TOKYO — The Bank of Japan has begun loosening its long-lived tight control over the nation’s bond market, gradually allowing the private-sector to determine prices. But the issuance of government bonds will not subside, creating the risk of an unexpected increase in interest rates during this transition.
Just after the BOJ recast its short- and long-term interest rate operations known as yield curve control on Thursday, there was an auction for 10-year Japanese government bonds, the yield on which serves as a benchmark for long-term interest rates. The results were a safe start, with the highest bid yield of 0.915%, in line with market expectations.
There is a reason for this. The BOJ had notified market participants that it would purchase JGBs on Monday, the business day following the auction. This provided a safety net for securities firms and other traders to feel secure in their bids. If successful bidders for the JGBs could not sell them to investors, they could sell them to the BOJ if the need arose.
“In a word, the recent bidding has been stomach churning. With a large supply of JGBs in the market, it would be difficult to absorb new issuance at low interest rates without the BOJ,” said one bond trader.
Escaping from the BOJ’s domination of the JGB market has been a long-held dream by traders. But many are now more anxious than happy as that starts to become a reality.
Prior to 2013 when the BOJ embarked on its ultra-loose, unconventional monetary policy, the annual market issuance of JGBs was about 150 trillion yen ($1 trillion). That skyrocketed to the 200 trillion-yen level in fiscal year 2020 during the COVID pandemic. In fiscal year 2023, the amount has only slightly decreased to about 190 trillion yen.
For now, the BOJ is expected to absorb about 60% of new issuances and “maintain this ratio for the time being,” said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management.
However, if the BOJ were to move toward full-scale tightening, this ratio would be expected to gradually decline. With the loss of a generous investor in the form of the BOJ that is indifferent to prices, the risk of a sharp rise in interest rates increases.
To get an idea of how much risk is involved, consider how much the BOJ has suppressed interest rates. One measure that can be used to estimate this is the “term premium.” It refers to the additional interest rate that investors demand as compensation for the risk of holding government bonds for a long period of time.
The long-term rate is considered to be the sum of the potential growth rate and the expected inflation rate, plus the term premium. The premium, which was normally in positive territory prior to the start of unconventional easing, is currently at around -1.1 percentage points. The BOJ’s government bond purchases have crushed that premium, pushing the long-term rate down by about 1.1 percentage points.
If the term premium were to return to zero, the long-term rate would be expected to rise to about 2.1%. In fact, in the U.S., the term premium has risen from negative to positive territory on fiscal concerns. The main reason for the sharp increase in U.S. long-term rates has been the jump in the term premium.
“With the Federal Reserve no longer the primary buyer, the risk of the private sector underwriting large amounts of Treasurys has manifested itself in the form of a sharp rise in long-term rates,” said Naokazu Koshimizu, a senior rates strategist at Nomura Securities.
The Fed is in the process of implementing quantitative tightening that will reduce its holdings of government bonds. But it is not realistic to expect the BOJ to reduce its total JGB holdings in the same way.
However, the possibility of a slowdown in government bond purchases remains. This is because the BOJ is shifting its focus to the level of interest rates rather than the volume of JGB purchases. In that case, “the amount of government debt supplied to the market will increase in real terms,” said Keisuke Tsuruta, fixed income strategist at Mitsubishi UFJ Morgan Stanley Securities.
The leading underwriters taking the place of the BOJ are players such as private banks and others. Depository institutions have reduced their holdings of government bonds from about 320 trillion yen to about 90 trillion yen over the past decade, holding less than 10% of the total. As a result, they are expected to have a large capacity to buy government bonds. But some analysts disagree.
“Given the various regulations, depository institutions have only purchasing capacity for about 30% of the BOJ’s government bond holdings,” said Hiroyuki Seki, managing executive officer at Mitsubishi UFJ Financial Group, in a June speech to the Ministry of Finance’s study group on national debt management.
“We need to take that into account when thinking about how to stabilize the government’s debt,” he said.
In the post-YCC era, the risk of interest rate spikes will grow, but that is a necessary cost to restore a healthy market. At the very least, alarm bells will start ringing against unbridled fiscal stimulus. In the long run, this should be a positive for the nation as a whole.
Source : Nikkei Asia