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As Japan seeks revival, hedge funds bet on a bust

Monday - 6/10/2013, 7:44am  ET

In this Wednesday, June 5, 2013 photo, Takashi Yamada, seated second right, a government-bond trader at major brokerage Daiwa Securities Co., and his desk bond dealers monitor screens at their bond trading section in Tokyo, Japan. Until a couple of months ago, Yamada had one of the most genteel jobs in Japan. Now, his days are so harried he doesn't have time to eat lunch. Shock-and-Awe monetary policies, announced in April, have sent Japanese government bonds, this nation's equivalent of U.S. Treasurys, into a whirl of volatility. (AP Photo/Shuji Kajiyama)

YURI KAGEYAMA
AP Business Writer

TOKYO (AP) -- Until a couple of months ago, Takashi Yamada had one of the most genteel jobs in Japan. Now, his days are so harried he doesn't have time to eat lunch.

Yamada, 45, is a government-bond trader at major brokerage Daiwa Securities Co.

Shock-and-Awe monetary policies, announced in April, have sent Japanese government bonds, this nation's equivalent of U.S. Treasurys, into a whirl of volatility.

"Our job is about interest rates, and that's supposed to be like rice in a meal, not steak, something basic but needed," Yamada said, looking weary and a bit out of breath, after nonstop juggling of bond selling and buying on several monitors at his desk. "No one expected this."

The sudden frenzy of his job underlines the growing fears about Japan's surging public debt. Bonds were long stable, which meant the adjustments to bond trades or "positions" Yamada had to do were routine and predictable. Not anymore.

The yield, or interest rate, on benchmark 10-year bonds shot up to 1 percent for the first time in a year late last month, although it later headed down. In the bond market, yields go up when prices drop so even tiny moves in those rates can translate into lots of yen made or lost.

The lavish Japan revival policies of Prime Minister Shinzo Abe, including the Bank of Japan's doubling the money supply in two years, are designed to wrest the nation out of deflation, or continually sinking prices that hurt growth, and two decades of economic doldrums.

But at the heart of "Abenomics" is a contradiction: Japan may not be able to afford the inflation that Abe's grand ambition hopes to ignite.

After years of deficits financed by sales of government bonds, public debt is already twice the size of the economy and interest payments consume a quarter of government spending. It is an unassailable reality that if inflation goes up so must interest rates and so must pressure on the bloated finances of a government atop the world's third-largest economy.

Although Abenomics has generally lifted Tokyo stocks and lowered the yen, a boon for the giant exporters of Japan Inc., the bond market that keeps Japan's government afloat is growing ever nervous.

The sell-off in bonds last month was one sign of the panicky mood and occurred despite the Bank of Japan's constant presence in the market, buying up more than half of government bonds for the next two years.

A handful of overseas hedge funds are seeking to make a killing on the gloomiest scenario for Abenomics. Experts say their methods involve futures trading, which allows betting on bonds you don't own.

They are counting on what they see as an inevitable catastrophe. If bond prices crash, their owners, mostly Japanese financial situations, will lose a major chunk of their assets overnight. It would freeze up the market that funds the government's mammoth deficits, shattering Japan's credibility as an economic power and send shockwaves rippling around the world.

"My assessment of the situation is that nothing can be done from this point forward to avoid a full bond crisis," said J. Kyle Bass, managing partner at Dallas-based Hayman Capital Management. "I think it is not only possible. It is probable."

His hedge fund invests in conventional ways, too, such as stocks, although none in Japanese equities, and currencies, including investing in a cheaper yen. But he has made positions that will allow his hedge fund to come out ahead if Japanese bond prices plunge. He declined to give details of how he hedges, citing policy.

Investors such as Bass are sometimes criticized as seeking to make money off a crisis or even helping to engineer one. The way Bass sees it, his hedge fund is carrying out an investment strategy that's prepared for the obvious risks.

"The better way to ask the question is: How do you hedge yourself against this eventuality?" Bass said in a recent interview in Tokyo.

He may be on to something.

The risks for investing in bonds tend to be minimal compared with stocks and currencies. But the rewards for betting on a bond crash can be great -- although that's a big "if."

After Abe took office late last year, the Bank of Japan set a 2 percent inflation target and the government promised structural reforms such as opening up trade, promoting women in the work place and boosting people's income. The government is pumping 8 trillion yen ($80 billion) into public spending, focused on infrastructure, to jump-start the economy.

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