Short JGB futures has asymmetric upside?

A

ajensen

A Bloomberg article makes me wonder if shorting JGB futures is a trade with asymmetric upside.

Bond Vigilantes Revive Wagers on a BOJ Hawkish Policy Shift
* Swaps, corporate bond coupons point to surge in 10-year yields
* May test governor Kuroda’s determination to stick with policy
By Ayai Tomisawa and Masaki Kondo
October 18, 2022 at 6:15 PM EDT, Updated onOctober 19, 2022 at 5:57 AM EDT

Governor Haruhiko Kuroda has taken pains to explain why the Bank of Japan is nowhere close to even a modest adjustment to its ultra-easy policy, but traders are yet to be convinced.

Yen swaps are climbing, average coupons on 10-year corporate bonds are pushing higher and overnight-indexed swaps are pricing in an end to negative-rate policy around the time Kuroda steps down in April. His yield curve control is also getting tested with the benchmark yield rising above the BOJ’s target range on Wednesday.

“I’m not sure Japan is going to have a UK moment, but certainly there are cracks appearing in the JGB market that imply the market is preparing for the BOJ” to have to tweak its yield curve control policy earlier than anticipated, said Brad Gibson, co-head of Asia Pacific fixed income at AllianceBernstein Australia Ltd., in an interview on Bloomberg Television.

These charts show how investors in some parts of the credit and swap markets are preparing for a surge in 10-year yields, essentially wagering the central bank will alter its policy of curve control. This will test Kuroda’s determination to stick with rock-bottom rates in the final months of his term, a policy that’s increasingly out of line with global peers.

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globalarbtrader said:
Ah... the widowmaker.

GAT
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I know the short JGB trade has that reputation, but in general, if a government is suppressing a bond yield or supporting its currency at a certain level, doesn't shorting the bond or currency have asymmetric upside? Of a course a prospective short JGB trader needs to estimate volatility and size the trade accordingly, as discussed in your books, which I have read!
 
Not when the risks are fairly priced. The risk here are extremely deep BOJ pockets, they can go on with this policy for a much longer time than most traders imagine, which BOJ has demonstrated at numerous occasions. Japan domestic sovereign bond ownership is extremely high, most foreign entities in this market are just miniscule players. At some point the policy divergence has to be reconciled with currency positioning but before that many other traders most likely will lose more money on this trade.

ajensen said:
I know the short JGB trade has that reputation, but in general, if a government is suppressing a bond yield or supporting its currency at a certain level, doesn't shorting the bond or currency have asymmetric upside? Of a course a prospective short JGB trader needs to estimate volatility and size the trade accordingly, as discussed in your books, which I have read!
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The trade certainly has asymmetric upside in the sense of having a better than 1:1 payoff, but whether it's +EV depends on odds and costs/risks.

Supporting a currency peg is different because such requires the use of potentially scarce FX reserves. Inflation in Japan is currently quite low even with the plunge in JPY, so there's really no significant or immediate pressure on them to change the YCC policy. It's conceivable the BOJ will be forced to change course if JPY keeps tanking and inflation clicks up to 5%+. My play would be to put on the bond short once this latter scenario is actually starting to happen, rather than jumping in now on the hypothetical possibility that it may happen in the future.
 
Man (a UK money manager) seems mildly bearish on 10-year JGBs:

As global rates rise, attention once again turns to Japanese bond markets. Yields on 10-year Japanese Government Bonds (‘JGBs’) have been capped at 25 basis points (‘bps’), with JGBs trading at or close to the cap for most of the year (Figure 2). The Bank of Japan has aggressively purchased bonds, thus keeping the cap roughly in place, even though yields for non-targeted maturities have now become dislocated from those selected for purchase (Figure 3).

The continuation of yield curve control presents its own problems. If yields are capped, it makes little sense for bondholders to sell targeted maturities – there is after all only one willing buyer, who effectively sets a price floor. We are already seeing reduced liquidity as consequence: the BoJ owns more than 65% of 10-year JGBs, and with global yields rising, it is unlikely that the figure will go down. We are already seeing signs of stress in the futures market, with the 10-year JGB price spiking repeatedly above the capped yield – albeit at stress levels lower than those seen in June (Figure 4).

In our view, reports of the death of yield curve control are greatly exaggerated. Without yield curve control, the entire JGB yield curve would undoubtedly be much higher. Yields for target maturities are at the limit of tolerated ranges, but have not consistently breached them. In that sense, the policy is still working.

But in the wake of a 75 bps rate hike by the Fed, we do not expect yield curve control to persist much longer. The interest rate differential to the dollar is simply too large, weighing not only on JGBs but also the yen. Japan is a major energy importer: a weakening currency in an inflationary environment will only further contribute to stress on the Japanese consumer. Yield curve control may not have failed, but its future hardly seems bright in the land of the rising sun.
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