Shorting Japanese 10 Year Government Bond Futures


Markets crave certainty, and in a world where heightened volatility and rampant inflation are everywhere, certainty of the truest kind is assigned a premium - our trade idea hinges on that assumption holding true as well as its inverse: when certainties are proven wrong, or markets no longer hold faith in their surety, they become mispriced and dislocated; that is what we are betting on here with our trade as the Japanese central bank has tried to bend one of the fundamental economic truths of modern monetary policy which is that you cannot control the long end of the yield curve, only that of the shorter end.

Investment Rationale

In February of 2016, the Bank of Japan (BOJ) was one of the first central banks to adopt negative interest rate policies (NRP) with the lowering of their policy deposit rate to -0.1%. While doing so, they instituted a slew of new policies and controls to ease them into a negative rate environment, largely only theorized in textbooks previously. One of these such measures is the yield curve control policy which “seeks to control the shape of the Japanese yield curve by pinning short-term rates and the 10-year Japanese government bond yield[ to 0-0.25%]”. The BOJ implemented these policies to deal with the deflationary and stagnating economic environment that had presided for the country’s last 3 decades, this time period has become known as the lost generation.

Depicted above however is their ‘kinked’ yield curve, which is the unnatural result of their actions given that shorter maturity bonds now have a higher yield than their artificially-pegged 0% to (+ or -) 0.25% 10 year government bond. This has also come at an unsustainable cost, with the BOJ’s balance sheet (below) having almost quintupled over the last decade with the end result of their 10-year JGB peg being that they now own over $4T worth of this security, representing half of the outstanding market.

While this has worked in the past somewhat, the nation's inflation has crept up over the pandemic and has shown no signs of slowing down as the inflation rate within Japan (depicted below) has risen greatly above the 2% target. This is the result of multiple real economic (non-financial) factors such as rising costs within food and energy markets.

Given Japan’s history of deflation, the risk of entering a hyperinflationary environment is not one that their economy can afford as this would plunge them into a stagflationary environment - however, given Japan’s monetary policies, this seems to be where we are headed. One of the largest contributors to inflation is the money supply (pictured below) which on an M3 basis includes government bonds. Should the country continue to see signs of a higher and higher inflation rate above their 2% target, it’s a necessity that they slow the growth of the money supply and taper the purchasing of these assets.

Additionally, the level to which they have had to sustain the volume of their buying within the market has only increased more and more over time as the 10 Year JGB yield has drifted higher and higher until the most recent quarter where it has consistently been trading in and around that higher bound for 3 months as the central bank defends that 0.25% max. This is unsustainable as the most recent spree of buying has brought the BoJ’s balance sheet to 135% of their GDP, far higher than many other nations. With the threat of hyperinflation now more problematic than deflation and the yield having teetered around this 0.25% yield maximum for some time now, it is likely that with the excess volatility in the market and newfound monetary priorities that this peg become abandoned; now is the time to short the 10-Year Japanese Government Bond with a currency hedged futures trade. It is likely that the yen nosedives as this event could have the country’s credit rating re-classified lower, sparking more volatility and flows out of JP markets.