BOJ stimulus causes shock but no awe in Japanese bond market

TOKYO (REUTERS) - Aimed at beating Japan's deflation and lowering bond yields, the Bank of Japan's unprecedented stimulus plan has so far severely destabilised the Japanese government bond market, and risks turning once low-risk low-return Japan government bonds (JGBs) into a high-risk low-return assets.

The BOJ's huge buying, which makes it by far the largest buyer of government bonds, and its heavy-handed operations have distorted the market and made JGBs unpredictable, leading to loss of investor confidence in the central bank's ability to rein in market interest rates.

The reflationary policy will inevitably see higher interest rates, but should the BOJ lose control of market rates it would risk speeding a country with public debts twice the size of its economy towards a fiscal catastrophe.

"The BOJ's huge bond buying tightens supply and lowers longer-yields, but the fall in yields will be prevented if more players shift out of the JGB market," said Dr Kazuto Ikeda, an economics and finance professor at Keio University.

"There are heightened risks that long-term yields will rise and impact fiscal conditions if markets come under some stress."

The BOJ's announcement on April 4 that it would inject US$1.4 trillion (S$1.7 trillion) into the economy in less than two years, nearly doubling the monetary base to 270 trillion yen (S$3.3 trillion) to achieve a 2 per cent inflation target, has cheered almost every market in the world except for JGBs.

Since then, JGBs have suffered high volatility, with the average daily trading range of the benchmark 10-year JGB futures widening to 1.25 points, six times wider than the 0.22 average range in the previous three months.

That alone is enough of a deterrent for many investors, who had valued low volatility, rather than their pathetically low yields.

Banks hold about 300 trillion yen of JGBs, or a third of outstanding JGBs. And many of them use market volatility to measure how much they could potentially lose on their portfolio, called value-at-risk, potentially triggering a vicious spiral of high volatility leading to mounting sales of bonds.

Analysts say volatility could rise further because the BOJ's massive purchases will probably reduce market liquidity.

The BOJ's JGB buying scheme amounts to nearly 90 trillion yen for this fiscal year ending in March 2014. That is about 70 per cent of the debt issuance planned during that period, excluding treasury bills.

Lack of liquidity could be the most severe in five to 10-year segments as the BOJ plans to buy 3.4 trillion yen of bonds in those maturities every month, way above the Ministry of Finance's monthly offer of 2.4 trillion yen in 10-year bonds.

Investors were aghast at the lack of consideration for market liquidity in the BOJ's plan.

Some suspect the oversight was a consequence of Governor Haruhiko Kuroda's top-down decision and rush to launch the new strategy, barely two weeks after his appointment in the job.

Mr Kuroda told a meeting on the government's monthly economic report, according to a Cabinet Office official on Friday, that long-term yields became volatile after the BOJ overhauled its monetary policy strategy, and he wants the market closely watched.


Banks, which had previously cashed in significantly from slow and steady declines in yields as the BOJ took baby stimulus steps, may now slow or halt and even sell JGBs as prospects for fat profits dwindle with the the room for further falls in yields becoming progressively smaller.

The retreat of investors who have played a built-in stabilising role in keeping JGB yields low despite the massive public debt could eventually lead to the BOJ having to openly underwrite debt, eroding both central bank independence and safeguards on fiscal discipline.

For the Ministry of Finance, it is a problem too.

JGB yields may stay depressed in the near-term, but risks are rising for a future spike in yields that would destroy fiscal consolidation.

"Over the long term, this may be a very annoying situation for the MOF," said Dr Yukio Noguchi, honorary professor at Hitotsubashi University.

Japan's public debt stood at 960 trillion yen at the end of December, the worst among major economies and around twice the size of its US$5 trillion economy. Nearly 90 per cent of the outstanding debt is held by domestic investors.

"The real purpose of the latest BOJ easing, as I understand it, is to buy JGBs, effectively monetising the debt. Even when fiscal deficit is growing and more debts are issued, the BOJ is effectively saying it will keep buying. That will relax fiscal austerity," said Dr Noguchi.

"It is extraordinary for yields to fall when there is no prospect for fiscal imbalances to improve."

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