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Japan’s Widow-maker Trade - Is this the canary in the coal-mine for the global economy?
Is Japan's carry trade signaling global economic tremors? Explore how this high-stakes currency strategy exploits the yen's low interest rates, potentially foreshadowing the next financial storm. Uncover the risky world where forex volatility meets economic prediction.
The Widow-maker Trade: Japan's Persistent Low-Yield Paradox
The Rise and Fall of Japan's Economic Miracle
In the 90’s japan’s economy was at the peak of the world. Its car industry was world class and exports were booming to every country, it was the most advanced economy in the world and its technological advancements were unparalleled.
Japanese automotive giants like Toyota, Honda, and Nissan were setting new standards in efficiency, quality, and innovation. The just-in-time manufacturing system, pioneered by Toyota, was revolutionising production methods globally. Japanese cars were synonymous with reliability and fuel efficiency, capturing significant market share in the United States and Europe.
In electronics, companies like Sony, Panasonic, and Sharp were at the forefront of the digital revolution. Sony's Walkman had already transformed personal audio, and now the company was leading the charge in video technology with advanced camcorders and the introduction of the PlayStation. Toshiba and NEC were pushing boundaries in computer technology, with Japan producing some of the world's most advanced semiconductors and memory chips.
The country's infrastructure was a testament to its economic might and technological capability. The Shinkansen (bullet train) network, continually expanding and improving, showcased Japan's engineering prowess and commitment to efficiency. Major cities like Tokyo were studded with architecturally ambitious skyscrapers, while large-scale public works projects demonstrated the government's ability to mobilize resources for national development.
Japanese financial institutions had become global powerhouses. The Tokyo Stock Exchange rivalled New York and London in terms of market capitalisation, and Japanese banks were among the largest in the world by assets. This financial clout fuelled aggressive overseas investments and acquisitions, with Japanese firms buying high-profile properties and companies across the globe.
This economic and technological dominance seemed unassailable. Japan's rise from the ashes of World War II to become an economic superpower was dubbed the "Japanese economic miracle," and many predicted that the 21st century would belong to Japan. However, beneath this surface of spectacular achievement and seemingly boundless potential, structural weaknesses were forming that would soon challenge Japan's economic model and global leadership position.
The Breaking point - The collapse of Japan’s economic bubble
By the early 90’s something started to break… For multiple reasons. It’s really impossible to know the event that pinpointed the collapse, but these major factors contributed to the collapse of japan’s stock market in the early 1990’s:
Real estate frenzy: Ginza Land Deals
Imagine paying $650,000 for a plot of land barely large enough to park a car. This wasn't fiction in Tokyo's Ginza district in 1989. Such astronomical prices weren't mere anomalies; they were symptoms of a dangerous bubble fueled by reckless lending and blind optimism. When this bubble burst, it didn't just pop – it imploded, with land values plummeting by up to 84% over a decade.
What really sealed the deal on japan’s economy was leverage. It’s really just basic maths. what must come up, must come down when there’s just hot air backing most of the value of something. Banks were willingly lending against inflated land values, and once the property bubble burst, many investors and companies found themselves with massive debts secured by completely devalued assets.
Speculative finance by non-financial companies - Zaitech
財テク
Zaitech literally means financial engineering. Something magical (ridiculous) happened at the peak of the japanese stock market bubble. companies were making a large porportion of their profits not from its business, but from its investments.
In 1986 it was rumoured that one third of Toyota’s pre-tax profits was based on “Zaitech”. it was an open secret that other prominent Japanese companies, like Sony Corp. and Sanyo Electric Co engaged in it. These mega-corporations had almost a quarter of their profit made up of financial and speculative instruments, and not from its direct engagement and business with customers. Imagine being able to borrow almost completely free money. Why wouldn’t you do the same thing as a struggling CEO that’s almost captured the entirety of the customer-base in japan?
At the peak, companies went beyond speculating with just earning profits, or bank loans, but went on to raise money specifically for financial engineering operations via sales of dollar-denominated euro-bonds with stock warrants attached to it. If your understanding of financial engineering isn’t on George Soros’ level like me, what it essentially means is that:
- they created IOU’s (corporate warrants) denominated in US dollars (this is important later as they are Japanese companies and most of their customers pay in Yen
- these IOU’s came with a bonus: they granted the bond-holder the right to buy company stock later
- they sold these bonds to investors in europe, US and even domestically
- they got a ton of cash to gamble with 🏄
Long-term credit bank of Japan (LTCB)
Often these banks supported Zaitech. What’s not to love about more fees underwriting corporate bonds, and generating the massive fees attached to them. What made the whole thing special was that companies weren’t legally required to disclose their liquid assets and didn’t even have to disclose what’s on their balance sheets. Japanese companies were even allowed to count stock market value as core capital.
The Zaitech phenomenon wasn't merely a series of poor financial decisions; it was a wholesale abandonment of economic common sense, fueled by unchecked greed and enabled by woefully inadequate regulation. This wasn't just a bubble; it was a masterclass in how to destabilize an entire economy.
The Aftermaths
Once the bubble burst, the government really didn’t know what to do. They tried the most orthodox economic programs at the time: issuing new government bonds and using them to fund public works and reduce taxes.
Normally, that would spur up the economy and create jobs, and attract investment. But this wasn’t a normal situation. This was the greatest bubble in human history. All this did was balloon the national debt, create zombie companies and entrench deflation. Without the confidence to go along with a booming economy, businesses were unwilling (or unable) to borrow despite more cheap money being available. Cheap money just meant more and more smaller bubbles just kept forming.
The reason why this happened is that even with more and money handouts, the illusion of confidence was destroyed. The whole nation watched in shock as many bank loans (and especially LTCB bank’s) were defunct and were simply revealed to be smoke.
Junk Collateral
When the bankruptcies started, and the banks went ahead to collect their collateral, they discovered something horrifying… There was nothing there.
This was because, in the frenzied lead-up to the bubble, banks had recklessly lent more money than the current collateral value of the borrower, and brokers had often worked with bankers to fabricate fake requests for approval. So when the bubble burst and the banks tried to recoup their losses, they were left with a mountain of low-value junk real estate instead of the cash they were owed. And to make matters worse, the value of that real estate was plummeting as the bubble burst. - Rei Saito
From bad to worse
If you know anything about 2008’s recession, then you know about bailouts, and japan did it before it was cool.
In 1995, the group of seven Jusen, a group of the largest lenders of residential mortgages went bankrupt. Suprisingly, the government decided to pour in 685 billion yen of public tax funds into an already bankrupted company, essentially a corporate bailout like the one in 2008.
In the end, and along with the tragedies of the Kobe Earthquake, the yen began to appreciate due to insurance companies selling off their foreign assets to pay for the insurance claims, as well as domestic consumption plummeting with foreigners rushing to buy yen to pay for goods.
If you don’t know why rapid appreciation of your local currency is bad → subscribe and I’ll write another article on it, but simply said, Japanese exports would become unprofitable, leading to more and more bankruptcies.
In the end, the BOJ slashed its interest rate to 0.5%, leading to similar low interest rate conditions that set off the bubble in 1986. Even going as far to lower the overnight rate to 0.15% in February, and to 0.03% in March of 1999. However scars from the bubble were fresh, and instead of lending, banks hunkered down and did everything they could to preserve capital. Businesses that needed money to grow ended up not receiving a penny due to the unwillingness of banks to lend. The economy ended up stagnating for years to come.
Do you see a parallel to the Zero Interest Rate Policy of the early 2020’s?
The Lost Decade and birth of the widow-maker trade
The reason why the “widowmaker trade” gained such prominence in the late 1990s and early 2000s was because several high profile investors and hedge funds suffered significant losses trying to short Japanese Government Bonds (JGBs).
If you don’t know, shorting bonds means you expect bond yeilds to rise (they are inversely correlated), and hence expect that the recession will probably end.
The problem is… It Never did. That’s why it was called the lost decade and the widowmaker trade, as wives lost their men shorting, and shorting and shorting bonds expecting the recession to end.
Notable losses were
- Tiger Management (Julian Robertson) - 1998: Julian Robertson, founder of Tiger Management, was one of the earliest and most prominent victims of the widowmaker trade. In 1998, Tiger Management took a large short position on JGBs, expecting yields to rise as Japan's economy recovered. However, the Asian Financial Crisis led to a flight to safety, pushing JGB yields even lower. This miscalculation contributed to substantial losses for the fund.
- Soros Fund Management - 2000: George Soros, known for his successful bet against the British pound in 1992, also fell victim to the JGB market. In early 2000, Soros's fund took a significant short position on JGBs, anticipating that Japan's zero interest rate policy would end. When the Bank of Japan unexpectedly cut rates back to zero, the fund reportedly lost hundreds of millions of dollars.
- Fischer Francis Trees & Watts (FFTW) - 2003: This fixed-income specialist firm, then a subsidiary of BNP Paribas, suffered large losses in 2003 due to its bearish stance on JGBs. The firm's Global Fixed Income fund reportedly lost about 23% in just a few months when JGB yields fell instead of rising as expected.
This all went ahead to show the world that japan was unburdened by traditional economic theories, and was stuck in a land of its own. What’s even suprising is that while the bond yeild remained low, the japanese government accumulated more and more debt..
A more and more indebted government…
As the government tried to stimulate the economy more and more to match the exuberance of the 1980s, most failed to boost economic growth as expected. As the government financed increased government spending and public works projects, financed by issuing more bonds, government debt increased while bond yields were held low due to the domestic demand for bonds.
Economic stagnation also meant that tax revenues were held precariously low, with lower profits and personal incomes, reducing the tax that the government could syphon out of salaries.
Aging populations also contributed to this debt. After the exuberance and riches of the 1980s, fewer people wanted to have children (like in most developed economies), and hence as the population aged, an increasing amount of social security spending and debt was required to combat the decay of the aging population
Today, japan is a prime example of a deflation trap. Persistant deflation in the aftermath of a recession made it hard for governments to inflate away its debt, often possible in inflationary environments.
What the government resulted to was thus staying steadfast towards its low interest rate policy environment. Because the interest rate made it cheap for the government to borrow money, japan wasn’t immediately compelled to stop debt accumulation. It could kick the can down the road for years to come… and it did.
Yield Curve control era (YCC)
Japan already implemented QE in March 2001, decades before it became a household name after the financial crisis of 2008. Facing a deflationary spiral and yields at zero, the bank of japan ventured into uncharted territory, performing financial alchemy on the banking system. It flooded the system with excess liquidity by expanding the bank’s balance sheet, aiming at jolting japan’s economy back to life. Lasting only five years, before being jolted awake again after the financial crisis. QE was the start of japan’s experiment into financial infamy, and being used as a template for the world in the financial crisis.
However even QE proved to be inadequate for Japan’s troubles. In September 2016 japan unleashed Yield Curve Control (YCC) as a desperate gambit to resurrect an economy trapped in a decades-long deflationary spiral. This policy marked a seismic shift from QE's focus on asset purchase quantities to directly targeting yield levels across the entire bond spectrum. It was as if the BoJ had granted itself godlike powers over the market, pledging to buy unlimited amounts of bonds to peg 10-year yields near zero.
By pledging to buy unlimited amounts of bonds to peg 10-year yields near zero, the BoJ hoped to stimulate borrowing, spending, and ultimately, inflation. Yield curve Control acted to essentially anchor the yield curve, by buying unlimited amount of bonds maintain 10 year yields at near zero.
Its goal was to simulate economic growth and achieve 2% target inflation. It has succeeded in keeping JGB yields low and stable, and has volatility. But if you know anything about finance, then everything stems from the government’s credibility of maintaining bond buying operations to infinity… and if that credibility is lost? Then we’re in quite a bit of a pickle.
Is the era of the widow-maker trade finally over? Is Japan the canary in the coal mine for the global economy?
Japan’s economy is pretty much in a pickle right now. It’s inextricably linked to the global financial system, largely due to the significant volume of carry trades involving its currency. Many prominent traders have said that japan is essentially the canary in the coal-mine for the global economy.
The best way to understand the relationship between the global economy and japan is to understand it through the mechanism of bond and borrow rates. simply put:
When Japanese bond yields are low, it typically means that the cost of borrowing yen is also low. This situation incentivises investors to borrow yen cheaply and invest in higher-yielding assets abroad. This influx of capital can pump up asset prices, including stocks and real estate, in markets worldwide.
Conversely, when Japanese bond yields rise, the cost of borrowing yen increases substantially. This can trigger a reversal of carry trades, as investors may need to sell off assets globally to repay their yen-denominated loans. Such a scenario can contribute to a broader selloff in international markets.
THE Plan when QE infinity restarts in November 2024
So this part is really hypothetical, and I have no idea what craziness will happen in the elections. One thing I’m sure of however is that QE will restart…. Maybe right after the elections, maybe the next year.
The state of the global economy right now isn’t pretty. Speaking from experience, trying to find jobs in this economy is a straight mental battle, and standards haven’t been higher. A lot of the money right now is flowing out of entrenched capital. People that made their wealth in the previous decade’s housing markets, people taking advantage of government programs and monolithic businesses that are so entrenched and tied to the government that they don’t notice what’s around them.
VC’s are screeching right now. Startups are dying, and too many big players are having their toes stepped on because the entrenched money is coming out to roost. The engine is seizing without further QE. Some event will cause QE to restart, with US yields again teetering on the zero bound. When US yeilds no longer provide Japanese carry trade investors any return, they will once again inflate the stock, real estate and crypto markets.
The only question is, will japan’s yeild curve spike because of the US, or the US’s because of Japan?
Sources and goodies to explore
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- Assessing the Risks to the Japanese Government Bond (JGB) Market:
- This IMF working paper by Waikei Raphael Lam and Kiichi Tokuoka discusses the risks associated with the Japanese Government Bond market, including the potential for rising yields due to various factors such as demographic changes and global financial distress. The paper provides a comprehensive analysis of the market dynamics and the factors that have kept yields low despite high public debt.
- Read the paper here.
- Introduction to Japanese Government Bond (JGB) Futures:
- This document from the Japan Exchange Group (JPX) explains the basics of JGB futures, their market mechanisms, and how they are used by market participants. It provides insights into the arbitrage opportunities and the correlation between JGB futures and cash JGB prices, which are crucial for understanding the market behavior that has confounded short-sellers.
- Read the paper here.
- A Lesson from the Japanese Government Bond Market:
- This paper examines the peculiarities of the Japanese Government Bond market, including the phenomenon of large price differentials between almost identical bonds. It provides an in-depth analysis of the factors that contribute to these anomalies and the challenges faced by traders.
- Read the paper here.
- Why Investors Are Having Another Crack at the 'Widow-Maker' Trade:
- This article from the Australian Financial Review discusses the allure of the widowmaker trade and the heavy losses sustained by professional investors over the years. It provides a historical perspective and current market conditions that continue to entice traders despite the risks.
- Read the article here.
- Investors Manoeuvre, Warily, for Long-Shot Bank of Japan Policy Move:
- This Reuters article explores the cautious approach of investors towards short-selling JGBs, highlighting the historical context of the widowmaker trade and the potential for a policy shift by the Bank of Japan that could impact yields.
- Read the article here.
- Unconventional monetary policy and the bond market in Japan
- This academic paper analyzes the effects of Japan's unconventional monetary policy, particularly Quantitative and Qualitative Easing (QQE), on the bond market. It provides insights into why shorting JGBs has been a challenging trade due to the Bank of Japan's (BoJ) persistent efforts to keep yields low.
- Read the paper here.
- The Determinants of long-term Japanese government bonds' low nominal yields:
- This paper analyzes the factors contributing to the persistently low nominal yields of Japanese government bonds, challenging conventional wisdom about the relationship between government deficits and bond yields.
- Authors: T Akram, A Das
- Read the paper here
- The analysis of co-movement between government bond and interest rate swap markets in Japan:
- This paper examines the relationship between Japanese government bond and interest rate swap markets, providing insights into the dynamics of these interconnected financial instruments.
- Author: T Ito
- Read the paper here
- Asymmetric dynamics in correlations of treasury and swap markets: Evidence from the US market:
- This 2012 study by Toyoshima et al. analyzes the dynamic conditional correlations between US treasury yields and swap rates.
- Key findings:
- 2-year maturity correlation dynamics differed from other maturities, possibly due to monetary policy sensitivity.
- Longer maturities showed reduced arbitrage activity during the financial crisis.
- Correlation volatility increased post-2007-2008 financial crisis.
- The study concludes that speculation on monetary policy increased correlation volatility between treasury and swap markets, especially during crises.
- Read the paper here.
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