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Tokyo - After spending a year trying to prevent benchmark yields from rising above zero percent, the Bank of Japan (BOJ) now faces the challenge of stopping them from falling too low.
Japan’s 10-year yield has gone from a one-year high in February to slipping below the BOJ’s targeted zero percent level earlier this month amid a bout of global risk aversion stemming from North Korea tensions. While the central bank has cut back on its debt purchases three times since mid-August, strategists question if that will be enough should global bonds keep rallying.
"I am worried about yields falling too low, which would be risky," said Yusuke Ikawa, Japan strategist at BNP Paribas Securities in Tokyo.
"The more the BOJ owns bonds, the more downward pressure it puts on yields. The bank will likely continue gradually scaling back purchases, but it can’t reduce outstanding debt holdings under its monetary base expansion policy."
Should yields stay negative for a sustained period, demand for Japanese bonds may slump, hurting an already moribund market. Thursday marks the first-year anniversary of BOJ Governor Haruhiko Kuroda’s policy of controlling the yield curve as part of his plan to achieve a 2% inflation target.
While the strategy has enabled the BOJ to be more flexible with bond purchases, Kuroda has maintained that Japan still needs stimulus, with the central bank in July pushing back for the sixth time its timing for reaching the inflation target.
"The issue is when yields fall during times of global risk aversion," said Koichi Sugisaki, a strategist with Morgan Stanley MUFG Securities.
"If the BOJ cuts purchases to contain the drop in yields, it effectively means monetary tightening. It is a really scary scenario."
Japanese financial markets on Tuesday suggested that any snap election called by Prime Minister Shinzo Abe was likely to see him retain power. That could mean the continuation of Abenomics - the recipe of ultra-loose monetary stance, flexible fiscal policy and selective deregulation - which according to Mizuho Securities could likely cause the upward momentum on interest rates to dissipate.
Kuroda said late last month that despite some signs of reduced liquidity, the market for Japanese government bonds is "functioning quite well" and actually makes it easier for the BOJ to manage yields with fewer purchases.
The 10-year yield briefly shot up to 0.15% in February, before the BOJ stepped in with its unlimited fixed-rate buying operations. It fell to -0.015% on September 8, the lowest since November. The yield was at 0.03% on Tuesday.
BOJ holdings
The BOJ holds about 40% of Japan’s outstanding government bonds. About 31% of all the securities held by the central bank as of end-August were in the five-to-10-year maturity segment, according to Bloomberg calculations based on BOJ data excluding floating-rate and inflation-indexed securities.
About 25% of its holdings comprised debt due in less than two years and another 25% were in the two-to-five-year zone.
"Even for those looking to make a profit from the BOJ trade, returns from such a trade would wane if the BOJ keeps cutting purchases," said Yasunobu Katsuki, senior analyst at Mizuho Securities.
Other market views:
Mizuho’s Katsuki The BOJ could refrain from actively halting the drop in yields even if they are below zero, by just showing its stance of cutting purchases. "No investor would want to buy bonds at such low yield levels".
The BOJ can avoid the markets’ one-sided push for yields into negative Katsutoshi Inadome, senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo. "It’s difficult to stem the drop in yields".
"The BOJ showed it can stop the rise in yields by fixed-rate operations but the only way ultimately to stop yields from falling is selling operations, which are unrealistic".
"Foreign investors could still buy bonds at rates lower than the BOJ’s floor" and what could happen is a "situation of an endless drop" in yields Kazuhiko Sano, chief strategist at Tokai Tokyo Securities.
The BOJ is faced with a dilemma: it could steer the 10-year yield back to zero by cutting bond purchases if yields stay negative, but that could reduce the impact of easing.
On the other hand, allowing yields to fall would force the bank to lower the 0% target for 10-year yield.
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