In volatility we haven’t seen since the Fukushima disaster, Japanese shares dropped by 7% on Thursday before bouncing off of those lows later in the day.  Ouch!

The ostensible cause?  Fed Chairman Ben Bernanke indicated that QE Infinity might—just might—come to end if U.S. economic data improve, and China’s PMI came in lower than expected.  A more likely explanation is the recent surge in Japanese government bond yields; the 10-year yield briefly jumped above 1% before falling back into the 80-basis-range.

Japanese stocks were definitely due for a breather; the Nikkei had been up by more than 50% year to date.  But does Thursday’s action point to something bigger?  Could it be that the short yen / long Japanese equities trade is over?

We’ll see. I expect that the yen still has much further to fall, and this may or may not mean a short-term rally in Japanese equities.

Related video: Japan, China and their Ticking Demographic Time Bombs

The real trading opportunity here, however, is in Japanese bonds.  This is a trade where the risk and potential reward are asymmetric; your downside is modest while your upside is enormous.

Japanese 10-year yields cannot go much lower than current levels.  At time of writing, the yield was 0.86%.  The all-time low was hit last month at just under 0.50%.

Could yields retest those old lows? Of course, anything is possible.  But given the scale of the money printing involved, I wouldn’t bet on it.

A far more likely outcome is something akin to the Eurozone crisis whereby the bond vigilantes mercilessly punished the countries with high budget deficits and debt loads.  Japan’s total debt is roughly 100 percentage points of GDP higher than that of Italy and its yearly budget deficit is substantially bigger, yet it pays a yield that is more than 75% lower.  Given that Japan is no longer a high-savings-rate country, they cannot depend on their citizens to bail them out this time.  And if the Bank of Japan steps in too aggressively, they run the risk of undermining confidence in the yen and turning its orderly decline into a rout…which would almost certainly cause yields on Japan’s debt to soar.

To take advantage of this, I recommend investors short Japanese debt.  The easiest way to do this is via the Powershares DB 3x Inverse Jap Gov Bond ETN ($JGBD).  Be careful here because this is a leveraged ETN that also happens to be somewhat thinly traded.

Give this trade a little room to run.  I would use a stop loss near the old lows $17.50.  Your risk here is manageable.  If I’m wrong, you have lost roughly 8%.  But if I’m right, and the bond vigilantes finally turn on Japan, we might be able to double our money in a matter of weeks or months.

Disclosures: Sizemore Capital is long JGBD.  This article first appeared on TraderPlanet.

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Japanese stocks are off to a nice start this year.  The iShares MSCI Japan ETF (NYSE:$EWJ), a popular option among investors for getting access to Japan’s biggest traded companies, is up 4% for the year and 14% over the past month.

Enjoy it while it lasts.

Japan’s recent surge is due to its new quantitative easing program—its largest in years—and the stated intentions of Prime Minister Shinzo Abe to weaken the value of the yen and boot Japan out of the deflationary slump it’s been in for the better part of two decades.

But Abe should be very careful what he wishes for.  Deflation is what keeps Japan’s borrowing costs as low as they are.  At time of writing, Japan’s 10-year government bonds yield a pitiful 0.75%.  According to financial writer John Mauldin, an increase of just 100 basis points in borrowing costs would devour 10% of tax revenues.

Japan 10 Year Government Yield

Writing for Bloomberg, Gary Shilling notes that debt service now accounts for 43% of Japanese government revenues and quarter of all spending.  Furthermore, more than half of all Japanese government spending is financed by new borrowing.   This means that half of every yen borrowed is used to service existing debts.  It’s a debtor’s nightmare that gets worse every year with budget deficits that are consistently higher than 7% of GDP.

All of this has been made possible by Japan’s seemingly inexhaustible supply of domestic borrowers.  But those days are now over.  As Japan’s population ages, its savings rate plummets.  Once you stop working, you stop saving and you start living off your investments instead.  As Japan is the oldest country in the world (and rapidly getting older) its savings rate has shrunk below that of the free-spending United States.

This means that Japan has two choices going forward.  Tap the international bond market and risk the beating that Spain and Italy took last year or finance the government directly via the central bank.  Neither of these two scenarios end well.

How long can this song and dance last?  It’s impossible to say, but you’ll know ahead of time that it is coming to an end.  Eventually the bond market vigilantes will wake out of their stupor, and then the jig will be up.

Keep an eye on the Japanese 10-year yield.  Thus far, it hasn’t budged much in response to the quantitative easing plans.  Yields popped from 70 basis points to 84 basis points before drifting back to current levels.

When the yield approaches 1.5%, get ready for the short opportunity of a lifetime in Japanese assets.  Because once Japan loses control of the situation, it will be only a short matter of time before it implodes into a hyperinflationary meltdown.

This article first appeared on MarketWatch.

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