The “Widowmaker” Pays Off as the Last Central Bank Domino Falls

In trader parlance, a “widowmaker” trade is one that can result in catastrophic loss.  The most persistent, classic widowmaker trade has been shorting Japanese Government Bonds (JGB) in the hope that the Bank of Japan (BOJ) will be forced to move off its perpetual zero-interest rate policy.  After years of holding fast, the BOJ finally blinked last night when they announced that their yield curve control (YCC) policy would expand from +/-25 basis points to +/-50 basis points around zero.

The widowmaker seemed like an obvious layup.  For decades, the BOJ had interest rate policies that were generally below those of the rest of the world’s central banks.  That left traders with what appeared to be a one-way bet.  Interest rates could only rise, so it seemed obvious to short JGBs.  Traders love one-way bets that have limited downside and relatively unconstrained upside.  Yet the JGB short never truly paid off – until today.

Yields on 10-Year JGBs, Quarterly Data Since 1988

Source: Bloomberg

We can see above that except for brief periods, yields on 10-year JGBs steadily fell.  (Remember, bond prices rise as yields fall.)  Only very nimble traders made money by shorting JGBs.  Those who had long-term short positions generally lost money on what appeared to be a risk-controlled wager.  A period of sustained deflation can do that.  Hence the widowmaker moniker.

In and of itself, a 25bp jump in yields shouldn’t be all that significant.  But the BOJ move was quite important.  They were the last holdout among the cadre of G7 central banks who have been raising rates – some quite aggressively.  When the US dollar was accelerating to multi-year highs against a wide range of other currencies, the yen was a notable victim.  The BOJ was able to stabilize the yen’s decline with a large intervention when JPY was about 150, and then benefitted when the dollar retreated from its highs.  But the latest YCC move accelerated the yen’s rise quite dramatically, and we see JPY gaining by 5 yen to the dollar to 132 (+3.6%).

Japanese Yen (JPY) per US Dollar (USD) – 1-Year Daily Bars

Source: Interactive Brokers

One might have suspected that there was a different widowmaker trade in play today.  The yen carry trade is a popular one among hedge funds.  The trade involves borrowing a low yielding currency – typically the yen – and using the proceeds to purchase higher yielding fixed income assets or to finance speculation in equities and other risk assets.  In theory, those who had the carry trade on should be getting clobbered with the yen rising dramatically.  It is now about 3.8% more expensive to pay back the borrowed yen. 

That we see a relatively muted response in US equities and bonds – the former are up and the latter are down modestly – make it clear that the carry trade is not as impactful today as it might otherwise have been.  It implies that the carry trade is not as popular today as many feared overnight.  Perhaps many traders took closed their carry trades as the yen bounced off its November lows.  Another theory is that hedge funds de-risked into the year-end period and thus missed the negative impact.  The BOJ’s move could have had a potentially disastrous effect in a typically low liquidity period.  That we can greet such a momentous move with a relative yawn in much of the world is a fairly lucky thing.