Japan Update: Yield Curve Out of Control: 10-Year JGB Yield Tops 0.545%

Japan Update  •  Bank of Japan  •  January 13, 2023

• Yield Curve Out of Control: 10-Year JGB Yield Tops 0.545%
• November Current Account Rises 16%
• Corporate Pension Returns Hit by Higher Rates
• TSMC Said to Eye Second Japan Fab

Yield Curve Out of Control: 10-Year JGB Yield Tops 0.545%

Like it or not, the Bank of Japan has inadvertently introduced a new policy: Yield Curve Out of Control. As we get closer to next week’s Monetary Policy Board meeting (January 17-18), the market is putting pressure on the central bank to make further adjustments to current policy. Traders are aggressively shorting 10-year JGBs despite aggressive fixed-rate buying operations in the hope that the Bank will have to widen the trading band around the 10-year peg from the current 0.50% to 0.75% or more—or perhaps abandon Yield Curve Control altogether.

Intraday, the yield on the benchmark 10-Year JGB (#369, 0.50%, due December 20, 2032) got as high as 0.545% before the BoJ’s fixe rate operations brought the yield back to the top of the trading band at 0.500%. The BoJ conducted two unscheduled Dutch auction buying operations in the 10-year JGB on Friday, buying ¥702 billion worth of bonds. In addition, the Bank bought ¥1,251.1 billion worth of 10-year JGBs through fixed rate operations and another ¥1,956.3 billion through a special fixed rate operation aimed at the cheapest to deliver JGB against 10-year JGB futures. So, adding it up, the BoJ bought ¥3,909.3 billion of 10-year JGBs just today and a total of ¥5,008.3 billion if we add in buying operations in other maturities. This is a new record for JGB purchases in a single day.

And still the yield curve is out of control.

JGB Yield Curve on Selected Dates

Source: Ministry of Finance, Japan Securities Dealers Association
Note: Yields for January 13, 2023, are unofficial reference prices from the JSDA

The BoJ widened the trading band around the 10-year peg of “about zero percent” from 0.25% to 0.50% with the aim of correcting the kink in the yield curve between five years and ten years. However, as you can see from the chart above, the distortion of the yield curve has only gotten worse since the trading band was widened. Instead of supporting YCC by “normalizing” the curve, the policy shift created YCOC by encouraging the market to believe that it had the BoJ on the run.

There are a lot of traders placing very large bets that the BoJ will, once again, attempt to normalize the curve by widening the trading band again, perhaps to 0.75%.

Frankly, we think this hope is misplaced. Widening the trading band has only intensified market pressure on the BoJ to adjust policy even further. Will 0.75% be enough? What about 1%? 2%? 5%? Widening the trading band made things worse, not better. Why would anybody think the BoJ will bow to market pressure this time?

We are not just whistling Dixie either. Consider Japan’s core CPI (excluding fresh food). Tokyo core CPI in December hit a nearly 41-year high of 4.0%. Nationwide core CPI, which will be released on January 20, is likely to show a similar increase. However according to our models, core CPI should have peaked in December and should start to decline rapidly in the January-March 2023 quarter. Given Japan’s sensitivity to USDJPY, the sharp appreciation of the yen against the US dollar should act to reduce core CPI even more rapidly. With economic activity still in a weak recovery, why would the BoJ want to raise rates now? It just doesn’t make sense.

One other important factor has to do with the mundane topic of JGB market plumbing. As we have reported many times, the BoJ now owns more than 90% of the most recently issued 10-year JGBs. That means there are very few bonds in other hands that can be used to facilitate trading. In order to preserve the functionality of the JGB market, the BoJ regularly conducts Securities Lending Facility (SLF) repo operations to provide enough bonds to facilitate trading.

Remember how we said the BoJ bought a record ¥5,008.3 billion worth of JGBs today? Well, the BoJ also loaned ¥5,184.7 billion worth of JGBs to bond dealers through the SLF—including the three on the run 10-year bonds #367 (¥1,295.4 billion), #368 (¥869.9 billion), and the current benchmark #369 (¥166.8 billion). Clearly, some of these bonds were used as borrow for short positions.

Here’s the catch: Under the rules of the trading game, you are not allowed to sell JGBs back to the BoJ that were initially acquired through the SLF. So, even if you could make a nice profit buying cheap, high-yielding 10-year JGBs in the secondary market, you must find a buyer other than the BoJ to take them off of your hands. Given that the BoJ is the only consistent buyer of JGBs, there is no guarantee that you will be able to make money even if you were lucky enough to get your 10-year JGBs at a yield of 0.545% (today’s high yield).

So, the only way to make money through a trade like this is if the BoJ blinks and widens the trading band again. We repeat—this strikes us as very unlikely given the current fiasco. What happens if the BoJ doesn’t widen the trading band next week? A rush for the exits, that’s what.

This is a dangerous game to play. If the BoJ holds fast, JGB shorts will have to be bought back and we might well see a big move in USDJPY.

It’s all fun and games until somebody loses an eye. You have been warned.

November Current Account Rises 16%

Japan’s current account for November 2022 jumped 16.4% to ¥1,803.6 billion, the first current account surplus since March 2022. The increase in the current account came from increased dividend payments from Japanese subsidiaries overseas and more spending by overseas tourists as entry requirements were eased following the COVID pandemic.

November’s balance of trade was a deficit of ¥1,537.8 billion, an improvement from October. Much of the improvement came as USDJPY fell from 150 to the 130 level for most of the month.

Analysts expect the pattern of small current account surpluses and trade deficits will continue through much of 2023. This is likely to leave the full-year current account surplus for 2023 at about ¥10 trillion, roughly the same as it is expected to be for all of 2022.

Corporate Pension Returns Hit by Higher Rates

Japanese corporate pension funds have reported an average return of -0.4% for the October-December 2022 quarter. This is the fourth consecutive quarter of negative returns, the first time this has happened since 2002. Many corporate pension funds were heavily invested in US dollar denominated debt. As interest rates rose and the yen strengthened against the US dollar, losses on these investments piled up.

The worst performing asset class was unhedged overseas bonds, which lost an average of 5.83% during the October-December quarter, significantly worse than the -1.67% reported for the July-September 2022 quarter. Domestic bonds, which comprise about 20% of the typical corporate pension portfolio asset allocation, lost 1.88% during the October-December quarter. This was made worse during the final week of the year after the Bank of Japan widened the trading band around the 10-year peg from 0.25% to 0.50%.

So far, corporate pension funds have lost 3.45% for the first three quarters of FY 2022 (year ending March 31, 2023). Unless there is a sharp rebound during the January-March quarter, corporate pensions are likely to report a negative return for the full year for the first time since FY 2019 (year ended March 31, 2020).

Comment: The figures in this article apply only to defined benefit pensions. Corporations are on the hook for any subpar performance. Defined benefit pensions remain the norm in Japan but there has been a significant shift to defined contribution pension plans that leave corporate sponsors free of the need to top up underperforming pension assets. The move from defined benefit to defined contribution pension plans is likely to accelerate following this year’s miserable investment results.

TSMC Said to Eye Second Japan Fab

Taiwan Semiconductor (TSMC) CEO C.C. Wei told analysts on Thursday that he is considering the construction of a second semiconductor factory in Japan. Wei said, “We are considering the construction of a second plant in Japan,” but pointed out that no final decision has been reached. TSMC is currently constructing its first semiconductor fab in Kumamoto with the assistance of the Japanese government and several large private sector partners.

Comment: The fab now under construction in Kumamoto will make chips for the automotive industry and other applications. Most of these chips will not be the cutting-edge type used in smartphones. Japan wants to restore its place as a major semiconductor manufacturing hub, particularly as growing tensions between Taiwan and China could mean the loss of Taiwanese fabs to the western bloc in the event of a Chinese invasion of Taiwan.

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