Is The Short-Yen Long-Equities Trade Over?

In volatility we haven’t seen since the Fukushima disaster, Japanese shares dropped by 7% on Thursday before bouncing off of those lows later in the day. Ouch!

The ostensible cause? Fed Chairman Ben Bernanke indicated that QE Infinity might -- just might -- come to end if U.S. economic data improve, and China’s PMI came in lower than expected. A more likely explanation is the recent surge in Japanese government bond yields; the 10-year yield briefly jumped above 1% before falling back into the 80-basis-range.

Long Run
Japanese stocks were definitely due for a breather; the Nikkei had been up by more than 50% year to date. But does Thursday’s action point to something bigger? Could it be that the short yen / long Japanese equities trade is over?

We’ll see. I expect that the yen still has much further to fall, and this may or may not mean a short-term rally in Japanese equities.

The real trading opportunity here, however, is in Japanese bonds.

This is a trade where the risk and potential reward are asymmetric; your downside is modest while your upside is enormous.

How Low?
Japanese 10-year yields can't go much lower. At time of writing, the yield was 0.86%. The all-time low was hit last month at just under 0.50%.

Could yields retest those old lows? Of course, anything is possible. But given the scale of the money printing involved, I wouldn’t bet on it.

A far more likely outcome is something akin to the euro-zone crisis whereby the bond vigilantes mercilessly punished the countries with high budget deficits and debt loads. Japan’s total debt is roughly 100 percentage points of GDP higher than that of Italy and its yearly budget deficit is substantially bigger, yet it pays a yield that is more than 75% lower. Given that Japan is no longer a high-savings-rate country, they cannot depend on their citizens to bail them out this time. And if the Bank of Japan steps in too aggressively, they run the risk of undermining confidence in the yen and turning its orderly decline into a rout…which would almost certainly cause yields on Japan’s debt to soar.

The Play
To take advantage of this, I recommend investors short Japanese debt. The easiest way to do this is via the Powershares DB 3x Inverse Jap Gov Bond ETN (JGBD). Be careful here because this is a leveraged ETN that also happens to be somewhat thinly traded.

Give this trade a little room to run. I would use a stop loss near the old lows $17.50. Your risk here is manageable. If I’m wrong, you have lost roughly 8%. But if I’m right, and the bond vigilantes finally turn on Japan, we might be able to double our money in a matter of weeks or months.

Disclosures: Sizemore Capital is long JGBD. This article first appeared on TraderPlanet.