In the last few months, the world has gone crazy for “Abenomics” – Japan’s hopeful escape route out of its two “lost decades.” It’s the aggressive monetary easing from the Bank of Japan that has produced the most significant reaction so far. The central bank has adopted a new inflation target of 2% to be achieved within two years, and to hit this target, the BoJ will double the size of the monetary base by the end of 2014, mainly through increased purchases of Japanese government bonds (JGB).
To put the BOJ’s quantitative easing in context: the policy measures will produce a massive expansion of the balance sheet to 60% of GDP by 2014. By contrast, the Fed’s balance sheet is unlikely to grow to more than 30% of GDP. What’s more, the BoJ will absorb 1.6 times net JGB supply in 2013, whereas the BoE and the Fed never took down more than 1 times net supply. This means that not only will the BoJ be taking down all net JGB supply in 2013; it will actually be reducing the JGB stock available to private investors by about ¥19 trillion.
The immediate impact of Abenomics has been tremendous. Japanese equities have soared, rising almost 40% since the start of the year; the dollar has appreciated 27.5% against the yen since November 2012 when Abe’s policies first became news; and 10-year Japanese bond yields have risen around 40 basis points.
Why, if there is so much monetary expansion, are Japanese government bond yields rising? After all, with the Bank of Japan’s buying program significantly tightening the supply-and-demand balance across the Japanese yield curve, this should exert strong downward pressure on JGB yields.
A couple of reasons spring to mind. First, domestic equities have rallied very sharply since the BoJ announcement, giving some negative sentiment to bond investors. Second, there may be speculation that domestic institutions are about to increase their diversification into foreign bonds and local equities. Third, it could simply be a correction of the earlier undershoot in JGB yields. Fourth and more significantly, many investors believe that the central bank’s massive buying will result in an improved economic outlook and higher inflation rates, which would drive up bond yields. If the last point is true, then the Bank of Japan’s policy could be considered a success.
But there is one other, less positive factor that could be driving the sell-off and that could lead a rather more disorderly jump in yields: a sharp increase in volatility of the JGB market.
In recent years, we had grown accustomed to see 1 basis point (one hundredth of a percentage point) intra-day moves in JGB yields – a 3 basis point move was headline material. And yet since the early April meetings, it has not been unusual to see JGB yields moving more than 5 basis points in a single day, and occasionally days there have even been intra-day moves of 20 to 30 basis points.
Volatility in the market can lead to a self-reinforcing sell-off. Many financial institutions have adopted the Value-at-Risk (VaR) approach – models designed to calculate the amount of risk on the basis of volatility, enabling banks to set limits against potential losses in their trading operations. VaR-driven models will tell banks to dump bonds as they become volatile, leading to sharp sell-offs, more volatility, more selling and more rises in bond yields, etc.
The threat of a volatility-induced selloff is genuine – back in 2003, the same issue caused the 10-year JGB yield to triple from 0.5% to 1.6% in the space of just three months. Given Japan’s huge debt overhang, its interest-rate sensitivity is considerable. Needless to say, if the 2003 episode is repeated, there could be dire consequences for Japan.
So, in the meantime, the market will continue to look to the Bank of Japan to do what it can to reduce the volatility of the JGB market. The central bank is likely to accept a gradual rise in bond yields if it reflects a rise in inflation expectations. But any volatility beyond reasonable is likely to have the Bank of Japan nervously responding with necessary adjustments to the frequency, pace and composition of JGB operations.
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