JGB Market Supported by Massive BoJ Buying

When 10-year JGB yields briefly spiked to the 1% level on Thursday last week, the BoJ intervened massively in the market, injecting almost $20 billion (2 trillion yen) to support prices. On Friday it followed up by buying another 900 billion yen in bond purchases (600 billion of bonds maturing between 5 and 10 years, 300 billion of bonds maturing in over 10 years) Thus the BoJ bought altogether bonds worth $30 billion in a mere two trading days to keep yields from going higher. Relative to the size of the economy, this would be equivalent to the Fed buying $90 billion in treasuries in just two days. However, the size of Japan's gross public debt is not much below that of the US. It amounts to about 1.2 quadrillion yen, or $12 trillion. As a percentage of economic output it is at 230 percent, however, and this is far more worrisome, it amounts to 2,700 percent of annual tax revenue.



The BoJ intervenes heavily to stop the sell-off in JGBs – click to enlarge.



BoJ chied Haruhiko Kuroda noted on Friday that it was 'extremely desirable' that the JGB market remain stable, noting that:


“We are going to conduct our market operations in a flexible manner to head off, as much as possible, volatility in long-term interest rates, which were rising temporarily recently.”

Mr. Kuroda also said the BOJ will continue to strength its communication with bond market participants.”


He has a great many 'communications' with bond market participants ahead of him we would wager. The recent release of the minutes of the BoJ's late April meeting showed that a number of board members were 'concerned' over the bond market's volatility. There was apparently also a 'rift' over the time line in which the 'inflation target' can be reached, but this just continued the debate of the previous meeting. Apparently two board members felt that if the central bank fails to achieve its stated target in the designated time period, its 'credibility will suffer'. Regarding the bond market, there was a recognition that  ultra-low yields and 2% CPI inflation may not be compatible:


“At the April 26 meeting, a few members said the market turbulence was due to a tug-of-war between downward pressure on yields from the BOJ's huge bond buying and upward pressure from expectations the central bank is determined to achieve 2 percent inflation at an early date, the minutes showed.

Some board members called for the need to continue examining steps to prevent a decline in liquidity in the JGB market that was blamed for the bond market volatility, the minutes showed, although they did not discuss any details or likely new ideas.”


In what has to be a very worrisome development from a contrarian point of view, Kuroda said in a recent speech delivered to academics that “Japan's financial system as a whole seems to possess sufficient resilience against such shocks as a rise in interest rates and deterioration in economic conditions.”



Japan, gross debt
Japan's gross public debt compared with that of other countries (via Japan's MoF) – click to enlarge.



The VaR Dance Into the Abyss

The reason why the BoJ may have countless opportunities to 'communicate' with its allegedly well-prepared financial system participants regarding the JGB market is encapsulated in a recent article at the International Financing Review that recounts the last time Japan faced rising JGB yields, more than a decade ago. There is of course a crucial difference between now and then: the public debt has become much larger.  The IFR writes:


“Extreme volatility in the Japanese government bond market could trigger a sell-off on a par with a market rout in the third quarter of 2003. That was when local banks and foreign investors were forced to dump their JGB holdings after heightened volatility caused the assets to exceed internal value-at-risk limits.

According to analysts at JP Morgan, the threat of a so-called “VaR shock” highlights one of the unintended consequences of quantitative easing, and the situation could be exacerbated this time around.

“The proliferation of risk parity investors and funds, which are strict value-at-risk investors and are heavily invested in bonds currently, is likely raising the sensitivity of bond markets to self-reinforced volatility-induced selling,” said Nikolaos Panigirtzoglou, head of flows and liquidity for Europe at JP Morgan, in a report.

Last month, Japan’s central bank confirmed plans for a ¥120trn (US$1.19trn) liquidity injection that is intended to boost inflation to 2% over the next two years.* The result has been a surge in JGB volatility and rising yields on anticipation of widespread shift from fixed-income to equities.

“It’s an example of the pro-cyclicality of markets. Those with mechanical VaR-based limits will increase positions as vol reduces, and cut positions as vol increases, just like in 2003,” said Guillaume Amblard, global head of fixed-income trading at BNP Paribas. “It creates a snowball effect and it’s exacerbated by the fact that there are some big leveraged positions in JGBs.”

JP Morgan analysts note that the 60-day standard deviation of the daily changes in 10-year JGB yields has doubled to 4bp since the BoJ confirmed its monetary easing strategy on April 4 – the highest level since 2008.


JP Morgan’s Panigirtzoglou believes that regional and co-operative (or shinkin) banks are the most vulnerable to rate increases as the maturity mismatch between assets and liabilities is currently running at all-time highs for such entities. Analysis shows that a 100bp yield curve shift results in a loss of ¥7trn for regionals and co-operatives combined, which equates to 35% of Tier 1 capital.”


The most disturbing bits of information are obviously that there exist some 'big leveraged positions in JGBs' and that a 100 basis points upward move in the yield curve would wipe out 35% of the tier 1 capital of Japan's shinkin banks. It is mentioned in the article that since 'everyone knows' what is brewing, the effects will be well contained, but how is that even possible? No-one really 'knows' how things are going to play out. We would rather venture that various exposed entities are watching each other to see who will blink first. Moreover, it the market begins to decline in earnest, the losses will be booked by whoever holds JGBs at the time – regardless of what these holders 'know'.

If on the other hand, the BoJ were to institute a 'yield barrier', it could end up as the sole owner of Japan's public debt – with the money supply blown up accordingly. Note here that Japan's banks barely have any uncovered money substitutes outstanding after numerous iterations of 'QE' coupled with a decline in outstanding bank credit to the private sector. As soon as bank reserves at the BoJ grow beyond the point where they cover all remaining money substitutes in the economy, they will become the equivalent of excess cash. After all, bank reserves can be exchanged for banknotes ,i.e., standard money, on demand. Normally this serves to accommodate withdrawal demands by the public in a fractionally reserved system, but Japan's banking system won't be fractionally reserved much longer at the current rate of bank reserve creation.

It will be interesting to see what happens once that occurs, but it seems highly unlikely that the result would be 'deflation'.



Charts by: stockmaster.in, Japanese Ministry of Finance



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