Singapore and New York (Reuters) – Investors who bet that Japan will have to stop its ultra-loose monetary policy are getting into riskier and more expensive territory as the fight moves to the bond market, which is the Bank of Japan’s home turf.
Japan is now the only major economy with near-zero interest rates, and the yen has taken a beating because of this. Hedge funds and momentum-chasers have made money as the gap between Japan and its rate-hiking peers has grown.
As the currency falls to levels not seen since the late 1990s, bets on further drops are being cut back, and funds are moving right into the path of the BOJ to short the government bonds that it has promised to support without limit.
The allure is a windfall profit if the BOJ gives up its yield-curve control (YCC) policy and 10-year Japanese government bond yields shoot up from their de facto cap of 0.25 percent to Goldman Sachs’ estimate of fair value, which is around 0.60 percent or higher.
Even so, the price could be too high while the BOJ stands firm. It bought so many bonds that it messed up a market that had been calm and drove up the cost of staying in a trade known as the “widowmaker” because it rarely makes money.
The BOJ bought more bonds in June than ever before. Because it controls the market, dealers must pay up to 3% more per week to borrow the most popular cash bonds, and futures contracts have become extremely volatile.
Ales Kounty, who runs the global bond portfolio at Janus Henderson Investors in London, said, “It finally makes things interesting.”
“But the problem is that there are a lot of leveraged positions, and this level of volatility is going to cause a lot of VaR shocks,” he said, referring to how the value-at-risk, or the size of the possible loss on the trade, can skyrocket.
The Bank of Japan hasn’t said anything to suggest that it will change its policy. This week, Governor Haruhiko Kuroda even said that if needed, the bank would take more steps to make money easier.
At its policy meeting next week, the bank is not likely to say anything new. Instead, it is likely to repeat its promise to keep policy very loose. Compared to other countries, Japan’s inflation is still pretty low, and the economy is still not back to where it was before the pandemic.
Tourists
Kounty’s fund is sticking to a strategy of using interest rate swaps to bet that Japan’s artificially flat yield curve will eventually get steeper. This, he says, might pay less than shorting bonds but can be done with much less risk.
But there are signs that at least some investors have been scared off by the recent wild swings in the bond market or by how much the BOJ is buying and have started to move away.
In recent days, the 10-year cash yield has dropped below the Bank of Japan’s goal. Since the middle of June, turnover on the futures market, which was popular with short sellers, has also dropped sharply. [JP/]
“I think a lot of tourists would have stayed away for now,” said Jimmy Lim, CEO and chief investment officer of $950 million macro fund Modular Asset Management. Since June, Lim has been cutting back on a short position in JGBs.
“In terms of value, you won’t gain much unless you completely give up on YCC,” he said. If policymakers only made small changes, the effect would be less dramatic.
“You lose carry while you wait for that to happen. If it happens next year, you could lose 40% of your carry, which means you’ll have less money to “r gain.”
WHO BLINKS FIRST?
The price squeeze on short sellers is just one of many things that put pressure on both sides of the trade and test their strength.
Investors think that the fact that inflation has finally hit the BOJ’s 2 percent goal after years of trying and that the yen is falling are signs that the policy can’t go on for much longer.
But they are also worried about how hard the BOJ will stand up for a policy experiment that it started.
Based on data from the BOJ, Deutsche Bank (ETR:DBKGn) calculated that the BOJ bought a record 16.1 trillion yen ($116 billion) in JGBs last month. This is more than the Federal Reserve will buy each month for most of 2020 and 2021.
This means that it now owns more than 50% of the bond market, which is a drain on liquidity. Some of its purchases have also caused unexpected tensions in the futures market.
“Bond scarcity can get worse, as it has, and some issues can become very special, with borrowing costs going up,” said a portfolio manager at a global asset management firm who asked to remain anonymous.
The high cost of borrowing JGBs also shows that there is still a lot of short interest.
A spokeswoman for BlueBay Asset Management said that the company hasn’t changed its bet on the BOJ giving up, and it still has “a short position with respect to Japanese yields.”
But with prices where they are now, it might not be such a sure thing.
David Beale, who works with macro funds at Deutsche Bank in Singapore, said, “From a hedge fund’s point of view, they still want to have something in their portfolios that will do well if the Bank of Japan changes its control of the yield curve at some point.”
“They’ll do it when the market doesn’t think they will.”
($1 = 138.2900 yen)
