Widowmaker Autopsy Report

Since January spreads on generic Japan 5Y CDS have cratered, outperforming corresponding Japan IG credit. Not that Japan IG has been a dog, but you are seeing meaningful level divergence between the two at the close of Q1 2015.

What gives?

A big part of the explanation is that 5Y CDS is the most liquid available credit hedge for Japan and it easy for dealers to sell CDS and pick up cheaper hedges. They will take this trade all day long.

The other part is that JGBs are bid. This is confusing to silly people who continually get destroyed shorting JGBs. I won’t mention the names found on the obituary page in the past few years. Government Debt to GDP stands at around 250% give or take. The government has no intention of letting up on monetary stimulus. Nominal yield looks ridiculous. So the story goes.

It’s a crock. JGBs are not a dog at all: 250% government debt to GDP is a fraction of total household and corporate wealth. All told, Japan is still the largest creditor country net of government debt.

Second, much of the credit exposure is in the carry trade: external lending in FX currencies in exchange for higher yields. This short yen, long FX debt trade is very sensitive to changing conditions. The commodity and raw material price collapses of the last few months reflect slowing global growth, and a redemption of FX debt into FX into JPY into JGBs. As long as there is a Japanese carry trade there will be a bid on JGBs when risk appetite is weak.

Finally, the nominal yields are JGBs are not ridiculous anymore. Just check comparable EU debt. In real terms (inflation adjusted), the yield has never been that ridiculous. Inflation picks up followed by a tightening cycle and a bear market—a really nasty one—in JGBs is certainly reasonable. But as the private sector shifts in equities, this is becoming a BOJ balance sheet problem. They have the luxury of holding a JGB40 to maturity on their books.

As we sadly carry out another round of financial losers, I do not say here that a true JGB crisis is impossible. But looking at net wealth, relative real yields, and anemic global growth, it makes no sense to be calling for it right now. When it starts for real, it will be pretty obvious and it will be epic. You can afford to let some lucky pot-head take the first winnings on a long grinding ride down.

Then that lucky pot-head can start a hedge fund. Call it "Hey Dude, Capital." Then you can read about her on the financial obituary pages a few years later.


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