The author is the former head of global asset allocation at a fund manager
Many times, bets on Japanese government bonds have had fortunes beyond the reach of traders.
The pay-off for short JGBs always looks tempting and asymmetric risk. Potential losses appear to be limited because yields, which move toward price, cannot go too far into negative territory. At the same time, the return can be great because the yield can increase a lot. This opportunity almost always proves illusory. Forecasts for inflation and bond yields in Japan rising from long depressed levels have consistently proven misplaced.
But with the return of inflation in the country, higher bond yields around the world, and new leadership at the Bank of Japan, will this time be different? One reason to believe is that yields are currently being held up by the BoJ’s policy to limit government borrowing costs through large bond purchases.
This policy, known as Yield Curve Control, is inconsistent with the central bank’s main economic goals. This includes asking companies and households to change their saving and borrowing behavior, anchoring inflation expectations in positive territory – things like that.
To do this, interest rates must be free to adjust to economic conditions, the opposite of the yields pegged to the YCC. There will be times when the static bond yield curve happens to deliver something consistent with the inflation target, but this will be transitory. Accepting the central bank’s primary objective can only mean removing the peg when it’s time to avoid overshooting the inflation target.
You see a picture of an interactive graphic. This is most likely because you are offline or JavaScript is disabled in your browser.
We’ve seen this movie before. In 1942, the US Federal Reserve implemented its own version of the YCC during World War II, only to abandon it in 1951. To this day, the 2.5 percent ceiling remains for long-term Treasuries, with a lower cap for short-term bonds. . Most recently, the Reserve Bank of Australia had a brief relationship with the yield curve target during the Covid-19 pandemic. Instead of targeting the entire curve, the RBA’s policy between March 2020 and November 2021 is to let three-year government bonds yield 0.25 per cent – then reduce to 0.1 per cent.
The experience of the two central banks is similar in many ways. As expectations begin to change, yield targets become unsustainable. In both cases, central banks are struggling to weed out policies that are no longer good for the economy and continue to be tested by twitchy bond traders.
But there are also important differences, the most relevant of which is how the policy comes out. The Fed seeks to defend the peg for several quarters, and thus outsource the creation of reserves to the demand of investors. When investors sell bonds, the Fed must buy them to maintain interest rates. To buy these bonds, the Fed creates new bank reserves. So, when doing the peg, the central bank passes the control of the volume of reserves to private actors in the bond market. This led to bad monetary policy, increased inflation and led to an institutional crisis. In contrast, the RBA’s defense of the target crumbled relatively quickly. As the RBA changed tack, three-year bonds were yielding more than seven times their target rate even though the central bank had bought 60 percent of the bonds.
Are there lessons for Japan? Bond traders are scrutinizing the BoJ’s commitment, and the JGB market is deteriorating and dominated by central bank holdings. The current policy rate in Japan is negative, although the market is expecting it to rise by 0.15 percentage points by the end of the year, and continuously thereafter. Markets may be wrong, but the bet is that the decades-long battle against deflation is over and YCC policy is no longer relevant.
The financial stability risk from a higher break in JGB yields may be closer to a “slow burn” than “market chaos” – with the biggest impact likely to be felt in reducing Japanese demand for overseas government bonds. Yes, there will be paper losses for the BoJ as rates rise. But this is unlikely to translate into realized losses under BoJ accounting rules, due to the treatment of bonds held to maturity. And the maturity profile of the BoJ’s portfolio is remarkably short, giving it the flexibility to respond to conditions by adjusting its balance sheet by deciding whether and how to reinvest from maturing bonds. But the BoJ should never have implemented the YCC in the first place. Its unraveling of course.
Tony Yates contributed to this column