Bizarro World: JGB Yields Slide After BOJ Tapers

Something strange happened on July 24: on that day the Bank of Japan announced it would reduce the size of its purchases of five-to-ten year JGBs from Y500 billion to Y470 billion. However, instead of yields and the yen spiking, as some had expected would happen, they slumped. And, just as unexpectedly, 10Y JGB yields continued to slump over the next month, despite another reduction in the amount of JGB in the 5-10 year bucket that the BOJ would purchase on August when it further reduced the amount to Y440 billion.

Then, on Friday morning, the BOJ again lowered the size of its purchases of long-term JGBS to Y410 billion, a level last seen on January 27 of this year (when Kuroda boosted the amount of monetizable debt to halt a surge in yields) from Y440 billion. And, once again, not only did yields not shoot up, but they declined again. Heading into Friday's rinban operation (as POMO is known in Japan), the 10-year JGB yield fell to 0.020% Thursday, the lowest level since May 2. After the operation Friday, 10-year bonds traded at 0.020% and then fell to 0.015%  in Friday afternoon trading, the lowest level since April, and approaching the BOJ's target of "around zero percent."

Faced with a rapidly declining supply of private bonds available for the BOJ to monetize from the market to push up the Nikkei225 expand the monetary base, traders had speculated that the central bank will cut bond buying when possible. And, on Friday, the BOJ did not disappoint when it judged it necessary to cut the size of its long-term bond buying Friday to address in bond yields caused by a combination of investors' risk-off sentiment and continued tight supply-demand conditions.

According to MarketNews, before Friday's operation, BOJ officials were worried that lowering the scale of its JGB buying might prompt yen buying and bond selling. But the BOJ's decision had little impact on the dollar-yen exchange rate, which stood around Y109.61 in early afternoon Asian trading, virtually unchanged from the level seen in early Asian trade. If the BOJ had not addressed the drop in bond yields, officials were concerned the central bank could have faced a situation where is would be unable to control yields along the JGB curve.

“The market rally is a blessing for the BOJ as it gives them more leeway to cut bond buying,” said Akio Kato, general manager of trading at Mitsubishi UFJ quoted by Bloomberg. “It raises the possibility the BOJ may trim purchases at its Monday operation. If it does so and markets continue to rally, the central bank may follow with another reduction at its Wednesday operations.”

Faced with a rapidly growing shortage of bonds, the BOJ has been eager to engage in a shadow tapering, i.e., slowing the rise in its JGB holdings over time to make an eventual unwinding of its aggressive easing policy smoother... but is being extra careful to ensure that smaller JGB purchases do not ignite a rise in the yen exchange rate.

As shown before, even before the recent reduction in bond purchases, the pace of bond monetizations has been steadily declining.

And now that yields dropped despite the BOJ's latest soft tapering, traders are speculating that the BOJ will further reduce the amount of bonds in the 5-to-10 year bucket. The BOJ will buy bonds with 1-to-3 and 3-to-5 year maturities on Monday, followed by purchases in the 5-to-10, 10-25 and over-25 year sectors on Wednesday.

“The BOJ is expected to continue reducing the amount as long as JGB yields stay under downward pressure,” said Eiichiro Miura, general manager of the fixed-income investment department at Nissay Asset Management Corp.

Meanwhile, according to MNI, BOJ officials don't expect JGB yields to continue falling "because bond players are cautious about buying bonds at very low yields." Sadly, this explanation makes no sense as nobody is buying Treasurys to pick up 0.015% but instead on hopes that some greater fool will buy them at an even higher price, and are thus traded as sources of capital appreciation not yield.

This, of course, works as long as momentum is with the buyers, however once it flips, the snap back tends to be quite vicious as several JGB yield spikes in the past few months demonstrated. In February, the 10-year yield surged to a one-year high of 0.15% as Japanese government bonds tracked the selloff in the global debt markets on speculation of monetary tightening across developed economies. The spike spurred the BOJ to step in with an unlimited bond buying operation to drive down yields.

It now finds itself at the other extreme.

The good news for the BOJ - for now - is that whether due to momentum, risk aversion, or rising fears of deflation, it can experiment how low it can reduce its bond purchases before it suffers another mini taper tantrum.

“Policy sustainability may be improving as the BOJ can control yields even with lower purchases,” said Souichi Takeyama, a rates strategist at SMBC Nikko Securities in Tokyo.

Echoing the sentiment, Akio Kato, trader at Mitsubishi UFJ Kokusai in Tokyo, said that the continued decline in JGB yields even as the Bank of Japan cut 10-year bond purchases today, raises the chance of a further reduction at its regular operations next week. "The continued rally in the bond market even after BOJ reduced its purchases will enhance the central bank’s ability to further scale back its buying until markets reverse and slump, pushing yields higher. If it does cut back purchases and markets continue to rally, the central bank may follow with another reduction at its Wednesday operations for longer maturities."

Far more ominously, Akio said that the impact from the scarcity of available bonds due to BOJ’s aggressive bond buying scheme is becoming increasingly evident, leading to insensitivity of yields. It also raises the question about credibility with BOJ’s target of buying around 80 trillion yen annually, as actual purchases have already fallen to 60 trillion or less.

Which, according to some analysts, is an outcome worse than yields spiking due to reflation concerns: at least then the BOJ still has control can step in and buy more, sending yields sharply lower as happened in February. In this case, however, yields are sliding due to fears that the supply side of the market is about to collapse, only to surge later when the BOJ no longer has an intervention mechanism. Which would imply that the only option left is for Japan to launch helicopter money, where the BOJ proceeds to directly monetize new government issuance. And since that would require blowing up the budget deficit, the outcomes are two: either the massive fiscal stimulus results in runaway inflation now that the BOJ no longer is the marginal rate setter, or the outcome is one giant asset bubble, should the newly created funds make their way straight into capital markets.