For nearly half a century, Japan’s bond market has been a graveyard for contrarian investors. The so-called “widowmaker” – betting against Japanese bonds (JGB) in anticipation of rising yields – has claimed many casualties. Short sellers consistently lost out as the Bank of Japan (BOJ) maintained near-zero interest rates. Even though the BOJ undertook easy monetary policy, they could not resuscitate inflation… until recently.
Chart 1: Japanese policy rates (Overnight) vs inflation
At the risk of being wrong, like many victims before me, maybe this time is different. Inflation in Japan is finally showing signs of sustainability. The implications are far reaching as the Yen carry trade has long been a driver of global liquidity. If this unwinds, it could destabilise markets – something we caught a glimpse of in 2024.
The widowmaker trade
The widowmaker trade emerged in the early 1990s after Japan’s asset bubble burst. At this time the BOJ embarked on easing policy to zero to combat deflation and economic slowdown. Yield curve control and bond purchases, hurt any investor who had shorted JGBs. The ominous name, stemmed from the financial ruin suffered by those who took a contrarian stance.
For many years, Japan remained an outlier, producing limited inflation until cracks emerged in the post-COVID era. Supply chain disruptions, higher energy costs and surprisingly higher wage growth triggered inflationary pressures that the BOJ could not ignore. As a result, interest rates were finally raised for the first time since the Global Financial Crisis (GFC), marking a pivotal shift from Japan’s loose monetary policy. Subsequently, bond yields climbed, to the relief of the final few investors that had persisted with the trade.
Chart 2: Japan’s 10-year Government Bond over time
Unwinding the carry trade
The Japanese Yen became a low-risk funding currency as the lack of inflation and growth perpetuated the need to keep interest rates low. This supported the Yen carry trade, which involved borrowing cheaply in Yen and investing in higher yielding assets abroad. Over time, Japanese investors accumulated more than $4 trillion of foreign assets.
However, problems arise when the relative cost of borrowing narrows. As Japanese rates increase, Yen-denominated funding becomes more expensive. At the same time repatriation of foreign proceeds strengthens the Yen, eroding the returns of those investors holding the carry trade. As the Yen appreciates, more traders are forced to unwind positions, amplifying market volatility and draining global liquidity. The longer this continues, the higher the number of margin calls and forced liquidations. A glimpse of this phenomenon played out in 2024 when the S&P 500 retraced meaningfully in the middle of the year before eventually stabilising.
Chart 3: US equity market vs Yen: USD performance in 2024
Global repercussions
As a key pillar of global liquidity, Japan’s shift in monetary policy can significantly impact financial markets. The unwinding of the carry trade would further expose the interconnectedness, and vulnerabilities of global markets.
As the largest foreign holder of U.S. Treasuries, Japan’s sustained repatriation of funds could drive up global borrowing costs, destabilising bond markets and prompting the forced liquidation of risk assets. Last year’s market turbulence was a stark reminder of how the strengthening Yen exacerbated fire sales and systematic risk during the 2008 financial crisis.
Furthermore, Japan’s policy divergence creates difficultly for the U.S. Federal Reserve (Fed) to manage U.S. interest rates. While the BOJ aims to curb inflation without triggering a domestic debt crisis, its tightening measures inadvertently drain liquidity. The BOJ need to tread carefully as any missteps could have dire consequences for Japan, whose government debt stands at 227% of GDP (World Bank Group: Q2 2024).
End of an era: friend or foe?
This marks a significant shift in global finance – one that must be addressed with caution. Cautious calibration will be key as the BOJ aims to stimulate growth while preventing a bond market meltdown.
It’s easy to paint the pessimistic picture, but after half a century, perhaps there is a positive outcome. If growth picks up in Japan, the carry unwinds and the Yen strengthens, one of the biggest deterrence’s of investing in Japan would have faded. For years, it was two-steps forward and one-step back as the currency eroded your gains as a foreign investor.
For investors, the lesson is clear. The period of predictable, low-cost Yen appears to be over, while artificially low global interest rates are coming to an end. There is an opportunity for Japan to reclaim its status as an attractive investment destination, a position it hasn’t held in over 35 years.
At Truffle, conducting thorough research and analysis is central to our valuation-based, fundamental investment approach. This enables us to identify and implement opportunities. We continue to monitor the Japanese market, assessing how changes may impact our valuations, with the aim of ultimately uncovering profitable long-term investment opportunities for our clients.
