30yr JGB yields have risen close to 30bps since July this year. As a result, in less than three months, the 10s30s curve has unwound almost all of the flattening that had occurred since the middle of last year. This selloff is not in isolation – US 30yr Treasury yields have risen close to 45bps since late August. However, it was the changes that the BoJ made back at its July meeting that have allowed long end JGB yields to become more connected with moves in global duration.
What are the BoJ trying to do?
At their July monetary policy meeting, the BoJ tweaked their policy to make it more sustainable given their view that it will take much longer than expected to reach the inflation target of 2%. In order to the limit the side effects of their policy, they allowed more flexibility around the 10yr target by widening the range to +/- 20bps.
Quantitative and qualitative easing (QQE) with yield curve control has limited both the activity and volatility in the JGB market. By allowing for more flexibly in their policy, the hope is that JGB yields can once again reconnect with domestic and global fundamentals, allowing long term yields to be more market driven. However, the implicit conclusion is that the BoJ wants a steeper curve, given the lobbying pressure from banks with declining interest margins. Concerns have been consistently raised by those both inside and outside the BoJ that a flattening yield curve was damaging margins and hurting financial intermediation.
Can the BoJ steepen the curve?
The BoJ are unlikely to make a steeper curve an explicit policy given both their desire for the curve to be more market driven and the fear of a stronger currency hampering their inflation objective. Nonetheless, they are currently adjusting their QE purchases to encourage a steeper curve. Although their stated policy is to expand the monetary base by 80tn Yen per year, this flow has been on a declining trend for some time as they shift
their focus towards their price target (Figure 1). The decline in purchases has not been equal across the curve, with the bulk of the decrease coming from the long end (Figure 2). They recently reduced their target purchases in the >25yr sector once again, reflecting their implicit desire for a steeper curve.
At the same time, the Government Pension Investment Fund (GPIF), one of the largest holders of JGBs, have also tweaked their investment policy which reduces the urgency for them to buy JGBs.
Will it work?
The combination of these factors does imply a steeper curve. However, the policy should not be viewed in isolation. If global bond yields are rising, JGBs yields may trade with a higher beta than the post-crisis norm. But do not expect the curve to steepen in the absence of a global selloff. The main reason is that whilst the BoJ are looking to limit the side effects of monetary policy, they are more concerned with their inflation target. If they attempt to push long term bond yields up without a backdrop of higher yields elsewhere, the currency is likely to strengthen.
There are other important limiting factors. The BoJ already holds over 50% of the bond market below 10yrs (Figure 3). They will eventually need to reduce purchases in these buckets if net supply (including QE) remains negative.
Secondly, the GPIF are not the only large holders of JGBs. Due to a combination of low JGB yields and BoJ purchases, city and regional bank holdings of JGBs are through a pre-crisis low. Any further steepening in the curve, may induce these domestic buyers back into the market (Figure 4).
This is especially relevant given the globalisation in yields that has occurred since the start of QE. Despite the fact that the flow of QE is starting to turn negative, the stock of bonds on central bank balance sheets will remain high. Hence, any steepening of the JGB curve in isolation will quickly be unwound by the global search for yield. In fact, the 10s30s JGB curve is already the steepest in the G4, partly due to the fact that the curve up until 10yrs is held down by yield curve control. More importantly, once you adjust for the cost of hedging*, 30yr JGBs are still more attractive than Treasuries.
Furthermore, it is questionable whether a steeper curve will actually improve banking profitability. After all, at the most basic level, higher yields represent tighter financial conditions. Right now, the BoJ’s Tankan survey does not show any problems with financial intermediation. In fact, it remains close to cyclical highs. Interestingly, the BoJ themselves (in the April financial stability review) concluded that half of the fall in income margins is due to structural factors (i.e. demographics and overbanking). As for interest rates, it is the outright level of interest rates that impact bank earnings rather than the steepness of the curve specifically. Raising the 10yr target would likely boost income via increasing interest rates on new loans (Figure 5) with deposit rates sticky at 0%.
Overall, there are lots of impediments to a steeper curve. Hence the policy shift at the BoJ should be viewed in the context of global duration. Importantly, for Japanese long term bond yields to sell off in isolation or be the cause of a global steepening, it must be driven by domestic fundamentals – i.e. growth and inflation.
That said, the policy change at the BoJ is still significant since it allows long end JGBs to participate far more in global yield movements. At the very least, this removes one impediment to higher rates globally.
* Based on a 3 month FX hedge