The Phaserl



on JGB, Kyle Bass, Bank of Japan, BoJ, bunds

by Kevin Muir, The Macro Tourist:

Remember when the trade-du-jour was to be short JGBs? All the cool kids had it on the sheets.

You couldn’t turn on CNBC without being blasted with Texas’s favourite hedge fund manager foreshadowing Japan’s coming demise.

Japan’s collapse seemed to be Kyle Bass’ raison d’etre. And he stuck with it for a long time. Have a gander at how young Kyle looks in the picture above. But more importantly, check out the level of the Dow Jones Index.

And it’s not like he was alone. As recently as last summer large hedge fund managers were still shorting JGBs by the bucketful. Crispin Odey had 35% in his fund in a long Australian bond / short JGB position.

I can’t claim I was immune to the siren lure of the short JGB story. After all, it was an awfully compelling story. It’s difficult to see how Japan will be able to manage its monster debt load without inflating it away.

Yet the great global bond rally of 2016 that drove European sovereign yields to batshit crazy negative levels, dragged Japanese government bonds along. Last summer, in a fit of panic when investors were convincedinflation would never again rear its ugly head, Japanese 30 year paper flirted with a 0% yield.

I still shake my head at the stupidity. One of the most overindebted countries in the history of modern finance trading with a 0% thirty year bond. Professor Malkiel – stick that in your pipe and smoke it.

But into that panic a crazy thing happened. Worried its bonds would trade at negative yields and pressure the financial system, the Bank of Japan pegged its 10 year yield at 0%.

In doing so, the Bank of Japan moved from a set rate of balance sheet expansion to one that varies based on whether that peg is either too high, or too low.

If the equilibrium level of 10 year rates was in fact below 0%, the Bank of Japan would be forced to sellbonds to keep rates stuck at 0%. If there was demand for credit and 10 year rates moved higher, then the BoJ would be forced to buy bonds to keep them from declining.

The BoJ program was a little more nuanced, and there were some caveats, but at its heart, the BoJ was giving up control of its balance sheet so it could peg a specific part of the yield curve. Of course Central Banks do this all the time. The difference is they usually operate at the front part of the curve, and when there is too much demand or supply, they change the rate.

When the Bank of Japan took this unprecedented step, I walked away from my short JGB position. I figured there were better fixed income markets to short. Yet I highlighted that by pegging the 10 year rate, the Bank of Japan had not eliminated volatility, but merely postponed it.

Eventually the Bank of Japan’s massive balance sheet expansion would kick in. At that point, inflation would pick up, credit would be demanded and the Bank of Japan would be forced to defend the 0% peg. Yet this defending would be expansionary as they would be forced to buy bonds and expand the amount of base money, which if not offset with a decline in the velocity of money, would create more inflation, etc… All of this would be occurring with an already highly supercharged Japanese Central Bank balance sheet.

I have been sitting and waiting for this expansionary feedback loop to kickstart. Until recently, the Bank of Japan had not been forced to buy any bonds to keep the rate pegged at 0%. When 10 year rates drifted far enough above 0%, the Bank of Japan made a bid to buy an unlimited number of bonds at a level below the market, which scared the market back to the pegged level.

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