The Bank of Japan’s shock decision to adopt a negative interest rate policy in late January has not had the immediate impact on markets that many policymakers had hoped for.
Aside from a brief euphoric blip on the day that the decision was announced, the yen has strengthened while Japanese stocks have been slammed, casting immediate doubt among some market watchers as to whether the decision will do anything to boost the Japanese economy.
While the decision to apply a negative interest rate to some deposits placed at the Bank of Japan by financial firms may lead to an increase in new bank lending to the private sector, helping to boost investment should it eventuate, one area that has immediately benefited from the decision is the Japanese government bond market, known as JGBs for short.
The adoption of a negative interest rate policy by the BOJ has seen yields on Japanese debt with maturities out to 10 years collapse, taking the entire government yield curve to below zero per cent.
Essentially, those buying JGBs are now willing to receive less from their investment that what they will eventually receive throughout the life of the investment.
According to Takeki Fukushima, an analyst at Citibank’s developed markets multi-asset team, there are two factors that have led to this unbelievable outcome to become a reality: outright government debt purchases by the Bank of Japan through its quantitative and qualitative easing (QQE) program and a reluctance from other JGB investors to sell at present.
Here’s Fukushima on the degree of support the Bank of Japan is offering at present, along with a chart that visually shows how the bank is now effectively one side of the JGB market.
“The BoJ buys almost the entire amount of the MoFâ€™s JGB issuance, says Fukushima. “In other words, even if interest rates fall so far that there are no new investors, the BoJ purchase program would support the bond market.”
The chart below, supplied by Citi, tells the story.
With the BOJ mopping up almost all new JGB issuance at present, along with recent market turbulence and the adoption of a negative interest rate policy from the bank, Fukushima suggests that for the moment, “investors have elected to preserve the unrealized gains on their bond holdings”.
In other words, with JGB prices continuing to soar, investors other than the Bank of Japan have, as yet, decided not to sell their holdings.
However, Fukushima believes this will not remain the case, laying the foundation for a sharp increase in market volatility.
“We expect yields to continue to decline, as with expectations for US rate hikes fading investors are likely to expect additional rate cuts and therefore not sell JGBs. However, if investors attempt to realize unrealised gains on their JGB holdings, as occurred in April-June 2013, there is likely to be major market turmoil,” says Fukushima.
“In other words, the current interest rate environment is such that interest rates will continue to fall if nobody sells, but if somebody does start to sell they are likely to climb quickly, so caution is required because the further interest rates decline the bigger the risk of a subsequent increase.”
Should this eventuate it will mean that even with QQE purchases from the Bank of Japan, an accelerated selloff in the market has the potential for JGB yields to spike higher, potentially adding to Japan debt servicing burden should it be sustained.
With a public debt-to-GDP ratio hovering around 250% of GDP, and growing, this would be an undesirable outcome for not only Japan but the global economy should it eventuate.