Published in The Financial Times 21/12/2012
The trade is known as the widowmaker because it has been financially fatal for so long. Generations of gunslinger macro traders have met their nemesis by shorting Japanese government bonds. They walk in cool and confident, armed with their PowerPoint presentations. They leave town horizontal, soaked in red ink.
The rationale was always compelling – why should Japan have such absurdly low bond yields when the debt to GDP ratio is the highest in the world, government spending is roughly twice tax revenues and the population is rapidly ageing? And the result was always the same. At whatever level of bond yields the call was made – 3% in 1996, 2% in 2002, 1% in 2011 – you lost money.
Back in the day a neophyte investment analyst was sometimes despatched to the trading desk to demand an explanation for an unusual price move. The standard response was a sarcastic “more buyers than sellers.”
That’s the best summary of what has been going on in the Japanese bond market for the past fifteen years. It also describes what has been happening in global bond markets since 2008, when the world started turning Japanese.
Private sector deleveraging, distrust of risk assets, loss of faith in growth, broken banks – these have all contributed to the surge in demand for government paper.
The turmoil in the periphery of the Eurozone appeared to offer an alternative narrative – that excess debt could lead to sovereign debt crises. But this was illusory since Greece, Spain and the rest are not sovereigns. Wherever governments have retained control over their currency, the markets have shrugged off deficits, ratings downgrades and the prognostications of professional doomsters.
Following the Japanese template, bond yields have fallen while debt levels have risen. The more debt you issue, it seems, the better the terms. This has been so in the developed world and in the developing world; in countries that have current account surpluses like Germany and in those that are in perpetual deficit like the US and UK.
The reality is that bond markets have reflected economic fundamentals. Risk-free rates should approximate nominal GDP growth, which has been in sharp decline globally. In Japan, it has usually been negative – which is why the Bank of Japan’s supposedly loose monetary policy has been too tight. With governments caught between stimulus and austerity and monetary policy achieving little traction, bonds have looked the safest bet.
Super-low yields were not a badge of honour, as some politicians maintained, but the sign of failure to turn back the deflationary forces unleashed by the global financial crisis
The great investment question for 2013 is whether change is in the air and the deflation trade is over.
In Japan itself, the thumping election victory of Mr. Shinzo Abe and his Liberal Democratic Party means that the last bastion of hard money has fallen. The next governor of the Bank of Japan, to be appointed in the spring, will be a dove, and a regime shift towards inflation targeting is likely. There will also be less enthusiasm for driving the economy off a fiscal cliff, as outgoing Prime Minister Noda risked through his planned tax hikes.
Globally the move to soft money is gathering new impetus – as witnessed by the Federal Reserve’s adoption of the Evans Rule and favourable mention of nominal GDP targeting by the Bank of England’s governor-designate.
Is this going to be enough to change the “more buyers than sellers” paradigm? In the first instance, probably not – because greater central bank activism means greater purchases of government bonds. The Swiss ten year bond trading at 0.5% should be a bloodchilling sight to any bond bear.
In the medium term, however, it is likely that governments succeed in providing what their electorates are more comfortable with – higher inflationary expectations. The aftermath of the global financial crisis shows that once radical options can quickly become mainstream. If current policies don’t produce results, new ideas are waiting in the wings – such as the outright cancellation of bonds held on central bank balance sheets.
In fact the successive waves of QE (quantitative easing) have lifted inflationary expectations as measured by the bond market’s breakeven rate. In the US the rate has risen from negative in the aftermath of the Lehman shock to the average levels of 2000-8. Even in Japan five year inflationary expectations have risen well above the bond yield. Almost everywhere investors in government bonds are facing negative real yields – an unnatural and potentially combustible situation.
In Japan this could be the widowmaker’s last ride. If so, the repercussions will be felt more widely. World bond markets have had it too good for too long.