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Rising volatility prompts Japan bond angst

The Bank of Japan’s bond-buying plan is bedevilled by contradictions: it seeks to promote financial stability but has triggered inevitable bouts of market volatility. What’s more, the central bank wants low yields and greater inflation expectations. A new communications policy is needed, analysts say.

High volatility in Japanese sovereign bond markets in recent weeks has led to talk of an investors’ strike, after bond repurchases aimed at boosting growth accompanied a sharp rise in yields. What’s more, the volatility might itself trigger a disorderly, and pro-cyclical, wave of mechanistic selling as yields exceed some portfolio managers’ internal value-at-risk (VaR) limits.

But those who view liquidity programmes as a guarantee of returns are failing to see the bigger picture, some analysts say.

Ten-year JGB yields fell as low as 0.45% in April, following the Bank of Japan’s announcement that it would increase bond purchases with a view to doubling the monetary base and lifting inflation to 2% within two years. However, investors were left scratching their heads soon after the announcement when yields starting rising, reaching 0.96% in recent sessions, a 13-month high.

According to some observers, the jump in yields is simply a correction to levels seen at the beginning of the year, but for others the rise is a worrying sign that policymakers' attempts to cut borrowing costs and fuel spending in the Japanese economy are doomed to fail.

“The aim of the bond-buying programme is to depress interest rates, which in theory should stop people saving and encourage them to spend. That is likely to include spending abroad, which should have the effect of depressing the yen,” says David Watts, a strategist at CreditSights in London. “However, if the impact of the move is to increase volatility, you run the risk of fuelling financial instability, which raises some tricky questions for the Bank of Japan.”

The problem for policymakers in Tokyo is that the bond-buying strategy is at its heart contradictory, pairing a desire for lower yields to boost growth with the expectation that higher inflation will necessarily lead to a rise in interest rates in the longer term. Bank of Japan board members recognized that contradiction at their meeting in April, with minutes of the April 26 policy meeting showing concern that investors might be confused, leading to “fluctuations in financial markets”.

In recent weeks, investors have voted with their feet, cutting orders at an auction of 40-year debt to just 2.64 times the $3.9 billion offering, the lowest level since August 2011. The bonds priced two basis points higher than trader expectations.

Meanwhile some influential investors have been expressing their displeasure on social media.

‘‘The BOJ dominates asset markets for better or worse,” said Bill Gross, co-chief investment officer at Pacific Investment Management Co (Pimco), on Twitter. “Watch JGBs, the yen and the exodus from each.”

Alongside rising yields has come a commensurate increase in bond volatility, which some argue threatens to push some investors to dump securities. Implied volatility on Japan 10-year note futures climbed to 7.23% in recent trade, as the contract hovered around 141, near a two-year low. Although volatility is low compared with values seen in credit markets (iTraxx implied volatility habitually ranges between 40% and 50%), it might be sufficient to increase capital requirements on large portfolios by unacceptable amounts, analysts say.

“As volatility increases, capital requirements rise and the attractiveness of holding financial assets falls,” says CreditSights' Watts. “That may lead to a sell-off, which will push yields even higher.”

Some industry experts have warned that extreme bond volatility might lead to a so-called VaR shock. VaR provides risk managers with an estimate of the worst-expected loss that might occur in a security or portfolio within a specified period. The number is expressed at a certain confidence level over time under normal market conditions. The measure came under some criticism during the financial crisis for its inability to predict the distribution of losses once the estimate is exceeded, and because it assumes normal distributions, which are very rarely reflected in reality. However, it remains a key metric used by banks to measure the riskiness of inventories.

The 60-day standard deviation of the daily changes in 10-year JGB yields has doubled since April to around 4bp, the highest level since 2008, analysts say. However, current levels of JGB volatility are still relatively low on an historical basis. During the big VaR shock of 2003, the standard deviation jumped from 2bp to 7bp over a four-month period, as 10-year yields rose 100bp, compared with a 65bp rise in recent weeks.

“There has been talk of a VaR shock but I am not sure we are quite there yet,” says Julian Jessop, chief global economist at London-based Capital Economics. “If you take a short-term view the rise in volatility is quite sharp, but unless yields continue rising, I am not sure we have a real problem.”

Still, bond volatility has got Japanese policymakers concerned, and Bank of Japan officials have held meetings with bond traders to explore ways of dampening the sharp declines. One idea is to change the way the bank conducts its bond repurchase sessions, moving to smaller daily purchases rather than the current ¥1 trillion ($9.9 billion) buybacks eight times a month, a move which might improve liquidity in the market.

“The Bank of Japan needs to communicate better with the bond market, because probably its priority is not to reduce interest rates, which are already low, but to weaken the yen and restore confidence,” says Thierry Apoteker, CEO at consultant TAC Financial. “At the same time it needs to avoid substantial losses in the banking sector, which it can do if necessary by stepping up intervention.”

However, the central bank should be careful not to overreact, says Jessop, because rising volatility might not be solely the result of the bond-buying programme.

“It’s worth noting that Japanese yields have risen alongside those in the US Treasury market, albeit at a faster rate, and that bond repurchases by the Federal Reserve also led to a rise in interest rates,” Jessop says. “Also, volatility is not by itself a measure of failure or success. If yields come down sharply volatility would also rise, but you would not hear anybody complaining.”

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