Last week, the Bank of Japan (BOJ) announced a plan to increase monetary easing by boosting purchases of long term government bonds. As if taking its cues from the US Federal Reserve, the BOJ has now made it a very public policy of fighting deflation and attempting to boost consumer inflation to 1%. So BOJ, are you sure this is what you really want? What if the BOJ is successful and consumer inflation pushes to 1%? Won't this affect bond prices adversely?
The problem with the strategy set forth by the BOJ is that Japanese investors have had a never ending appetite for JGBs in part because of its net "real yield." Real yield is calculated by adding the current bond yields (10 year JGB is just under 1%) to the current deflation rate (roughly -2%) giving investors a positive real yield of 3%. As long as consumer prices and costs of living continue their downward deflationary spiral, a 1% yield on the 10 year may not seem so bad. What if the BOJ gets what it wants? Will Japanese investors be quite so keen on a 1% yield in a positive inflationary environment? This gives me a serious moment of pause. For a moment we will just ignore how horribly irresponsible and unsustainable it is for one agency of a government to assist in financing the bad policy of another.
Perhaps we should dig a little deeper here. Perhaps we should take this announcement for exactly what it is. This is the BOJ trying to tell the bond market that everything will be just fine. By all means, please keep lending your government money it cannot ever pay back. Please keep supporting policy whereby the Japanese government spends more than twice what it generates from tax revenue. The BOJ, the Japanese government, the citizens of Japan, the PM of Japan are all abundantly aware of the important fact that a small increase in bond yields is just not possible. A small increase in borrowing costs sends Japan into a debt crisis. The BOJ made this announcement this week in an attempt to weaken the yen and let the market know they intend on supporting the bond market till the bitter end. They can't afford for rates to rise so of course they are going to buy bonds. Is this anything that we did not already know? The bond market rallied on this news, right?
As a floor trader in Chicago, some of my best trading days have come from going with market action that appears to be 100% contrary to recent announcements. We should identify last week's price action in the Japanese Government Bond (JGB) market as potentially one of those moments. Should we have expected a large jump in JGB prices? Perhaps. Did the JGB market actually have a big jump? Well, not exactly. March JGB futures rallied on the news in Tuesday's trade, but the price did not take out highs we saw earlier in February or even prices seen in mid January. I am not confident enough to say that the market is about to reverse a 20+ year trend, but I am confident in saying that the price action does not match the news. Keep JGBs on your radar. Big things are coming
Disclosure: I am the owner of a CTA based in Chicago that seeks to profit from a long position in JGB puts for both myself and my clients.