The widowmaker doesn’t care if this is nuts

Japan is the home of the “widowmaker” trade: the obviously mispriced Japanese government bonds (JGBs) which keep getting more and more mispriced until all the short-sellers have gone out of business.

JGBs claimed victims in 1993, 2003 and 2013, when yields plunged in the face of all the arguments presented by the bond vigilantes worried about the slow economy and government debt at levels unheard of elsewhere in the world.

This year was meant to be different. Frantic money-printing by the Bank of Japan last year weakened the yen and so pushed up the price of imported goods, particularly energy, while signs of consumer spending allowed shops to push through price increases.

Sure enough, inflation hit 3.7 per cent in May, helped on by the rise in the consumption tax. With deflation in the past, bonds must now sell off and offer fat profits to the ragged survivors of the anti-JGB trade.

Not so much. Japanese bond bears are having an awful time, with the yield on the 7-year JGB, closely watched by traders, dropping to just 0.28 per cent so far this year, only 6bp above its all-time low. Rising inflation has been met by falling yields, in a reversal of all bond logic, as this chart shows:

The Japanese inflation-linked market does not function well, but this chart shows just how much real, after-inflation, yields have fallen. The black line shows an index of inflation-linked JGB real yields, while the other two show the 7- and 10-year yields minus inflation.

Negative real yields send a signal to companies and households to consume, rather than save, which is exactly what the government wants them to do. Figures on Friday show the message has not yet got through: household spending unexpectedly plunged 8 per cent in May compared to the previous year. At some point either inflation – anyway temporarily boosted by the tax rise – will soon drop back sharply, or bond yields must rise. Will that happen before the last of the bond bears finally capitulates?