20 January 2023
Bank of Japan – Exception to the rule
The Bank of Japan is the only major central bank to buck the trend of increasing interest rates as inflation rises. We examine how the Bank of Japan’s actions have created a market for Japanese government bonds that is detached from economic fundamentals.
Fundamentals
In an environment of high inflation, economic principles tell us that interest rates should increase. Indeed, most central banks around the world have been hiking rates. The Bank of Japan (BoJ) sees itself as the exception to this rule. While inflation has increased to the highest rate in 30 years, the BoJ persists with its approach to keeping rates artificially low by intervening in fixed income markets. These actions are taken through yield curve control (YCC) whereby the BoJ buys Japanese government bonds (JGBs) to keep yields within a defined band. While the market continually anticipated a change in policy throughout 2022, the central bank took action when the market least expected it: in December, the BoJ widened the YCC band from 0.25% to 0.50% for 10-year JGBs. The market anticipated that the BoJ would widen the YCC band again (or even abandon it) at the 18 January BoJ meeting, given the high-inflation environment. However, the Governor of the Bank of Japan, Haruhiko Kuroda, remained adamant that he will not be pushed around by the market and the YCC band remained unchanged.
Quantitative valuations
The market continues to challenge the BoJ, most recently pushing JGBs to breach the 10-year YCC limit of 0.5% on 13 January and forcing the BoJ to intervene. The impact can be seen in derivatives markets, where the 10-year swap rate, which is allowed to trade more freely, currently yields 50 basis points (bps) over JGBs. That said, Japanese rates are attractive to yen investors who may struggle to find yield when investing internationally, given that it costs 5.3% to hedge US dollar-denominated securities back to yen. (All data from Bloomberg, as of 17 January 2023).
Technicals
The technical predicament in JGBs is extreme. The BoJ has bought over $100 billion of JGBs in the past two months – which equates to 2.5% of the readily available JGBs in the market each month – in order to maintain rates at its desired level. As a result, the Bank of Japan owns almost all of the 7-10-year duration of the JGB market.* Based on the expectation that yields will rise, consensus market positioning is short duration, according to proprietary J.P. Morgan Asset Management surveys as of 10 January 2023. There is also evidence that Japanese investors have reduced their purchases of foreign bonds given the high hedging costs. If the BoJ was to remove its YCC program, we would expect this to be a tailwind for demand in global bond markets given the meaningful size of the Japanese investor base.
*Source: Bank of Japan, Ministry of Finance Japan and Morgan Stanley Research as of 30 December 2022.
What does this mean for fixed income investors?
For portfolios that have JGBs within their benchmark we see a short position as preferable in the current market environment. The BoJ fooled the market once with the timing of changes to the YCC band. If this happens again, it may provide a good opportunity to reset short-duration positions in Japan. We believe the market will continue to challenge the BoJ and we favour a short-duration stance in JGBs because we expect that the BoJ will eventually remove YCC, causing yields to rise. We don’t believe the BoJ’s position is sustainable, as it creates a domestic market where there is no organic private sector demand for bonds. “Don’t fight the Fed” may be a common mantra in fixed income markets, but no one said this applies to the BoJ. The Bank of Japan is merely delaying the inevitable rise in Japanese interest rates.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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