Japanese Bond Yields: From Wild Turkey To Cold Turkey?

May.16.13 | About: CurrencyShares Japanese (FXY)

There has been much speculation about the aftermath of potentially higher Japanese government bond yields from Abenomics including several interesting pieces from authors on SA (here, here and here) and a piece from yours truly.

Recently, sharply increasing Japanese Government Bond (JGB) yields have attracted the attention of the financial community. Does this portend a trend change?

(click to enlarge)Click to enlarge

Source: investing.com

Keynes: Speculative Demand for Money

When describing sources of money demand, Keynes proposed that there exists a speculative demand for money. This appears in textbooks but is often considered rather obscure. After all, are there many real world examples? But I think what Japan is going through today can be described very well by his notion of speculative demand.

In a nutshell, Keynes argued that assuming people store wealth in money or bonds, when interest rates are high, rates would then be expected to fall and bond prices would be expected to rise. So bonds are more attractive than money when interest rates are high. But the vice versa is true when interest rates are low, as they would be expected to rise in the future and thus bond prices would be expected to fall.

It's All In The Numbers

A look at some simple arithmetic can show the implications pretty clearly. If you buy a 10-year bond with a 0.3% coupon at par, even if the yield falls to 0.01%, the bond is only worth 102.90 (omitting any change in the duration). But if the yield rises to 1%, the bond price falls to 93.37, and at 2%, it's only worth 84.73. So at some point, bonds at very low interest rates are no longer attractive, because potential capital losses could be huge, whereas any upside is limited and is largely based on the status quo remaining intact.

Coupon(Par=100) 0.01% YTM 1% YTM 2% YTM
0.3% 102.9 93.37 84.73
0.5% 104.9 95.26 86.53
0.7% 106.9 97.16 88.32
Click to enlarge

(Bond calculator here)

In a static environment, perhaps Japan could be stuck in perpetuity at low rates as has been the case for over a decade.

(click to enlarge)Click to enlarge

Source: Tradingeconomics.com 1995-present 10-year JGB yields

However, with the BoJ's new commitment to easing, deep uncertainties were created. Though I argued that the BoJ might not achieve its declared goals of 2% CPI and this may not even be its true intention, the uncertainty fostered by this move makes bonds look like a shaky investment. If nominal rates rise by only 1% (rather than the 2% goal) due to an increase in inflation, the losses could be massive (from 0.5% yield to 1.5% yield is a 9% mark-to-market loss). Even if nominal rates don't rise at all due to CPI increases, the perceived opportunity cost of holding JGBs has become higher. A Japanese financial institution could've made a decade's worth of Japanese fixed income yields if it had simply sold yen for dollars in November 2012. So some portfolio rebalancing and prudent loss aversion from expecting said rebalancing can drive yields higher with no increase in inflation.

The Day It All Changed

After Japan announced its new easing program, one data point stood out prominently. On April 5, 10-year JGB yields fell sharply to 0.3% but then rebounded even more to 0.6%. This was mind boggling as yields had been in a downtrend since the BoJ became more aggressive. Hyperinflation-is-coming proponents in the U.S. often claim that with the Fed expanding its balance into infinity, at some point, U.S. long-term rates will rise nonetheless because inflation expectations are higher. They have been disappointed for years, this appears to be actually happening in Japan.

From "Yes, We Can" to "Don't Panic, I've got the Ball"

Compared with the triumphant headlines after the G7 meeting ("G7 content with Japan's policies, finance minister says", "G-7 Tackles Bank Reform, Gives Japan the Green Light", "G7 to press on with bank reforms, Japan escapes censure"), the past few days have seen caution and perhaps a tinge of worry from Japanese policymakers.

May 10th: IMF's Shinohara: current yen level appropriate given Japan PM Abe's policies

May 11th: BOJ chief expects no spike in long-term Japan interest rates

May 14th: Japan economy minister says government, Bank of Japan to work for JGB market stability

May 15th: Japan PM Abe: Closely watching JGB market movements

May 15th: Yen may end fall around 105: Sakakibara(former Vice Minister of Finance)

There are a few other noteworthy Twitter blasts on the subject that don't appear to have a news article yet, but I think the picture is pretty clear. Higher JGB yields are causing some worry for Japanese officials (and probably the institutions owning said bonds).

Looking Ahead

Personally, I still stick to my 3-stage yen devaluation hypothesis. Currently, the yen is falling as domestic net outflows are increasing, the BoJ's resolve is accepted and international censure has been limited. However, too much too fast has created problems, including a stock market spiraling upwards, JGB yields moving sharply higher, and an increasingly irate German Finance Minister ("German FinMin stresses G20 pledge to avoid forex manipulation").

I maintain my call on the yen entering a period of consolidation (with an upward drift) as multiple forces push and tug it in different directions, while the next big move will come when U.S. interest rates start going upward. So initiating new short yen (NYSEARCA:FXY) positions now would probably be too late, and it would be best to wait for a while, though I would definitely not go long the yen with such a strong trend.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.