data could underperform, or the Fed could be cautious due to factors related to how its decision-making could impact the fiscal side of things.

For example, if the Fed were to raise rates three times in 2017, that would expect to raise the US federal budget deficit by 0.80%-0.85% as a percentage of GDP. This would come to around $150 billion, at an average cost of $1,230 per taxpayer. Needless to say, this is not a trivial amount.

The US will also find any fiscal consolidation efforts difficult in the near term and could table such proposals such as public infrastructure spending to avoid expanding budget deficits. I would expect the US to run deficits at -3% to -4% of GDP over at least the next two years. For now, each Fed rate hike will cost the US taxpayer about $50 billion and this number could grow without increased fiscal responsibility.

However, it's uncertain what effect this will have, as raising rates is a binary choice and only done in 25-bp increments.

3. Japan's sovereign debt markets is engineered by the BOJ

The BOJ owns 35%-40% of the JGB market as part of its quantitative easing efforts. Therefore, like in the EU, Japan's government debt market is largely not subject to a free market mechanism as it's effectively "rigged" in favor of fulfilling the central bank's policy objectives.

This can keep yields low as long as QE is in place. The EU's QE efforts are set to expire by year-end 2017. However, with Japan's perpetual stagnancy, there is no end in sight regarding its own program.

4. Time

The idea of going short JGBs is not new. If yields continue to stay relatively low, the potential returns on this trade don't project to be very favorable.

Conclusion

It seems almost shocking that the most indebted country in history could have long-dated bond yields trading near 0%. Yet due to massive amounts of quantitative easing and low rates designed to spur along a moribund economy, bond yields have been held down for a very long time.

It is expected that once the debt load becomes large enough and enough inflationary pressure builds in the economy, bond yields will finally rise and those positioned correctly can potentially achieve solid gains going short the sovereign debt market.

However, this trade carries risk. Most prominent is the notion that inflation could fail to materialize due to numerous structural headwinds globally. Moreover, the world's most influential central banks - Fed, ECB, BOJ - are still more or less in "risk off" mode. The latter two will not tighten their overnight rates for possibly two years, although the ECB will begin tightening in the sense of possibly ending its QE program at the end of 2017.

The Fed projected three rate hikes for 2017, but the US faces its own debt situation with the second largest debt-to-revenue ratio in the world (behind Japan). Uncertainty with respect to how President Trump's policies will affect the global economy may keep the Fed on hold until it gains greater clarity. Accordingly, if rates stay relatively steady in the US, it will limit capital outflows out of Japan and continue to hold down JGB yields.

Disclosure: I/we 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.

Additional disclosure: Short 20-year JGB's; long USD/JPY