Kyle Bass’s Prediction

Ichiro Suzuki

Kyle Bass is a highly successful hedge fund manager who predicted and effectively bet against the U.S. subprime mortgage debt securities, by purchasing credit default swaps on them. After winning in the subprime crisis, he eyed on Japanese government bonds and bet against them when the country’s debt to GDP ratio, already the world’s highest by far, was rising fast. It is not certain how seriously he bet against Japan, but he publicly talked about it.

There is truth to what Mr. Bass said. Japan got onto a trajectory of rapid debt accumulation in the 1990s, in the aftermath of the bust of the historic bubble. The real estate market crashed, forcing banks to hardships of reconstructing their balance sheets with non-performing loans write-offs rather than extending new loans. Corporate Japan also re-examined their sprawling operations to be better focused in a changing world, holding back new capital investments. In order to prevent the economy from collapsing, the government expanded budgets for public works, driving up debt levels.

Even worse, amid a severe economic downturn, Japan’s working age population had peaked. By the time Mr. Bass became very bearish on Japanese government bonds, the country’s entire population was peaking out, getting onto an irreversible trend of slow decline. Demography is a big negative factor for the Japanese economy. At a conference he said “Japan’s population is quickly aging amid population bust. More diapers for adults were sold last year than the ones for babies. The Ministry of Finance is so desperate to sell its bonds that they hired AKB48 for a JGB campaign to retail investors, and they are the worst girl band you can think of.” Japan’s debt to GDP ratio at that time exceeded 150%. No wonder any investor with a sane mind felt negatively about it. Collapsed of Japanese government bonds’ prices looked a sure thing. 

They didn’t collapse, however. Post-Global Financial Crisis deflationary pressure in the global economy drove major central to very aggressive actions. Led by Ben Bernanke’s Fed, central banks around the world fiercely expanded their balance sheets with purchases of government debts in order to provide liquidity into the struggling economies. Quantitative easing suppressed long-term interest rates so vehemently that sub 1% ten-year government bond yield became common by the middle of the 2010s. In the case of Japan, it was zero, and occasionally negative. There was no incentive in holding onto such low yield debts other than greater certainty of being paid back at their maturity. The notoriously risk-averse Japanese household sector had appreciated this greater certainty immensely. Despite the Ministry of Finance’s JGB campaign with AKB48, the household sector didn’t jump onto JGBs. Instead, they deposited their assets with banks that paid them a minuscule 0.1% interest, from which 20% was deducted as a tax. Retail deposits are guaranteed up to ¥10 million per account, and they loved it. Banks in turn recycled such deposits into JGBs in the absence of lucrative lending opportunities. On top of risk-aversion, holding onto near interest-free deposits was a rational economic decision at that time. In a country of persisting mild deflation, zero interest rates still increased purchasing power for depositors/ consumers. The majority of outstanding JGB has been indirectly owned by such ‘satisfied’ depositors, greatly reducing the risk of investors’ revolt. Investors didn’t shout for much higher yields, to be compensated for risk-taking of lending to a country of horrendous finances. 

After a few years, Mr. Bass no longer talked loudly about a strategy of shorting JGBs. It was a call made too early, way too early. In fact, such a call was originally made well over ten years before him. It was a right call but Japan proved having been capable of withstanding headwinds much more resiliently than emerging markets countries. John Maynard Keynes famously said “The market can stay irrational longer than you can be solvent.”  More than a dozen years after his presentation on a case for shorting JGBs, the market, and even Japanese investors, are beginning to demand far higher reruns than they used to, amid the global bond markets’ fragility. On a very long end of the yield curve, JGB’s 30-year yield move to the north of 3% in May, adding 0.4% to its level seen a few months earlier. The BOJ is determined to restore its monetary policy’s normalcy, by raising its policy rates and allowing long-term interest rates to be taken care of by market forces, albeit within the constraints of not damaging the economy seriously. A full-blown bond market crisis may still be some time away, but the reality in the market has moved a few steps closer to Kyle Bass’s prediction. History has witnessed many crises unfolding at a greater speed than expected or wanted. 

About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.

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