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‘X Day’: How To Trade a Japanese Bond Implosion

Friday, 18 Feb 2011 | 8:32 AM ET

As investors fret about a default of Greece’s $300 billion debt bill, consider this: at $10.2 trillion, the Japanese bond market is the largest government debt market on the planet. And Hedge fund manager Kyle Bass, who made his first fortune betting against subprime mortgages , is now wagering that this market will collapse—soon.

In a February 14 investor letter to his clients at Hayman Capital Management, and CNBC’s "The Strategy Session" Wednesday, Bass made the case for a financial doomsday scenario, known as ‘X-Day.’

Sayonara Japan
Stocks are being lifted by a slew of new M&A deals, and a look at why Japan might be closer to a global default and a necessary restructuring than anyone thinks, with Kyle Bass, Hayman Capital Partners managing partner.

Think it’s impossible? Bass lays out the domino effect in his investor letter, titled “The Cognitive Dissonance of it All.” Here’s how he sees it going down:

  • STAGE 1: PILE ON DEBT

This stage is already complete in Japan. Bass focuses on the gap between the huge amount of debt racked up by Japan over the last 20 years, and the puny tax revenue that is intended to maintain it:

“Japan currently maintains central government debt approaching one quadrillion (one thousand trillion) Yen and central government revenues are roughly 48 trillion. Their ratio of central government debt to revenue is a fatal 20 times," Bass said.

And for all you keeping score, note that United States’ government debt to revenue is currently at a slightly less-alarming 3 times.

  • STAGE 2: GET STUCK IN LOW INTEREST RATE TRAP

Japanese monetary policy—like a lot of other Western economies (talking about you, America)—is committed to maintaining abnormally low interest rates in the hopes of stimulating growth.

But the problem, Bass explains, is that this is really a trap having nothing to do with growth. It’s about paying creditors. In order to simply afford paying the interest on its hulking debt, Japan must maintain interest rates near zero. As Bass describes in his letter:

“Japan had to borrow at France’s rates (a AAA?rated member of the U.N. Security Council), the interest burden alone would bankrupt the government.”

Therefore—any increase in interest rates in Japan is terminal. But rates have been below 2 percent for decades. Why would they have any reason to spike now?

  • STAGE 3: RUN OUT OF BUYERS FOR YOUR DEBT

Japanese rates, Bass said, are a few years away from spiking once the Japanese stop buying their own debt. Unlike the United States, which has China as a perpetual purchaser of Treasuries , Japan has sold most of its debt to its own population. And that population is aging fast, and saving less.

Bass: China Inflation Could Hit 10 Percent Next Quarter
Hayman Capital's Kyle Bass, the hedge fund manager who predicted the housing crisis, explains why he sees even sharper inflation in emerging markets in the coming months, how he's hedging against it , and his Japan doomsday scenario.

That demographic shift is key to the unraveling of the Japanese bond market. An aging population means costly expenditures, making government deficits worse. An aging population also means a smaller population: fewer people paying taxes, fewer citizens buying new debt. That one-two punch is the death blow:

The severe decline in the population in addition to Japanese resistance to large scale immigration combine to form a volatile catalyst for a toxic bond crisis that could very likely be the largest the world has ever witnessed,” he added.

So how in the world do you trade ‘X Day’? Ironically—it could be to buy Japanese stocks.

“The trade here is short Japanese bonds, short the Yen—but get long the Nikkei,” says Peter Boockvar, Miller Tabak’s Equity Strategist.

“It’s a bizarre outcome—but any threat of a Japanese default would force Japan’s bondholders directly out of JGBs (Japanese Government Bonds) and into stocks—leading to a sharp Nikkei rally,” Boockvar said.

Furthermore, adds Boockvar, the bond rout would likely force the Bank of Japan to print a lot of Yen in order to further monetize their debt, which would boost Japanese stocks even further. “Remember, Japan is an export driven economy. A massive devaluation of the Yen would boost exports, and subsequently the Nikkei.”

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