Do JGB yields contain useful information?

Liseth Galvis-Corfe - 02 August 2018

In these dog days of summer, excitement is found in extraordinary places. Three interventions by the Bank of Japan in the government bond market last week lifted expectations of a policy shift at this week’s monetary policy meeting, but this was not delivered. Instead, Governor Kuroda announced a technical change whereby the acceptable range of movement of 10-year JGB yields was widened to 20 basis points either side of zero. Also, the BoJ will buy a greater proportion of ETFs that track the Topix index (from ¥2.7 to ¥4.2 trillion per year). The undergirding message was that the central bank intends to suppress short and long-term interest rates for a long time, despite its negative impact on bank profits. No tightening here.

The excitement, such as it was, concerned the rise in 10-year JGB yields to the giddy heights of 11 basis points and the nudge that it appeared to give to US 10-year yields, which have since regained the 3-handle. A cursory examination of figure 1 confirms that there are several instances – including 2013 and 2015 – when JGBs appear to steal a march on USTs. Bearing in mind that the BoJ’s holding proportion of nearby current bond issues in June was above 70 per cent, how is it possible that a bond market as controlled and sterile as Japan’s could possibly transmit a signal to the much larger and more tradeable US market? 

Figure 1 shows the correspondence of 10-year JGB and UST yields since 2007. The relationship was tightest from January 2007 to August 2011. Since then, there is a separation caused by a strong influence of the US term premium on the US benchmark bond. The co-movement resumes in May 2013, when yields soared in the context of the “taper tantrum” as the Federal Reserve tightened monetary policy. The two series have diverged over the past 2 years as the Federal Reserve commenced its series of gentle interest rate hikes and the BoJ has nailed its colours to the mast of Yield Curve Control.  It turns out that, statistically, the evidence for a systematic transmission from Japan to US is tenuous, but there is a logical connection.

As interest rates have been at historic lows in Japan, domestic investors have been searching for yield in international markets. Currently, Japan is the second largest foreign creditor to the US, after China. According to the US Treasury Department, it is estimated that Japanese holders, including the government, own $1.04 trillion in US Treasury securities (May 2018). Among the main holders of foreign bonds, we also find Japanese pension funds and insurers. Figure 2 shows that since 2013, net purchases/sales of long term debt securities and equities have increased substantially.  Shinzo Abe, since his election in September 2012, has fostered international asset reallocation. In 2014, GPIF, the country’s largest pension fund announced an increase in its foreign fixed income exposure from 11 per cent to 15 per cent, in foreign equities the increase was from 12 per cent to 25 per cent.

QE in Japan has distorted the bond market, liquidity has reduced considerably and the BoJ is still far from the 2 per cent inflation target (0.7 per cent was the inflation rate in June 2018). For now, it seems that monetary tightening is unattainable. However, at some point, the BoJ must take measures to reduce its exaggerated gross public debt level, which now stands at 253 per cent of GDP, the highest in the world. When the unwinding starts, Japanese yields will rise, and it will be more attractive for Japanese investors of foreign bonds to switch to the local market. This shift could have disruptive consequences for US Treasuries. Japanese holders of US Treasuries are already suffering from the increase in US Dollar hedging costs, if JGB yields increase, the home market will look an even better bet. 

Figure 1

Data source: Thomson Reuters Datastream 

Figure 2

Data source: CEIC

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