"Widow Trading" makes a comeback: Shorting Japanese government bonds becomes one of the most profitable trades this year!

The "widow trade," which has caused countless short sellers to lose their shirts, is transforming into one of the most profitable bets in the global bond market this year. As the Japanese bond market experiences its most severe sell-off in decades, the strategy of shorting Japanese government bonds is finally beginning to yield substantial returns for investors.

According to media estimates on Tuesday, Japanese government bonds have lost more than 4% in total return this year, excluding currency fluctuations, making them the worst-performing asset in the global government bond market. The Japanese bond market continues to be impacted by repeated expectations of interest rate hikes and concerns over potential large-scale fiscal stimulus from the new Prime Minister.

Mark Nash, a fund manager at Jupiter Asset Management, stated:

Forget about U.S. Treasuries or U.K. Gilts; one of the clearest strategies is to sell Japanese government bonds. Compared to other markets, the widow trade has become one of the most profitable trades.

This shift is significant, as the yield on Japan's 30-year government bonds reached a historic high this month, and Goldman Sachs has labeled Japan as a "net exporter of bearish shocks" in the global bond market. Political turmoil has exacerbated market volatility—new Prime Minister Kishi Sanae has promised cash subsidies and tax cuts, raising concerns that fiscal expansion will push up long-term yields, while the subsequent collapse of the ruling coalition has plunged Japan into its most severe political crisis in decades.

The "Widow Trade" Finally Turns Around

The "widow trade" strategy has existed in the Japanese bond market for decades—investors borrow and short-sell Japanese government bonds, expecting to buy them back at a profit after prices fall. This trade earned its name due to the repeated losses suffered by bond investors during Japan's prolonged ultra-loose monetary policy period.

Now the situation has completely reversed, with the S&P-related Japanese bond futures index down about 2% this year. Hiroyuki Kimura, a portfolio manager at Western Asset Management, which manages over $230 billion in assets, stated that his fund has maintained a long-term short duration strategy in the Japanese bond market and plans to stick to this position. This trade is primarily executed through significant short positions in five-year government bonds.

Mark Dowding, Chief Investment Officer at RBC BlueBay Asset Management, revealed in a report on October 10 that the firm has recently established a position betting on the decline of Japanese 10-year government bond prices and is currently shorting duration in the Japanese market. Previously, the firm had clashed with bond bulls in the "widow trade."

Multiple Factors Support Shorting Logic

The rationale supporting this trade is clear and straightforward. Japan's core inflation rate has consistently exceeded the central bank's 2% target for nearly three years. Despite implementing a series of interest rate hikes since last year, Japanese rates remain extremely low by global standards.

**Concerns over fiscal policy also provide broad support for shorting trades, as Japan has the highest government debt-to-GDP ratio among developed countries, with a significant lead. Although bond auctions have shown signs of easing pressure, they remain closely monitored as yields hover near multi-year highs ** The Japanese yen has also become the worst-performing currency against the US dollar among the G10 in the past six months, despite the prospects of further interest rate hikes by the Bank of Japan.

Lauren van Biljon, Senior Portfolio Manager at Allspring Global Investments UK Ltd., stated:

We expect an agreement on fiscal stimulus, although the scale of spending remains unclear. This indicates a need for caution regarding Japan's duration issues. The yield curve is already steep, but that doesn't mean it can't become steeper.

Political Turmoil Increases Uncertainty

The impact of Japan's next prime minister on the $7.7 trillion bond market has become a key focus for traders.

Sanae Takaichi, who won the parliamentary vote on Tuesday to become Japan's prime minister, has promised cash subsidies and tax cuts, but traders also believe her ascension will delay interest rate hikes. This has raised concerns that long-term bonds will ultimately face significant selling pressure, as investors worry that future generations will pay for today's fiscal generosity.

Just days after Takaichi won the Liberal Democratic Party leadership election, the ruling coalition collapsed—plunging Japan into its most severe political crisis in decades. She has secured a new partnership to form a coalition, but the risks of political news dragging down bonds are far from over.

Market analysis suggests that Bank of Japan officials do not see an urgent need for a rate hike next week, and on Tuesday, the yield on Japan's five-year government bonds fell two basis points to 1.22%.

However, this trade is not without risks. Local life insurance companies may return by the end of the year, boosting demand, while improved fiscal conditions provide some room for the government to reduce issuance in the next fiscal year. US rate cuts may also provide further support, as Japanese government bonds have historically shown correlation with US Treasuries