"Unprecedented" JGB Supply/Demand Imbalance If Inflation Stays Muted In Japan, Morgan Stanley Says

Another day, another sign that all is not well in the Land of the Rising Sun. It was just yesterday when we noted that BoJ’s number two Hiroshi Nakaso suggested that a prolonged slump in oil prices (which, as we explained earlier, seems likely) would be a good enough justification to ease monetary policy further. This came on the heels of a survey (conducted by the BoJ itself) which showed that nearly two thirds of dealers were having “some or a lot” of trouble filling orders for JGBs with the central bank in the market for the entirety of gross issuance. 

On Tuesday, the BoJ — whose governor last week called the possibility that the market would eventually question the central bank’s credibility “very unlikely” — conducted a “liquidity enhancing” auction of around $2.5 billion in 20-, 30-, and 40-year bonds and the results were, well, bad as the bid-to-cover fell and yields rose, with the 10-year hitting its highest level since November.

With liquidity drying up, bid-asks getting wider, and everyone from dealers to current and former BoJ officials expressing extreme consternation about where this is ultimately headed, here’s Citi to explain why, if anything, the BoJ will likely increase the amount of JGBs it’s willing to purchase: 

Declining liquidity in the market is prompting investors to estimate the deadline for QQE, possibly caused by a lack of sellers… 

The consumption tax is expected to be hiked to 10% in April 2017, so it would be very difficult for the BoJ to exit from QQE after the summer of 2016 when the tax hike will be in sight. If the Bank failed to unwind the policy before that we think it is very likely to continue QQE until the impact of the tax hike is clear in later 2017, making it difficult to normalize the policy before the end of governor Kuroda’s term in March 2018. In that sense, the de facto deadline should be in the middle of 2016, so the Bank is likely to ease further especially if core CPI growth turns negative. Given that the practical deadline will come in less than 1.5 years, we think there is still room to increase JGB purchases, although we expect the Bank to enhance the lending support program by possibly doubling the maturity from the current 4 years.

… and more from Morgan Stanley…

Our economics team expects Japan's core CPI inflation rate to start rising from this spring, reach around +1% by the end of this year, and then climb towards around 1.7% into FY2016. This is not currently the market consensus, at least according to market pricing, but if such a trajectory does start to be considered more likely, then the resulting upward pressure on interest rates could help BOJ operations to go quite smoothly. Conversely, if inflation expectations remain muted, then the amount available for purchase by the BOJ is liable to be largely exhausted during the next 1.5 to 2 years, at which point supply/demand may tighten to unprecedented proportions. 


Of course we’re already beginning to see the malicious effects of tight liquidity in government bond markets (look no farther than October’s Treasury flash crash) and one can only imagine what sort of dislocations will materialize should supply/demand tighten “to unprecedented proportions.” As far as inflation expectations go, we would have to agree with BoJ dissenter Takahide Kiuchi who last week suggested that 2% is not around the corner