There have been several trades that have received the moniker ‘widow-maker’, but arguably none as famous or as reliably pain-inducing as shorting Japanese government bonds. Generations of investors have been seduced by their apparent mispricing but yields in Japan just keep falling.
This year, policymakers in most developed nations have turned hawkish. The US Federal Reserve, the Bank of England, and the European Central Bank are all either hiking rates or preparing to, while the Royal Bank of Australia has recently dropped its yield curve targeting. However, the Bank of Japan has so far remained steadfastly committed to ultra-easy monetary policy, recently committing to buy unlimited government bonds at 0.25 per cent to keep rates low. The yen has devalued sharply as a result. But could policy at the BoJ be about to change?
High inflation has been the catalyst for other central banks to reverse accommodative policy. In the US, core inflation is above 6 per cent. But in Japan it is still below 2 per cent and, more importantly, expectations for future inflation are weak, contrasting with the persistence seen elsewhere. And given how far it has moved this year, clearly yen weakness will not spur the BoJ to change course.
However, the currency’s devaluation is making imports more expensive, especially food and energy. Public unhappiness with falling disposable income could become a political issue in the elections for the upper house on 10 July, and it is possible that a change in policy could follow.
Perhaps the most credible argument in favour of a policy shift is that it would give the BoJ more flexibility in future. However, in stark contrast to other central banks, the BoJ does not want to tighten financial conditions and will be at pains to make sure it does not give even the impression of doing so.
Overall then, while the BoJ might adjust its yield curve targeting in the coming months, it is unlikely that it will abandon the policy altogether. Japan has been battling chronically low GDP and price growth since the 90s. It is now trying to stimulate sustainable inflation, putting it in contrast with the rest of the world. We expect the BoJ will continue to cap yields at low levels, meaning Japanese government bonds could remain the best performing bond market even in the event of a minor policy adjustment. As a result, any recovery in the yen is more likely to be driven by external factors, such US inflation falling or a hard landing, than by policy action at home. For now, shorting Japanese government bonds looks set to remain the widow-maker.