SINGAPORE/NEW YORK- Investors betting that Japan will have to quit its ultra-loose monetary policy are running into riskier and pricier territory as the showdown shifts to the Bank of Japan’s home turf in the bond market.
Japan is now alone among major economies in its stance of enforcing near zero interest rates, and hedge funds and momentum-chasers have made hay as the growing divergence with its rate-hiking peers has pounded the yen.
As the currency hits depths not seen since the late 1990s, wagers on further declines are being pared back, and funds have stepped directly 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 abandons its yield-curve control (YCC) policy and 10-year Japanese government bond yields shoot from their de-facto cap of 0.25 percent to Goldman Sachs’ estimate of fair value at around 0.60 percent or further.
Yet the price could be uncomfortably high while the BOJ remains steadfast. Its vast bond buying has bent a previously quiet market out of shape and sent the cost soaring for those staying in a trade nicknamed the “widowmaker” for its notorious unprofitability.
The BOJ spent more on bonds in June than ever before, its control of the market has had dealers’ borrowing charges for the most popular cash bonds spiking as high as 3 percent a week and futures have turned diabolically volatile.
“(It) makes things finally interesting,” said Ales Koutny, global bonds portfolio manager at Janus Henderson Investors in London.
“But the problem is there is 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 potential loss on the trade, can skyrocket.
The Bank of Japan has given no hint of a policy shift, with Governor Haruhiko Kuroda even suggesting this week it would take extra monetary easing steps if needed.
Its policy meeting next week is expected to deliver no surprises, with the bank reiterating its pledge to keep policy ultra-loose. Japanese inflation is still relatively low compared with other countries and the tepid economy has still not recovered to pre-pandemic levels.
Koutny’s fund is sticking to a strategy of using interest rate swaps to bet that Japan’s artificially flat yield curve will eventually steepen, which he says might pay less than shorting bonds but can be maintained with far less volatility.
There are signs, though, that at least some investors have been spooked by wild swings in the bond market recently, or by the vastness of BOJ buying, and have started to drift away.
The 10-year cash yield has dropped slightly below the Bank of Japan’s target in recent days. Turnover in the futures market, which has been popular with short sellers, has also fallen away sharply since the middle of June.
“I think a lot of tourists would have gone out of it for the time being,” said Jimmy Lim, CEO and chief investment officer at $950 million macro fund Modular Asset Management, who has pared back a short position in JGBs since June.
