The obituary of Japan’s ‘Widow Maker’

With commodity prices easing as global economic activity slows, hopes for tamer inflationary pressures which could lead to a looser monetary policy in 2023 triggered a notable relief rally in battered stocks by the end of last week. Time will tell if this is yet another bear market rally but with the earnings season around the corner, we doubt corporate earnings results and projections will bring with them much confidence to chase stocks higher. 

Although we have been expecting manufacturing-led inflation to start easing thanks to improving conditions in supply-chain bottlenecks of the past and falling sales of consumer durable goods after two strong years of surging demand during the pandemic, we also believe wage inflation and price rises in the service sector which account for the bulk of the economies of developed markets should remain highly problematic. Interestingly, this is also underlined by growing unionisation of labour force and more notably, industrial strikes which are spreading across the developed nations. 

Some Japan capital market participants (mostly domestic players) believe that with growing likelihood of a recession in the US and subsequently tamer inflation rates should help reverse the widening interest rate differentials between Japan and other major markets. This they hope will in turn reduce the devaluation pressure on the Japanese currency and give BOJ more breathing room to continue with its ultra-loose monetary policy. We disagree!

As we have highlighted in the past month, we think BOJ’s outlook for inflation to remain subdued at around 2% level for the rest of the year will prove overtly optimistic. To be sure, the central bank’s core measure of inflation in May, by deducting the volatile food and energy costs leave the gauge below 1%. However, this is of little consolation for Japanese households whose budgets remain under increasing pressure from rising prices of everyday goods. This as we have argued will inevitably become a huge headache for Kishida’s government ahead of July’s Upper House elections.

Indeed, recent surveys suggest that over 10,000 food items alone are likely to see average price hikes of over 12% by next month. Moreover, apparel retailers have also indicated steep price hikes for their coming autumn wear. All this seem to suggest that despite government’s recently granted gasoline subsidies, inflation rate in Japan is likely to soar from this month and as we have pointed out we would not be at all surprised to see the see the headline number reaching 5% in the second half of this year.

We think the negative feedback loop of weaker yen translating to higher import prices and widening trade deficit which in turn adds more downward pressure on the Japanese currency is unlikely to be broken as long as BOJ continues with its heavy-handed intervention in buying JGBs. This policy to keep long bond yields suppressed close to zero, has also wreaked havoc in the JGB market by blowing up the spreads that leave hedging strategies very difficult to execute. This has also led to a dramatic drop in demand for bonds being auctioned as shown last week.

This brings us to the title of this week’s publication as some market participants have expressed reservations about fighting the BOJ as a fool’s errand and underlining why the strategy of shorting JGBs is famously termed ‘The Widow Maker’. However, this term in its reference to Japan’s government bond market was coined during the two lost deflationary decades which has very little resemblance to the inflationary ere we are facing today. 

Even if our outlook for inflation proves too pessimistic, there are no reasons to expect the JGB market which is being continuously propped by Japan’s central bank to rally from here. In other words, the downside risks of shorting longer dated Japan’s sovereign debt looks negligible while the potential windfall from this trade looks asymmetrically high should the central bank be forced to shift its policy. We thus believe that the ‘Widow Maker’ is long dead and buried.