Japanese bond markets have attracted more attention recently than for many years. Ten-year bond yields have risen to 0.5% following a shift in the Bank of Japan’s tolerance bands. The announcement of Kazuo Ueda as the incoming Bank of Japan Governor marks a shift from a bureaucrat to a technocrat. For better or worse, the world seems to be rumbling closer to the yield curve policy pioneered by the BoJ.
Behind that are some unseen stresses: as part of their operations the BoJ has literally cornered the market in ten-year JGBs. And there is an ominous widening of spreads between un-collateralised and collateralised Japanese repo rates. In this article I aim to disentangle some of what is going on and what it means both for Japan and the rest of the world.
Governor Ueda will continue with QE
I start with Governor-to-be Ueda. Arcus Invest’s Peter Tasker, who is as well connected as anyone to Japanese politics, makes the point in an article that Ueda was Kishida’s first choice as Governor and not a back-up. His technocratic background and connections with other central banks mean that he can keep more closely in step with them and avoid the policy errors which the Bank of Japan has been prone to over the last 30 years. The experience of the United Kingdom’s LDI crisis shows how important that is in today’s fragile markets.
Ueda’s Diet testimony last week made it clear that Japanese inflation is still far from the 2% target agreed ten years ago. As a point of fact, the CPI index has in fact deflated slightly over the past four years and market expectations of five-year inflation are around 0.7 to 1.1%. In response to this disinflationary tendency the Bank of Japan has its foot firmly on the monetary pedal; monthly bond issuance in January 2023 was the highest ever. It seems unlikely that this stance will change under Ueda.
Bank of Japan has cornered parts of the JGB market
However, the Bank of Japan has some technical problems to solve. I am indebted to a piece by Oxford Economics for some of the following analysis, but the opinions are my own. To stop bond yields soaring as a result of this bond issuance, the BoJ has taken – like many other central banks – to buying them back using short-term finance. But the Japanese have done it on a greater scale and has over the past twelve months absorbed more, in some cases much more, than 100% of issuance around the ten year tenor. The 20 to 30bp downward kink in the JGB yield curve at this maturity is strong evidence of their actions. In effect the BoJ has cornered the market in them.
It is not at all surprising therefore that JGB market liquidity, like U.K. gilts, is very limited. This in turn has knock-on effects on reverse repo markets. The shortage of collateral has led to a widening of the spread between the un-collateralised overnight rate and collateralised reverse repo markets over the past few months, an unequivocal sign of stress.
The Bank of Japan may lose this tussle with speculators
A tussle has ensued. The BoJ has responded to the lack of liquidity by lending out the bonds it owns under its securities lending facility. In turn traders believing that the BoJ will not be able to hold the line have hit back by borrowing those bonds to sell the market short. The BoJ has therefore raised the fees it charges, which will in turn reduce liquidity.
At the heart of this tussle is a battle between market forces and the Bank of Japan. While I am always wary of fighting major central banks, my money is on market forces winning eventually. Market corners are not sustainable, particularly when the BoJ is lending the very bonds which it is then having to buy back from the speculators. Alternatively, they will be forced to crank up the cost of borrowing bonds, which will increase the stresses on short-term rates. Even though Japan Inc is far less leveraged than western countries, this is an unwelcome side-effect which the Bank of Japan cannot ignore.
This is the big test for Yield Curve Control
If I am right that the Bank of Japan will continue with QE, it may well find itself more in step with other central banks. Japanese interest rate policy may be divergent today, but other monetary authorities, most notably the Peoples Bank of China, are expanding their balance sheets substantially. I surmise that Governor Ueda with his international connections would like to see Japanese interest rates moving closer in line too.
The big question, however, is over Yield Curve Control. If the BoJ succeeds in seeing off the speculators, expect other central banks to introduce similar policies, effectively manipulating the bond market and keeping bond yields relatively low. If, on the other hand, the BoJ is forced into defeat, then they will back off and I would expect global bond yields to rise substantially. Either way, there will be an impact on valuations of riskier assets such as equities. That is why investors need to pay close attention to the JGB market.