Monday, January 12, 2009
Lessons from shorting JGBs – the credible promise to be reckless
A background to the trade
The logic was as follows. Seven year JGBs were yielding about 130bps. The government looked like it would try quantitative easing – and that there was a chance – albeit small – that inflation could take off.
If you shorted seven year JGBs you were obliged to pay out 130bps (plus or minus small borrow fees or derivative margins) for seven years. Given short rates were zero at the time, being short JGBs and long cash had a negative carry of 130bps. It was painful – but not very expensive. If you shorted 100% of your wealth the negative carry would be 1.3% of your wealth per year.
The maximum loss would obtain if the seven year JGB suddenly traded – like cash – at a zero yield. Then you would lose the entire seven years of spread at once – or about 10% of your wealth all of a sudden. This would be painful – but is tolerable as a maximum theoretical loss. (Its not uncommon to have 10% of your wealth in a stock portfolio at any time.) Moreover the largest practical loss was a few percent of your wealth – somewhere near my actual loss.
A bad trade – and normally I would suck it up – learn a lesson and go on.
But times like this remind me again of the fortune you could make if inflation returned. Suppose – and it was unlikely in Japan – that inflation really took off – and bond yields went back to 7.3%. Roughly (and there is plenty of bond maths I am over-simplifying here) you would make 6% times seven years discounted a bit in profit – a very big profit on a trade with a seemingly small maximum loss. Indeed the gain might be 20 times the practical maximum annual negative carry.
And it struck me that the chance of inflation was real – and under-priced. Over time I found different ways to lose money betting on the possibility of reflation in Japan – most notably on Japanese regional banks (see this post on 77 Bank).
Moreover – I was just betting on policy being something other than entirely stupid. But for that you need my (admittedly trivial) understanding of where asset price deflation got to in Japan. Lets start closer to home – Australia.
Asset price inflation in Australia and deflation in Japan – or why Ben Bernanke wants to throw money out of helicopters
In Australia it became absolutely standard practice to buy real estate with negative carry. The idea was that you could buy a house for 100 thousand using 7% money and have a 3% rental yield. You made a 4% loss each year. The 4% loss could offset other tax. But everyone accepted it because house prices rose more than 4% a year and the capital gains tax was (slightly) concessional. The negative yield was sustainable so long as people continued to expect property prices to rise.
Well there was a point where Japan was the reverse of this. Banks would fall over themselves to lend you money at 1% to buy property with a 4% yield. You got 3% positive carry in a land where almost everything yielded something close to nothing. And yet people wouldn't do it. Why not? Because everyone knew that property prices fell more than 3% per yield. Positive carry was not enough to offset property price deflation.
When things deflate at 3-5% per year then money in the bank at zero interest (of which the Japs have plenty) is a very fine investment – it yields 3-5% per year post tax real – and it is very low risk. Obviously that was a better investment than almost everyone made in 2008. In realty it is an investment better than is available to most people anywhere.
And if everyone thinks this way (cash is good, borrowing bad, don't buy assets because they fall in price) then the situation is self-sustaining. Welcome to Japan.
Japan deflated because – well everyone thought it would continue to deflate. And that led to a lack of domestic investment and (eventually) the Japanese – like the Chinese – managing to fund a whole lot of really dumb lending in America. It was just bad.
Lots of people could see this – Krugman and Ben Bernanke to name just two. And a simple shock to the system which convinces people that holding the money in the bank is stupid and that they better go out and buy real assets would fix it.
What you needed was to credibly convince the population that deflation was over – and that there would be inflation. What the BOJ needed to do was credibly promise to be irresponsible.
You have to convince that cash-is-trash.
How do you do this? Well the first answer is just print money.
And that is what the BOJ did – and what central banks around the world are still doing. And it doesn't work. The reason that it doesn't work is that people are more than happy to hold the money idle in enormous quantity. It yields 3-5% post tax real after all.
Just printing money is not enough. You need a real shock.
The Ben Bernanke suggestion – and he really did suggest this: load up a helicopter and throw it out the window over downtown Tokyo. If that doesn't work continue doing it until you get inflation.
This would be a dramatic uncontrolled experiment – and it could induce LOTS of inflation. In Japan bank deposits are a large multiple of GDP – and very large per capita relative to America. If the Japanese were shocked into believing that cash is trash they might try to spend these on assets very fast – and that might produce dangerous outcomes. The BOJ dismissed Kruman's suggestions as “dangerous”. And they probably were dangerous – but they might have been better than years of continued deflation.
Anyway they chose continued deflation and my short JGB position lost money.
Now Ben Bernanke is in charge
Ben suggested helicopters for Japan. He wants to credibly promise inflation in the US too. Ben is – I suspect – good for his word – even though the bond market sees it otherwise.
And if it comes to the crunch my guess is that he will charter the helicopter. He will pick a middle income state (Iowa – because it is politically sensitive?) and drop cash.
Maybe – less reckless in appearance than throwing money out of helicopters would be the Fed turning up at schools with big piles of crisp $20 notes. Whatever. He wants to credibly promise to be reckless.
Giving money in one-off tax breaks (as per Australia or Bush's various plans) is not the same thing. That money isn't freshly printed cash. You need to credibly convince the populace that you are prepared to risk the Zimbabwe outcome. You have to credibly promise to be reckless.
Bernanke knows this. He is on the record for suggesting it.
So when do you short treasuries?
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