Stocks, commodities and currencies have been going haywire this week, so I’ll hope to provide you something a little bit more calming, which is still interesting without requiring second-to-second monitoring. Bonds! Specifically, the Japanese government short-term bills and notes, as Bloomberg reports.
These contracts, all the way up to the 5-year time frame, are seen as potentially going into negative yield as the BOJ is looking to flatten the yield curve to get money into the economy and provide monetary velocity support (arguably to keep it from going in reverse, but we take what we can get here) or allowing bond sellers to not need extra liquidity when they exit positions, to get the gains into assets that spin through the economy. That’s pretty much everything I can state on this (I don’t have that much bond investment experience myself, so beyond quips on the “wow!” factor not bound by any particular needs to maintain professionalism, you should look elsewhere) so let me tell you a little more on why you should click the link, after you hit the jump.
“The BOJ needs the plunge in oil prices like it needs a hole in the head”, quoting Nicholas Spiro of Spiro Sovereign Strategy, is probably one of the most succinct, funny ways of looking at the BOJ issues of deflation. As I have argued before, I think the extra cash infusion that lower fuel prices provides Japanese companies (which hopefully gets passed on to the wider economy through increased capex spending and bonuses) will have a positive effect on the economy overall, but lower inflation – even if it’s off the much more benign development of lowered input prices – is probably not one of the main reasons I’d use for increased monetary velocity in Japan.
The cross-currency basis swap discussion in the article is shallow and for those already initiated into basis swaps (of which I am not one), but it seems to indicate that although the 2-year JGB rate is 0.01%, there is a gain to be had for swapping the notional into US dollars, since the TIBOR/LIBOR spread on currency markets and general FX market positioning demand allows a more than 0.5% extra yield to be had for holding US dollars. The collapsing of the yield curve thus allows there to be a separation that the rest of the currency markets cannot compensate for as this would misprice a whole host of other contracts, and thus this spread of risk and yield exists. As Europe also sees lower rates and the BOJ is more aggressive on the qualitative and quantitative easing, there appears to be a currency gain to be made entering EUR/JPY basis swaps as well without getting transaction costs on the notional contract values, which would make that a nice place to park money at least temporarily. I’ll look into trying to understand basis swaps a little bit more fully after I’m done laughing at the Swedish political theater that is currently going on.
Tying into this is the discussion of why the cutoff is at 5 year contracts. UBS’s Ikawa mentions that notes will stop being favoured over bills here, as the volatility of the 5-year notes is too much to bear over the shorter-term bills. This is a pretty natural cause of the longer maturity driving a longer duration, which is the major component of bond price volatility. There are two arguments in play here:
- Is the 5-year note volatility too high to bear compared to the near-volatility-less bills? If the inflation expectations go down further (say, thanks to a further election upset where the LDP gets less than 266 lower-house seats in the Kokkai?) then debt further out the yield curve should increase in price in ways that the bills would not (compounding of expected interest), while the bills would be unchanged.
- The BOJ then runs up against the question on if there are any debt contracts to buy at these lower durations like bills to balance this out, or if they will focus on getting the extended yield curve – past the 5y notes – flattened. If this happens duration goes up (moves opposite to expected interest rates), but the implicit guarantee and consistent buying could depress market swings and effectively make expected short-term volatility lower, effectively extending the gap already mentioned over the 2-year notes.
- If the FX-generated spread on going into cross currency swaps with JGBs as collateral persists, then buying any JGB to anchor a basis swap paying better than the basis swap premium is still a steal just from a risk estimation alone. When the risk of differential inflation in the funding currency is much higher than the risk of bonds having a diminished real return in the same currency, then having it underwritten by the Japanese government or Bank of Japan is a great way to collect money.
- Should however the creditworthiness start fraying significantly, I guess JGB yield to USD/JPY basis swaps will be looked into for ideas on spreads and taking on trades betting on the Japanese government to pay its debts!
It will anyhow be very, very interesting to follow these developments going forwards, and I expect to see some good indicative moves after the December 14th election!
