Japan's Bond Market: Armageddon Postponed

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-- John Mauldin delivered that one-liner, which he attributed to George Soros, in his outlook for 2013.

Alas, it appears I’m now part of the fraternity. I lost money shorting Japanese government bonds this year.

In May and June it looked like the bond vigilantes had finally awakened from their long coma. The 10-year yield more than doubled, shooting from 0.44% to nearly 1.0% in less than two months. The bond market seemed to believe for a moment that Abenomics might — just might — be successful in shaking Japan out of its two-decade deflationary funk.

So much for that idea. Yield have trickled lower ever since, and the 10-year now yields 0.64%…or about 75% less than the 10-year Treasury yield in the U.S. One prominent Japanese analyst sees the yield falling all the way to 0.25%.

This is madness.

At the risk of whipping a dead horse, Japan is sleepwalking into a major debt and currency crisis. It is not a matter of “if” but “when.”

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As I wrote earlier this year, debt service now accounts for 43% of Japanese government revenues and quarter of all spending. Furthermore, more than half of all Japanese government spending is financed by new borrowing. This means that half of every yen borrowed is used to service existing debts. It’s a debtor’s nightmare that gets worse every year with budget deficits that are consistently higher than 7% of GDP.

All of this might be manageable if Japan were a young and growing country. But it’s not, and it never will be again (or at least not in our lifetimes). Japan is the oldest country in the world, a place that sells more adult diapers than infant diapers. It’s population — and tax base — is shrinking, and its national savings rate — once among the highest in the world — is now lower than that of the United States. This means that the Japanese government cannot depend on a pliant domestic investor base to lend it money. It will have to depend even more heavily on the Bank of Japan or — worse — go to the international bond market cap in hand.

At some point, the bond market is going to collectively realize that the game is up and that Japan’s massive debts — currently pushing 250% of GDP — are not payable. As yields rise, the Bank of Japan will be forced to intervene, which will cause the value of the yen to plunge. In short order, Japan will shift from a deflationary monetary regime to a hyperinflationary one.

That day isn’t here yet. If anything, the bond market is more complacent now than it was a year ago. But when it comes, you will have your choice of available trading options. In my last attempt, I used the PowerShares DB 3x Inverse Japanese Govt Bond ETN (JGBD), which is a leveraged version of the PowerShares DB Inverse Japanese Govt Bond ETN (JGBS). Both are viable options for individual investors.

WisdomTree also has a product in the works that would pair a bearish bet on Japanese bonds with a long position in U.S. bonds.

With yields already as low as they are, your risk of loss is tolerable. In fact, your greatest risk is not to your wallet but to your reputation: you could end up becoming a member of the illustrious club of macro traders that shorted Japan too soon…

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he had no position in any security mentioned.