The JGB endgame ap­proaches

Financial Mirror (Cyprus) - - FRONT PAGE - By Neil New­man

Over the last cou­ple of weeks, the world’s at­ten­tion has been fo­cused by turns on Bri­tish pol­i­tics, Italy’s bank­ing cri­sis, the US pres­i­den­tial race and most re­cently, last night’s ghastly events in Nice. It is lit­tle sur­prise then, that a se­ries of three sto­ries from Ja­pan (or per­haps just two and a half) has passed largely un­der the radar. Taken to­gether, how­ever, these de­vel­op­ments bear heav­ily on the fu­ture of the Ja­panese gov­ern­ment bond mar­ket, with pro­found and po­ten­tially omi­nous con­se­quences both for do­mes­tic in­sti­tu­tions and for for­eign in­vestors with ex­po­sure to JGBs.

In the first week of July, Ja­panese in­vestors bought JPY 2.5trn (US$24bn) of for­eign bonds. That is more than they have ever be­fore pur­chased in a sin­gle week, and greater than their to­tal pur­chases for the en­tire month of June (see the chart). What is more, this flow took place in a four-day week for US mar­kets, which were closed last Mon­day for the July 4 hol­i­day.

Bank of Tokyo Mit­subishi, Ja­pan’s largest bank, said from to­day it will no longer par­tic­i­pate in the JGB mar­ket as a pri­mary dealer.

For­mer US Fed­eral Re­serve chair, “He­li­copter” Ben Ber­nanke, the ar­chi­tect of US quan­ti­ta­tive eas­ing and the Fed’s sub­se­quent “ta­per­ing”, held meet­ings in Tokyo with both prime min­is­ter Shinzo Abe and Bank of Ja­pan gov­er­nor Haruhiko Kuroda.

Ja­panese in­sti­tu­tions are not new­com­ers to in­ter­na­tional bond mar­kets. But what has changed in the last 12 months is that their buy­ing has risen dra­mat­i­cally, as the BoJ’s quan­ti­ta­tive eas­ing pro­gram of as­set pur­chases has caused in­creas­ingly se­vere dis­tor­tions in Ja­pan’s do­mes­tic bond mar­ket. These dis­tor­tions—to­gether with Tokyo’s pro­cliv­ity for con­sult­ing em­i­nent US econ­o­mists be­fore tak­ing new pol­icy ac­tion—sug­gest that the endgame may now fi­nally be ap­proach­ing for the JGB mar­ket. The prob­lem for Ja­panese in­sti­tu­tions is three­fold: 1) The JGB mar­ket is shrink­ing rapidly. If the BoJ is to hit its tar­get of ex­pand­ing the mon­e­tary base by JPY 80trn this year, it will ac­tu­ally need to buy some JPY 120trn in JGBs over fis­cal 2016, or around 10% of the to­tal out­stand­ing is­suance. With the Min­istry of Fi­nance aim­ing to is­sue just JPY 34trn of deficit-fi­nanc­ing bonds, down from JPY 37trn last year, the JGB free float is fast di­min­ish­ing, forc­ing Ja­panese in­sti­tu­tions to look else­where for as­sets and weigh­ing on yields around the world.

2) With the BoJ con­sis­tently on the bid—and the cen­tral bank is re­port­edly well ahead of its buy­ing tar­get so far this year—for­eign in­vestors have in­creased their ex­po­sure to the mar­ket. At the end of 2015, for­eign­ers owned some 10% of out­stand­ing JGBs, or roughly JPY 110trn, dou­ble their hold­ings of five years be­fore. As a re­sult the “BoJ trade”—buy and flip to the cen­tral bank—has be­come in­creas­ingly crowded, even as the trad­able pool of JGBs has shrunk in size. Ac­cord­ing to the Ja­pan Cen­ter for Eco­nomic Re­search, at the end of last year there was only JPY 129trn to JPY 148trn left avail­able for pur­chase from do­mes­tic banks and pen­sion funds, which im­plies that for­eign­ers now own al­most half of the JGB mar­ket’s free float.

3) Spec­u­la­tion in the cor­po­rate bond mar­ket has shot up sharply. As traders at­tempt to sec­ond guess which is­sues the BoJ will buy next us­ing its for­mula of ma­tu­rity dates and credit rat­ings, short-dated yields have risen and the cor­po­rate curve has in­verted as the one to three year seg­ment of the mar­ket threat­ens to dry up.

The prob­lem for the BoJ—and for for­eign JGB buy­ers—is that the sit­u­a­tion in the Ja­panese mar­ket is un­sus­tain­able. At its cur­rent rate of buy­ing, the BoJ could own half the en­tire mar­ket by the end of this year. In six years, the JGB mar­ket could van­ish en­tirely.

The BoJ badly needs an exit route. Con­sid­er­ing three pos­si­ble endgames sug­gests the form this is likely to take.

1) The BoJ keeps buy­ing un­til the JGB mar­ket no longer ex­ists. Do­mes­tic pen­sion funds will no longer be able to in­vest in Ja­pan’s sov­er­eign debt, and will have to hold cor­po­rates, for­eign sov­er­eigns, eq­ui­ties and pri­vate equity in­stead. Fol­low­ing suc­ces­sive scan­dals at Olym­pus, Toshiba, Sharp and IHI, among oth­ers, the cor­po­rate bonds of Ja­pan Inc. are seen by many as car­ry­ing un­ac­cept­able un­seen man­age­ment risks. Mean­while, the club of AAA-rated global sov­er­eigns is shrink­ing fast, with the UK the lat­est to be ejected and Aus­tralia pos­si­bly the next. In short Ja­panese pen­sions will have to take on more risk, just as Ja­pan’s de­mog­ra­phy dic­tates they should be re­duc­ing their risk.

2) At some point in the next few years—pre­sum­ably when the bal­ance of JGBs avail­able for pur­chase from do­mes­tic banks and pen­sion funds (which ex­cludes bonds ear­marked as to be held to ma­tu­rity) has shrunk con­sid­er­ably—the BoJ sim­ply stops buy­ing. With no BoJ on the bid, and no more real in­vestors in the mar­ket, the JGB mar­ket crashes. This would be a grossly ir­re­spon­si­ble course of ac­tion, but it would largely be those for­eign in­vestors fool­ish enough to have stuck around who would be left to carry the can.

3) The BoJ tries “some­thing else”. Dras­tic mea­sures, such as the is­sue of a JPY 500trn zero coupon per­pet­ual JGB to the BoJ in or­der to erase half the gov­ern­ment’s out­stand­ing debt, are con­ceiv­able—and who knows what Ber­nanke dis­cussed with Abe and Kuroda last week? But bar­ring such an un­prece­dented step, it seems the least dis­rup­tive op­tion would be for the BoJ to at­tempt to ta­per its JGB pur­chases in the open mar­ket. In that case, the JGB mar­ket may not crash en­tirely. But much like the US trea­sury mar­ket in 2013, it will sell off un­til yields are high enough to tempt real in­vestors to re­turn. Any for­eign­ers who bought in ex­pect­ing fur­ther cap­i­tal gains will get badly burned.

For the time be­ing, traders seem happy to ig­nore the wildly flash­ing over­bought sig­nals, and are con­tin­u­ing to chase trad­ing prof­its. How­ever, the pres­ence in the mar­ket of do­mes­tic in­sti­tu­tions is di­min­ish­ing along with the pool of avail­able bonds—a dy­namic which threat­ens ul­ti­mately to de­prive for­eign in­vestors of an exit route.

On the mar­ket’s cur­rent tra­jec­tory, the BoJ will be forced to move to­wards an endgame of one form or another within the next 12 months. Un­wary in­vestors who are left stand­ing when the mu­sic stops will likely re­gret ever hav­ing joined in the game.

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