Recent days have seen a big sell off in the JGB market. The 10Y yield has leapt from 60bps last Thursday to 86bps today. The 5Y yield, meanwhile, has risen from 23bps to over 40bps over the same period. It is certainly one of the sharpest sell offs in the market since 2003 (although pales in comparison to that, so far at least). But is it a sign that the BoJ’s attempt to end deflation are starting to work against it?
Chart 1: JGB yield curveSource: Bloomberg and Daiwa Capital Markets Europe Ltd.
Well, the chart above suggests that there has indeed been a change in the behaviour of the JGB market in the wake of the BoJ’s decision to double the money base. Yields are significantly higher than they were beforehand. This, in some ways, makes sense, not least below 5 years where there is effectively no increase in asset purchases over-and-above those previously planned (see chart 2). When coupled with the change in economic sentiment triggered by Abenomics, it’s no surprise that yields here have risen. What is perhaps more surprising is the move in the five to ten year sector, given that this is where the increase in BoJ purchases is greatest. But even moves here need to be put into context. While the 10-year yield has risen sharply in recent days, at 86bps it remains well below its average level over the past decade (see chart 3).
Chart 2: JGBs: Planned BoJ purchases*
*Total assets to be purchased over the coming twelve months. Source: BoJ and Daiwa Capital Markets Europe Ltd.
In any case, higher JGB yields and reduced demand for JGBs are not necessarily a bad thing. The BoJ’s aim is to wean Japanese banks off their overdependence on JGBs and encourage them to invest in riskier assets and lend more. And the ultimate sign of success for the Japanese authorities will be a 10-year yield above 3%, reflecting 2% expected inflation.** But the BoJ doesn’t want that to happen too soon. It is having to tread a fine line between its desire to keep interest rates low to engender the recovery necessary to deliver 2% inflation and the natural inclination of investors to demand higher yields from JGBs to compensate for higher expected inflation. So far, notwithstanding the moves of recent days, it’s done that fairly successfully.
Chart 3: 10Y JGB yieldSource: Bloomberg and Daiwa Capital Markets Europe Ltd.
Greater volatility in the JGB market was perhaps inevitable in the wake of the step change in the monetary policy regime. That volatility can perhaps be expected to continue as market participants continue to adjust to that. And, of course, there’s always a danger that, as growth and inflation expectations build, the upward pressure on yields becomes greater than the BoJ is comfortable with. But that will not mark a failure in the policy, as some commentators suggest – it will just trigger more BoJ action. The market will not have a free hand in determining JGB yields for as long as the BoJ is trying to meet its inflation target. If it feels that yields have risen too much, or too fast, intervention of some kind, probably initially verbal, would undoubtedly follow. We would also expect the BoJ to re-jig the maturity structure of its purchases, increase the amounts it is planning to buy or even set yield targets, which it would maintain through market interventions.
Previous monetary policy regimes in Japan may have felt powerless in the face of moves in the JGB market. But the current monetary policy regime, centred on the achievement of a 2% inflation target, is fundamentally different. If the new BoJ feels that movements in the JGB market threaten its ability to achieve that objective, expect it to act.
**And, no, an increase in yields, provided that it accurately reflects faster nominal GDP growth, will not trigger a fiscal crisis. First, given that the average maturity of the Japanese government’s debt is more than seven years, higher yields will only slowly increase the government’s debt interest costs. Second, there is no reason to believe that the real yield that the Japanese government will face will be any higher than they are now when nominal yields are above 3%. Finally, faster nominal GDP growth will boost tax revenues and make fiscal adjustment easier to undertake. Rising interest rates, provided they are for the right reason, which the BoJ will ensure they are, will ultimately be a positive sign for Japan’s debt sustainability.
Grant Lewis, Head of Research