Japan PM Abe's True Test; Rising Government Bond Yields
Abenomics' massive monetary stimulus was supposed to depress long-term interest rates to spur economic activity, but the Japanese government bond market has other ideas.
Banks, unable to make money on their Japanese government bonds (JGBs) anymore, have begun sloughing off their holdings, putting upward pressure on yields. Major banks sold off about 11 percent of their holdings in April alone.
Large lenders have hiked their prime rates to make up for the loss of earnings on JGBs, which threatens to price potential borrowers out of the mortgage market, while higher long-term rates could sap corporate Japan's already anaemic demand for loans.
That puts at risk the very activity Prime Minister Shinzo Abe had intended to spark with the Bank of Japan's massive quantitative easing (QE) on April 4, when it promised to inject $1.4 trillion into the economy over two years.
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"QE policy doesn't mean just buying more government bonds. Buying more bonds is just a tool, a means to achieve lower interest rates," said Takuji Okubo, chief economist at Japan Macro Advisors.
"QE is also convincing the market that yields will stay low, and the Bank of Japan is not doing the latter," he said.
The yield on the benchmark 10-year JGB is still very low both historically and compared with other sovereign debt.
But it has jumped about half a percentage point from the record-low 0.315 percent reached the day after the BOJ unveiled its radical plan to double the monetary base over two years to achieve 2 percent inflation. At one stage in recent frenetic trading, it reached 1 percent.
The plan's rationale was that the intense burst of monetary stimulus would drive down interest rates, as the central bank bought an amount equivalent to about 70 percent of new issuance each month.
Instead, after a brief tumble, rates began to rise as banks and other investors sold JGBs, worried they were holding assets that would lose value as the promised inflation emerged.
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"There is a conflict of the logic in terms of the higher inflation rate and lower nominal interest rate," said Tadashi Matsukawa, head of fixed-income at Pinebridge Investments in Tokyo.
The worst-case scenario for Japan would be a bond market caught in a vicious circle of selling, which could happen some economists suggest if investors start to worry about the impact of rising long-term rates on the country's public debt.
That will make it increasingly costly for the Japanese government to service the debt, which at 230 percent of gross domestic product is already the heaviest among industrialised countries.
"The Bank of Japan cannot control the JGB market. They have already used every method to control JGBs, so the JGB yield will go up sharply," said Takeshi Fujimaki, a former adviser to billionaire investor George Soros and now president of investment advisory firm Fujimaki Japan.
"A 'good' interest rate rise is when yields rise because of expected inflation," Fujimaki said.
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But if that inflation is not the result of a healthy pick up in economic growth, it would lead to what Fujimaki called a "bad" interest rate rise, as investors sell more JGBs to reduce their financial exposure to Japan's increasing fiscal burden.
Japan's cabinet on Friday rubber-stamped measures aimed at boosting sustained growth in consumption, output and incomes, with more steps promised after next month's upper house elections.
But measures announced so far have left markets unconvinced, despite a drumbeat of reassurance from government and BOJ officials. Reflecting some doubts, the yen rose to a 10-week high last week, while the Nikkei stock average is more than 20 percent below its 5-1/2 peak hit on May 23.
"Japan's economy is on a steady path of recovery and it will gradually gather strength," and financial markets will calm down, BOJ Governor Haruhiko Kuroda told reporters on Thursday after a meeting with Abe.
In a sign that Japanese are also worried interest rates will continue to head higher, homebuyers are rushing to secure fixed-rate mortgages.
Japan's top three banks, Bank of Tokyo-Mitsubishi UFJ, Mizuho Bank and Sumitomo Mitsui Banking Corp all raised 10-year fixed rates for most qualified borrowers to 1.6 percent in June, from 1.4 percent in May and 1.35 percent in April, to reflect the rise in benchmark long-term interest rates.
Banks themselves contributed to some of that rise as they shed JGBs. The total balance of Japanese government bonds held by the country's major banks plunged in April to 96.27 trillion yen, down 10.8 percent from March, dropping below the 100 trillion yen threshold for the first time since June 2011, BOJ data shows.
To be sure, falling bond prices and a corollary rise in interest rates is also much more widespread as investors grow concerned about the direction of U.S. and Japanese monetary policy. They are worried that the U.S. Federal Reserve, which meets this week, is preparing to taper off its own stimulus program and investors were upset last week that the Bank of Japan decided against introducing new money market methods to calm volatile prices.
The risk for the Japanese government is that the broader market turbulence, partly the result of investors selling off their riskier assets, continues as investors fret over the direction of monetary policy.
"That will make the situation difficult for Mr. Abe's policymaking," said Naomi Muguruma, senior strategist at Mitsubishi UFJ Morgan Stanley Securities.
"I think it's too early to determine whether or not Abenomics is a success or failure, but as far as the JGB market is concerned, Abenomics and the BOJ's new policy framework actually increased market volatility and also confused market participants," she said.
The lack of clarity on Japanese policy, combined with less market liquidity as the central bank snaps up so many bonds, has prompted investors to brace for large price swings.
Implied volatilities on JGB futures have been above 5 percent for most of the past month, hovering around their highest levels since they spiked following Japan's March 2011 earthquake and tsunami, and up sharply from around 2 percent before the BOJ unveiled its radical monetary policy.