The 'Widowmaker' And Yen Crash Theories

There has been a recent shift amongst those predicting the collapse of the Japanese economy to switch away from the so-called "widowmaker trade" - short Japanese Government Bonds (JGBs) - towards forecasts of a collapse in the Japanese yen (pictured above). Although this may result from learning a lesson from roughly two decades of failed "JGB collapse" predictions, I suspect that this is the result of learning the wrong things. Being structurally short the yen is hardly the safest trade in the world either.

(As a reminder, the yen is quoted in markets as the number of yen per U.S. dollar. This means that higher exchange rate quotes mean the yen is weaker, and therefore the rise over the past few years in the time series above represents a yen selloff versus the U.S. dollar. The red line represents a recent fair value level estimate I have run across - 110 yen to the dollar - but I do not have a time series for the fair value. Since it changes slowly, it will be close to fair value in recent periods, but it is not meaningful for the earlier time periods within the chart.)

[UPDATE: The Russian authorities "Volcker"-ed their interest rate markets in order to prop up the rouble. That worked for about 2 hours. Neil Wilson explains in the good article 'Russian Roulette' why this will not work. The Japanese yen rallied on 'safe haven' flows, which is what this article (published a few hours earlier) said would happen in such a situation. I would like to apologise to any yen shorts for moving the currency market. :-) ]

The 'Widowmaker Trade': Really?

I will repeat what I wrote on July 20th (2014) to explain my views on the 'Widowmaker trade':

The JGB market has not been cooperating with those who have been calling for collapse and hyperinflation; rather yields have marched from stupidly expensive to insanely expensive levels. At a 0.54% yield, the 10-year JGB is at a very interesting position.As I have pointed out before (when yield levels were slightly higher...), the payoff on an outright short position which can be held for a considerable period looks attractively asymmetric.

The analysis above still stands. However, I do not give investment recommendations, and someone at a specialist fixed income fund would immediately see why the above comment had to be taken with a grain of salt. I had only pointed out an asymmetry, but there was no notion of a catalyst that will make the position pay off. Looking at the levels of JGB yields now, it is clear that July would have been a bad time to put in place a JGB short.

My bias is that I am a secular JGB bull. But I find it hard to be bullish on JGBs on a "medium-term" horizon from current yield levels. As long as someone has a reasonable yield target (something closer to 1% rather than 5% or higher) and some realistic notion of what will be a catalyst for a selloff (not hyperinflation), a short-JGB position could have a fairly attractive risk-reward profile. The trade is only a 'widowmaker' if you do not know what you are doing, and either enter at too high a level (above 1%, historically) and/or scale it too large. (Too large a position size means you can get killed by the carry and rolldown if yields go sideways, which is what JGB yields do most of the time.)

Rotating Into 'Yen Crash' Theories

The notoriety of the short-JGB trade has finally caused people to pivot towards "yen crash" scenarios. I will now give some recent examples.

David Stockman - the director of the Office of Management and Budget under President Reagan - launched an attack on "Abenomics" in the article 'The Curse of Keynesian Dogma: Japan's Lemmings March Towards The Cliff Chanting "Abenomics"' (December 14, 2014). He writes:

In the meanwhile, the Yen has lost 40% of its value and teeters on the brink of an uncontrolled free fall [emphasis mine-BR]. Currency depreciation, of course, is supposedly the heart of the primitive Keynesian cure on which Abenomics is predicated, but there is no evidence or honest economic logic to support the proposition that—–over any reasonable period of time—–a nation can become richer by making its people poorer.

I would note that I agree that depreciating the yen is damaging for the welfare of Japanese consumers; but it helps exporters. An undervalued yen was always part of the mercantilist tinge to Japanese policies.

Yen weakness will continue:

But upon news of Prime Minister Abe’s electoral “mandate” to plow full stream ahead, the Yen could plunge through 120 in an instant, and be well on its way to 140 and not so far down the road to 200. 

(Note that the article was written before the Abe election victory.) His bearishness on the yen is partially based on the Japanese need to import commodities, which I have noted myself as being the potential Achilles Heel for the Japanese economy. But if we look at global oil prices, that potential weakness is not currently an issue.

Of course, he casually mentions Japanese default:

 Namely, these madmen through the open market desk at the BOJ are “bid” any and all bonds on offer; and at nose-bleed prices (that is, the inverse of the 0.398% yield) that vastly exceed the true economic value of debt that one day the Japanese government must and will default on.

Presumably fear of "The Widowmaker" kept him from dwelling on that rather bold claim.

In 'HSBC fears horrible end to Japan's QE blitz as Abe wins landslide', Ambrose Evan-Pritchard discusses some yen bearish calls.

• David Bloom and Paul Mackel, currency strategists at HSBC warn: "Mr Abe may succeed in driving up wages, setting off a 'wage-inflation spiral'. This may not necessarily lead to a bond rout since the Bank of Japan is effectively holding down bond yields. However, the exchange rate might take the strain instead."
• He quotes Takeshi Fujimaki as saying, "Once investors see through the BOJ’s camouflage, the yen will spiral out of control to Y200 (to the dollar) and beyond".  Since he previously argued that Japan would have hyperinflation by 2015, a yen at 200 is a fairly benign forecast.

The Problem With The "Yen Crash" Pivot

The advantage of trading the yen instead of JGBs is that it moves a lot, unlike the glacial Japanese interest rate market. Additionally, instead of fighting the Bank of Japan, you are doing what they want you to do: weaken the yen. If people believe that the only reason JGB bears lost money was because they were fighting the central bank, that appears to be progress.

I would argue that they learned the wrong lesson. Stock-flow analysis explains why Japan can easily sustain low bond yields and a high debt-to-GDP ratio. It also tells us why shorting the yen has its risks.

The Japanese private sector is a massive owner of foreign currency financial and real assets, which represents a short position in the yen. The tendency to want to repatriate profits would cause the yen to get expensive, foiling Japan's export ambitions. Therefore, the Japanese authorities either had to short the yen themselves (thus creating Japan's oversized foreign currency reserves) or set Japanese interest rates at such a low level so that foreign private sector actors will short the yen for them.

And many foreign investors are cautious about shorting the yen. During a financial crisis, the risk is that repatriation flows will spike, causing the value of the yen to shoot up. As most people figured out after 2009, trades that blow up during a financial crisis pose particular career risk. Therefore, one imagines that the Japanese authorities are quite happy that many are using Japanese quantitative easing as an excuse to short the yen without taking into account this career risk.

To be clear, the yen could easily sell off further. Developed country currencies trade in a wide range around 'fair value' without it having an important effect on the economy (although currency traders will squawk). The yen reached around 76 in 2011-2012, which was heavily overvalued versus 'fair value' around 110.  (That is a level I have seen quoted; I have no strong opinion on the exact level.) It would have to hit 160 in order to reach a symmetric amount of undervaluation. Therefore, a weakening to 140 is not exactly earth-shattering.

Conversely, the global macro backdrop that allows the yen to reach 140 is probably consistent with JGB yields rising to around 1% or so. At which point, you have to ask yourself: which position poses less risk if things do not turn out the way that you expect?

See Also:

• My "JGB Collapse" home page.

(c) Brian Romanchuk 2014