by Charles Sizemore | December 5, 2012 9:43 am
All subcultures have their rites of passage. Marine recruits have basic training. Fraternity boys have hazing. And macro traders have the Japan short.
It seems you’re not part of the club until you’ve lost money shorting Japan bonds or, more recently, the yen.
You’ll do it for all the right reasons, of course. We all do. And chances are good you’ll still lose on the trade. It happens to the best of us. Even hedge fund “masters of the universe” like Greenlight Capital’s David Einhorn. Japanese bond yields have defied the bears for years, as if they are held low by the weight of an immovable sumo wrestler.
Or maybe not.
Just two weeks ago, I wrote that Japan would be the next shoe to drop in the global financial crisis, and I got a fair amount of hate mail for it from other investors. (“Hate mail” may be a little too harsh. We’ll go with “strongly worded professional disagreement.”)
Yes, Japan may be the most heavily indebted country in the world with debts that far outweigh those of Greece, Spain or Italy. But this debt is held domestically, the thinking goes, so Japan isn’t at risk of an attack of selling by the bond vigilantes.
This is flawed thinking for a number of reasons, which I’ll address in a second. But first, I want to ask a simple question:
Why not short Japanese bonds and the yen?
Seriously, you have nothing to lose. The Japanese 10-year yields a pitiful 0.69%, less than half the yield of the also pitifully low 10-year U.S. Treasury. The laws of mathematics are pretty straightforward here. Bond yields can’t go below zero. Shorting Japanese bonds at these levels is a coin toss in which “heads, I win” and “tails, I have virtually no room to lose.”
And the yen?
Traders are lining up to short the yen right now. The short position in the currency recently hit a five-year high, as measured by the U.S. Commodities Futures Trading Commission. Whenever I see a crowded trade like this, I get a little suspicious. But I can certainly understand the bearishness here.
The yen has been in a raging bull market since the carry trade “blew up” in 2008. Traders had been using the yen as their funding currency for years because rates were so much lower in Japan than anywhere else in the world. But once the dust settled after the 2008 meltdown, rates in the U.S. and Europe weren’t much higher. And with the eurozone looking like it was about to come unwound, parking a little cash in yen seemed like a less bad idea.
All of this contributed to the yen bull market. But this trend has gone about as far as it can. As I wrote in the last article, Japan’s domestic population is dying. It’s the oldest country in the world, and more adult diapers are sold there than children’s diapers (stop and think about that for a second).
With a shrinking domestic market, Japan needs exports to stay above water … which means that it needs a weak currency. The high price of the yen (along with weakness in Japan’s export markets in the U.S. and Europe) sent Japan’s famed trade surplus into deficit for much of 2011 and 2012. You think Japan’s leaders are happy about that?
The fair question to ask is “Why now?” Japan has been a wreck for 20 years, and the country has lived with high debt levels for a long time. Why is this time different?
To start, Japan’s probable next prime minister, Shinzo Abe, has made it a point of policy to lower the value of the yen with unprecedented levels of quantitative easing. He also wants an explicit inflation target of 2% to 3%. It’s hard to see interest rates staying at less than 0.7% if inflation gets anywhere near that level.
If the yen continues to crack, we may actually get a decent short-term rally in Japanese stocks. But whatever you do, don’t fall in love with this trade. If interest rates rise significantly, Japan will have a hard time rolling over its debt — and it’s colossal, at 220% of GDP. If we start to see rates creeping up, I expect to see a lot of volatility in Japanese equities.
All of this is compounded by the fact that Japan will have to increasingly fund its large budget deficits (roughly 10% of GDP per year) in the international bond market. The Japanese savings rate isn’t what it used to be. In fact, at 1.9%, it’s lower than America’s now.
Do you think international bond investors — those same investors that drove Spain and Italy to the brink of needing sovereign bailouts — will continue to roll over Japanese debt at current rates? Yeah, me neither.
When Japanese rates begin to rise, I believe we’ll have the short opportunity of a lifetime in Japanese assets — stocks, bonds, the yen, you name it.
Investors wanting to short Japanese bonds can go about it several different ways. One option is the Powershares DB Inverse Japanese Government Bond ETN (NYSE:JGBS), though you should be careful with this one. It’s thinly traded.
Shorting the yen via exchange-traded funds is a little easier with the ProShares UltraShort Yen ETF (NYSE:YCS). And shorting Japanese equities can be done with the ProShares UltraShort MSCI Japan ETF (NYSE:EWV) or by simply shorting the popular iShares MSCI Japan ETF (NYSE:EWJ).
In the meantime, be patient. Unless you want to join the “macro traders who lost money in Japan” club.
Note: For an interesting piece that takes the other side of the argument, check out Steven Towns’ bullish piece on Japanese equities. Towns makes a compelling case for several Japanese blue chips, and many I would consider buying after a major crash. But for now, I see the best opportunities in Japan coming on the short side.
As of this writing, Sizemore Capital has no positions in any securities mentioned.
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