Japanese Government-Bond Selloff Sparks Fears of Too Much, Too Fast

Wednesday, 15 May 2013 09:14 AM

 

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A three-day rout in the bond market has raised concerns that the Bank of Japan is getting more than it bargained for, by prodding investors to shift money out of the safety of government bonds faster than the government expected.

As prices have slid, the yield on the benchmark 10-year bond has jumped to an eight-month high. While still very low by historical standards, the interest rate is almost triple the record low it briefly plumbed in April after the BOJ unleashed an enormous monetary easing aimed at ending 15 years of deflation and getting the sluggish economy moving.

The Japanese government bond market has defied decades of predictions that it was a bubble waiting to burst. Most strategists believe JGBs will continue to avoid the worst case — a rush for the exits that could send the government's borrowing costs so high it could no longer service a debt that, at some 230 percent of GDP, is the worst among industrial economies.

But the selloff that began on Friday still carries potentially major headaches, from the Finance Ministry's debt management to the BOJ's handling of its massive asset purchases, to a rise in mortgage costs in an economy that is just beginning to show signs of life.

"The BOJ is trying to keep rates low enough so that investors don't buy them, but obviously they would prefer a gentle squeeze as opposed to the current scramble," said Neale Vincent, strategist at Nomura Securities in Tokyo.

JGB yields had remained remarkably low in recent months, even as Tokyo stocks have soared and the yen has slid on Prime Minister Shinzo Abe's plans to reflate the world's third-biggest economy.

The 10-year yield rose as high as 0.855 percent on Tuesday, its highest since mid-August and more than 50 basis points above the April record low of 0.315 percent. It has spiked about a quarter of a percentage point in the past three sessions. Before the BOJ's April 4 "quantitative and qualitative easing," the 10-year bond yielded around 0.55 percent.

The benchmark 10-year bond futures contract ended down 0.84 point on Tuesday at 142.11, after dropping to a session low of 141.95, its deepest nadir since early April 2012.

The central bank, in an audacious plan that stunned global financial markets, said that over two years it will roughly double the amount of government debt it holds to double Japan's monetary base to generate two-percent inflation.

It pledged to buy 7.5 trillion yen of JGBs a month, equal to about 70 percent of new issuance, with the hope that sellers will move their funds into investments that will spur economic activity.

RISK OF SOARING YIELDS

Economics Minister Akira Amari said on Tuesday that the government and the BOJ will keep trying to reduce volatility in the JGB market, underscoring that the administration understands the risk that a persistent surge in yields would pose.

"Spikes in Japanese government bond yields would affect interest payments, which would impact fiscal reconstruction," Amari told a regular news conference. The Finance Ministry estimates that just a two-percentage-point rise in the 10-year yield would boost annual government interest payments by 8 trillion yen within three years.

But BOJ Governor Haruhiko Kuroda sounded unruffled after Friday's start of the sell-off, saying higher interest rates were a normal response to an improving economy.

"The BOJ dealt with short-term volatility in bond prices by adjusting its market operations," Kuroda told reporters on Saturday after a two-day meeting of Group of Seven finance officials outside of London.

"I do not expect a sudden spike in long-term bond yields. In the long run, if the economy recovers and inflation heads towards two percent, we might see nominal interest rates rise but that's natural."

The market could find a floor for now, some market participants say, as the rapid climb in JGB yields narrows the premium that investors receive for buying U.S. Treasuries, making such outflows less attractive. Others said the moves of the past three days present the BOJ with an opportunity to adjust its market operations to reduce volatility.

"The BOJ is going to buy an enormous amount of bonds but in roughly equal monthly installments over the next two years. It wants to encourage a shift out of JGBs, but investors want to shift out now," Nomura's Vincent said, adding that a more flexible purchase schedule would help to reduce the market volatility.

"When the market settles down, buying of 7.5 trillion (yen) a month will be tough, but it's easy to do now. I would front-load the schedule a bit."

The JGB selloff also dragged down shares in Japanese real estate investment trusts, which dropped to a 2 1/2-month low, and prompted profit-taking in stocks. The Nikkei share average pulled back from 5-1/2 year highs on Tuesday, slipping for the first time in three days.

The spark that kindled the JGB selloff was the dollar's push above 100 yen on Friday. During the U.S. currency's month-long attempt to crack that key yen level the 10-year JGB yield had stayed locked in a very narrow range of 10 basis points, breaking out only when the dollar jumped.

"The BOJ is going to double the monetary base by not targeting the overnight call rate anymore. This is obviously going to weaken the yen," said Maki Shimizu, senior strategist at Citigroup in Tokyo.

But the dollar appears to be taking a breather after Monday's ascent to a 4 1/2-year high of 102.15 yen. The spread between the U.S. 10-year yield and its Japanese counterpart has shrunk to about 107 basis points on Tuesday from 120 points last week.

The spread is still far wider than it was last July, when it shriveled to only 70 basis points as Europe's debt turmoil prompted investors to seek the relative safety of U.S. and Japanese sovereign debt. But the narrowing gap alleviates some pressure on the yen and gives Japanese investors less incentive to put their funds in overseas bond markets.

The yield spread could widen, however, due to external factors, such as any indication from the U.S. Federal Reserve that it intends to taper its bond purchases following recent signs of improvement in the U.S. labor market.

"Maybe the pace of yen depreciation will not accelerate much from here, but if Fed considers tightening or at least not easing further, that could change," said Citigroup's Shimizu.

© 2014 Thomson/Reuters. All rights reserved.

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