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Japan’s Infamous Widowmaker Trade

The left main artery is absolutely critical to your survival.

This coronary artery and its branches provide a significant amount of oxygenated blood to the heart muscles.

Cardiologists sometimes refer to the left main artery, or a blockage within it, as the “widowmaker.”

This sinister nickname refers to the fact that an obstruction in this vital blood vessel foments the acute risk of a sudden, massive heart attack with a high mortality rate.

Like the human body, the financial markets have their own widowmaker, and it continues to confound traders and kill their capital.

The chart below shows the yield on 10-year Japanese government bonds (JGBs).

The Widowmaker: 10-Year Japanese Government Bond (JGB) Yields

There have been a few counter-trend moves, but interest rates in Japan have experienced an inexorable decline for around 25 years.

Yet, for a decade or more, many traders and prominent hedge fund managers have bet on rising rates and falling JGB prices in hopes of producing a profit. Remember, bond yields and prices are inversely related.

The JGB bull market has continued unabated despite Japan’s ever-growing mountain of government debt. In fact, Japan’s government debt-to-GDP has risen above 240%, the highest level in the world.

However, the market isn’t implying that Japan’s at risk of default… yet.

And until we see excessive weakness in the Japanese yen and a high inflation rate, that’s not going to change.

Terminal Decline

Japan is actually in the throes of gargantuan deflationary pressures due to bleak demographic trends.

The country’s total population peaked around 2008.

It may seem modern and teeming with cutting edge technology, but Japan has one of the most rapidly aging populations on the planet. In 1950, roughly 5% of Japan’s population was over the age of 65. Now, over 26% of the population is over 65.

Given Japan’s shrinking population and increasingly geriatric society, it’s no wonder economic growth has remained elusive. It’s also not surprising that the Bank of Japan (BOJ) has had such a hard time spurring inflation.

Together, tepid economic growth and inflation equate to low interest rates.

Plus, the BOJ is hoovering up JGBs as part of its quantitative easing (QE) program, which reduces the supply of government bonds.

Today, Japan’s yield curve is negative out past 10 years, and the 40-year JGB is yielding just 0.28%. Just a few years ago, these levels were seemingly implausible.

Simply looking at yields, however, provides an incomplete picture.

Bond Math

When bond yields decline, prices rise, but prices rise even faster the lower yields go. This is what’s known as convexity.

This year, the 10-year JGB is already up over 3%, despite a small 0.4% decline in yield. You can see why shorting JGBs is the quintessential widowmaker trade.

However, because of this convexity and the strength in the yen since mid-2015, I believe a fantastic pairs trade for hedge funds has presented itself: long 10-year U.S. Treasuries (T-Notes) and short 10-year JGBs. This trade has healthy positive carry (pays you to be in it), and you’re hedged if global interest rates continue to decline.

Nonetheless, hedge fund managers inclined to bet on Japanese rates have probably already done so, and after the appearance of negative JGB yields this year, they’re likely experiencing cardiac arrest.

Safe (and high-yield) investing,

Alan Gula, CFA