As we pointed out recently, Japan has been quietly undergoing a mini bond tantrum as over the past two months, its sovereign debt suffered the worst rout in 13 years, handing investors bigger losses over the past two months than any other government bonds, amid speculation the Bank of Japan plans to change its asset-purchase strategy.
The selloff started in late July, around the time the time the BOJ disappointed with its latest announcement, and accelerated on fears that as part of its “comprehensive assessment” of its policies, the central bank would set back the BOJ’s monetary easing stance.
It then resumed in late August, after central bankers made another coordinated push for fiscal stimulus at Jackson Hole, which would mean more sovereign debt supply, and thus lower prices, all else equal. Then earlier this week, Kuroda said that a review of the current stimulus efforts due by the Sept. 20-21 policy meeting in which some analysts and investors read between the lines that the BOJ may be seeking to force a shift toward a steeper yield curve after the gap between two- and 30-year securities compressed to a record 30 basis points.
Kuroda on Monday also pointedly flagged concerns about negative potential effects from the slide in long-maturity bond yields. Earlier this year, rates as long as 20 years touched zero percent. The BOJ chief noted that the drop hurt returns on pension programs, and could affect confidence levels and the economy more broadly.
As Kuroda said, clearly highlighting the dangers of a flatter yield curve, “some business firms have revised down their profit forecasts due in part to the increase in the net present value of retirement benefit obligations. We should take account of the possibility that such developments can affect people’s confidence by causing concerns over the sustainability of the financial function in a broad sense, thereby negatively affecting economic activity.”
These hints prompted Evercore ISI analysts to suggest that Japan’s central bank in coming weeks will modify its stimulus program to alleviate risks from ultra-low long-term yields, by pursuing a reverse “Operation Twist”, where the central bank sell long-end bonds while buying the short-end.
The change would help to make the Bank of Japan’s easing more sustainable over the longer haul, given diminishing chances of hitting the 2 percent inflation target soon, according to the analysis by Evercore ISI’s Krishna Guha and Ernie Tedeschi. “The BOJ’s policy review will point to a rebalancing of its monetary policy aimed at maintaining or increasing downward pressure on short-to-medium term real interest rates (and in turn put downward pressure on the yen) while engineering a steepening of the yield curve,” Guha and Tedeschi wrote in a note.
To avoid market fears that the central bank is seeking an outright tightening of monetary conditions, which a “reverse Twist” would suggest, the BOJ may cut short rates further from the current -0.20%. A cut in the already-negative benchmark rate, levied on a portion of banks’ reserves parked at the BOJ, which would also steepen the yield curve, could show the BOJ is still implementing unvarnished stimulus. The Evercore ISI analysts, cited by Bloomberg, said a rate cut could come either this month or later in the year.
It may not stop there: the BOJ could additionally add local-government or nonfinancial corporate bonds to its asset purchases. Another option could be to pledge an “overshoot” of the 2 percent inflation target, which would suggest avoiding any shrinkage of the balance sheet for an extended period. As the Evercore analysts added: “A core part of the operation would be shifting government debt purchases to shorter maturities, allowing ultra-long term yields beyond 10 years in particular to rise,” Guha and Tedeschi wrote. “The combination of credible aggression today with a commitment to maintain that and the associated balance sheet/rate settings longer into the future would in our view make the policy additionally effective.”
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On the surface, pushing for a steeper yield curve may seem like a good idea, and something which Japan’s bank and pension funds will applaud. However, there is a problem: with trillions in long-dated JGBs carrying negative yields, a sudden withdrawal of support for the long-end could roil the market in a repeat of what happened to the 2013 US Taper Tantrum and the 2015 Bund Tantrum, when in a very short period of time, benchmark bonds were liquidated en masse, resulting in tens of billions in mark to market losses for investors.
As a result, the reversal is spurring concern the second-largest debt market is the vanguard for a broader selloff.
Cited by Bloomberg, Chotaro Morita, the chief rates strategist at Tokyo-based SMBC Nikko Securities Inc., one of the 21 primary dealers that trade directly with the central bank, said that “The impact of the BOJ’s stimulus is that the bond markets worldwide are becoming one market. If there’s a reversal of policy, you can’t rule out that it would roil global debt.“
Indeed, as we have shown repeatedly out over the past few weeks, and as JPM’s head quant, Marko Kolanovic, noted yesterday, with cross asset correlation soaring, not to mention with risk-party and CTA funds approaching record leverage, the risk is that investors frontrunning a perceived change in the BOJ’s policy in two weeks time could lead to a dramatic selloff in JGBs, which then spreads across to global fixed income markets, all of which trade like connected vessels.
Another risk factor is that just hours before the BOJ announces what may be a seachange in policy, the Fed itself will announce its latest monetary policy decision, which – in the case Yellen raises rates by another 25 bps – will further add to market dislocation.
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But why so much attention on Japan? Well, Japan’s sway over global debt has increased in 2016. The correlation between securities in Tokyo and a gauge of worldwide bonds has risen to 0.86 this year, from 0.58 in 2015, according to Bank of America Corp. indexes. A correlation of 1 would mean they moved in lockstep.
Goldman Sachs warned in May that Japan could be the catalyst for the next international selloff in bonds. While there’s no immediate danger of a global spike in long-term yields amid tepid inflation worldwide, any shift in the BOJ’s unprecedented asset-purchase plan would have a ripple effect, according to Goldman’s Francesco Garzarelli.
“A change in tack by the BOJ would be felt on global bonds,” he said in e-mailed responses to questions on Wednesday.
Furthermore, in a note in early June, he also also warned that a sharp 1% spike in rates across the curve in the US alone, would result in MTM losses of $2.4 trillion.
That excludes the crossover impact into stocks, as a selloff in bonds leads to a correlated liquidation across equities, as a result of record leverage for Risk-Parity and other quant funds…
… for whom coordinated selling in both asset classes could lead to dramatic deleveraging, and a positive feedback loop of even more selling.
As BofA calculated one month ago, “even a relatively benign 2% selloff of the S&P coupled with just a 1% selloff of the 10Y could result in up to 50% deleveraging, which in turn would accelerate further liquidations by other comparable funds, and lead to a self-fulfilling crash across asset classes.”
A central bank-prompted market fiasco won’t be new: in 2015, it was euro-area government debt that was in the driving seat for fixed-income markets around the world. Traders were caught off guard as nascent signs of inflation and euro-zone economic growth fueled a bond rout that began in Europe and quickly spread. The 10-year German yield surged by more than one percentage point in less than two months, and the Bloomberg Global Developed Sovereign Bond Index lost more than $750 billion in market value between April 29 and June 5 last year.
Meanwhile, the selloff in Japanese bonds, as shown in the top chart, has already begun: Japan’s government debt has tumbled 2.1% this quarter, heading for its steepest such loss since 2003.
Making matters worse, the rush among Japanese investors to seek income in bonds abroad after Japan’s launch of Negative rates in January, have now started to dry up. Japanese investors sold a net 1.33 trillion yen ($13.1 billion) of overseas debt in the week ended Sept. 2, unloading securities for the first time since June, according to Ministry of Finance data. That was after buying 4.72 trillion yen of U.S. sovereign bonds in July, the biggest amount in ministry data to 2005 after the record 4.95 trillion yen they purchased in March.
“Japanese purchases of Treasuries have stopped temporarily,” said Hideo Shimomura, the chief fund investor at Mitsubishi UFJ Kokusai in Tokyo. “Long-term yields in Japan have risen. Money will be coming back.” Incidentally, three months ago the world was shocked to learn that Mitsubishi UFJ had appealed the BOJ to quit as a primary dealer for the rapidly shrinking JGB market.
Which brings up another point: with virtually no sources of liquidity on either side of the market, the BOJ holding a third of all Japanese treasuries, and banks no longer actively involved in market making of JGBs, the market has never been more illiquid.
Which means that any coordinated selloff of longer-dated yields would certainly result in the infamous “VaR shock” which sent shockwaves across Japan in 2003. Recall that in early June, BOJ board member Takehiro Sato already knew which way the wind was blowing. As we wrote at the time, this is what he said:
Financial institutions are facing the risk of a negative spread for marginal assets due to the extreme flattening of the yield curve and the drop in the yield on government bonds in short- to long-term zones into negative territory. When there is a negative spread, shrinking the balance sheet, rather than expanding it, would be a reasonable business decision. In the future, this may prompt an increasing number of financial institutions to take such actions as restraining loans to borrowers with potentially high credit costs and raising interest rates on loans to firms with poor access to finance.
…a weakening of the financial intermediary functioning could affect the financial system’s resilience against shocks in times of stress. In addition, an excessive drop in bond yields in the super-long-term zone could also make the financial system vulnerable by increasing the risk of a buildup of financial imbalances in the system.
He concluded by saying that from financial institutions’ recent move to purchase super-long-term bonds in pursuit of tiny positive yield, “I detect a vulnerability similar to that seen before the so-called VaR (Value at Risk) shock in 2003.“
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So will the BOJ shock markets and unleash this year’s “bond tantrum”, one which would come at a time when there is an unprecedented $13 trillion in negative yielding bonds? According to Old Mutual Global Investors which oversees the equivalent of about $436 billion, a policy change aimed at steepening the yield curve wouldn’t be surprising, even though it would come at the expense of bondholders.
“It would definitely see some pain,” said Mark Nash, head of global bonds at the London-based fund manager. “Money flows across borders. It’s all linked.”
How much pain?
If Sato, and Goldman, are right, and the BOJ is about to unwittingly launch a repeat of the 2003 VaR shock, this much:
What that selloff – in a time of soaring cross-asset correlations, record quant leverage and virtually non-existent market liquidity – would mean for equities, we don’t know, – but thanks to Haruhiko “Peter Pan” Kuroda, we will soon find out.