Jittery JGBs threaten BOJ’s game plan

A confused local bond market has triggered JGB volatility to soar to record levels, prompting concern among strategists who say this could derail the Bank of Japan’s efforts to lift the country out of deflation.

  • 18 Apr 2013
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Record levels of volatility in Japan’s government bond market is instilling concern that markets will take longer than expected to stabilize, making it more challenging for the Bank of Japan to reach its inflation target.

Yields in Japan’s benchmark 10-year bonds fell to a record low of 0.425% on April 4 when the BOJ announced plans to buy ¥7.5 trillion (US$77.8 billion) worth of Japanese government bonds (JGBs) from May that will add up to 70% of government bond issuance. On April 5, the 10-year yield opened 10 basis points (bp) but soared 30bp during intra-day trading. Yields were 5bp higher than April 4 at the time Asiamoney PLUS went to press.

The volatility in JGBs, which are considered staple safe-haven assets for the Japanese, has elevated yields across the entire JGB curve. This is the opposite of what the BOJ is trying to do—to keep rates low in order to spur sustainable risk taking by investors that has begun to take form in Japanese equities.

“We think favourable stock and forex responses will not last if bond market instability continues due to the current state of the Japanese economy, which needs sustained ultra-easing action in order to have a shot at reaching the 2% inflation target within two years,” said Akito Fukunaga, chief rates strategist at RBS.

Higher yields make it more expensive for the Japanese to borrow money to invest in risk-free assets. Making it cheaper to incur debt is crucial in moving the country closer to higher inflation of 2% in the next two years.

But volatile bond yields prompted Japanese banks to unwind their long-JGB positions especially in five-year tenors that triggered a further selloff in the past few days according to Yuya Yamashita, a rates strategist at J.P. Morgan. Yields on five-year bonds are up 12bp since April 3, the largest underperformers of the market compared to other maturities. JGB intraday trading volumes have also fallen.

“The BOJ's handling of market operations has increased the uncertainty and instability and the positioning in JGBs has deteriorated for dealers and investors,” according to an April 16 research report published by rates strategists Maki Shimizu and Eiji Dohke at Citi.

Concern over rising bond yields is a major concern especially as the BOJ will be committing bond buying on the longer end of the curve that will increase its average purchases in maturities from three years to seven. The shorter end has a larger influence on the entire curve. With rates moving in an unpredictable trajectory, it has become more difficult for investors to calculate risk.

“The JGB market entered a new phase and many market participants were not able to find fair values,” according to Yamashita. “If volatility becomes higher, investors and dealers’ risk-taking capability will go down. So that accelerates volatility further. Investors as well as dealers might calculate their portfolio risks on realised volatility to some extent. So heightening in real volatility will prompt them to reduce their positions, leading to a further selloff.”

An absence of a stable flow of JGB purchases will continue to push yields higher, which will create a lack of demand for the remaining 30% of government bond issuance that needs to be soaked up by investors.

“This will make it difficult to achieve the target in two years,” according to RBS’ Fukunaga. “In other words, Governor Kuroda appears to be encouraging bond investors to buy bonds for the time being without creating wall of ‘stupidity.’”

For the time being, investment banks are encouraging clients to take advantage of the current volatility. Citi recommends buying the 10-year JGBs for the next two to three weeks, according to an April 16 report, citing that investors should aim to enter the trade above 0.6%. The position should be unwound before mid-May when yields are likely to rise on a concentration of longer-tenor bond auctions and fiscal concerns.

Regardless of the topsy-turvy market, some strategists say yields will eventually settle down as the BOJ begins to provide more liquidity in inter-bank trading to encourage purchases in JGBs with shorter maturities, as well as increase communication with market participants in order to resolve the current mismatch in supply and demand.

“They will try to have more communication with market participants, that’s one thing. Another thing is the BOJ is expected to conduct various operations such as JGB and T-bill purchases and fund-supplying to stabilize the market,” said Yamashita. “The new phase of monetary easing will likely have a bullish impact on JGBs so I expect yields to eventually move lower.”

  • 18 Apr 2013

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