The JGB endgame approaches

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.