Friday, May 31, 2013

Japan’s equity and bond markets: Shocking

by Economist

Volatile bond yields may spell trouble for Abenomics

IT IS the one thing that was not supposed to happen. On April 4th the Bank of Japan (BoJ) announced its shock-and-awe plan to hoover up ¥7 trillion ($68 billion) of government bonds a month and double the monetary base. But instead of producing rising bond prices and falling yields, the central bank’s actions have so far led to the opposite. On May 23rd the yield on ten-year Japanese government bonds touched 1%, three times higher than before the BoJ’s April announcement. And on the same day Japanese stocks plunged, with the Nikkei 225 index dropping by 7% (see chart). Could “Abenomics”, the economic-revival plan of Shinzo Abe, Japan’s prime minister, already be coming unstuck?

The most tangible success for Abenomics had been a soaring stockmarket: the Nikkei share index rose by 79% in the year to May 22nd. Although its fall since its peak reached 13% on May 30th, this partly reflects profit-taking. But the spike in bond yields is continuing to unnerve investors. In April Haruhiko Kuroda, the governor of the BoJ, had said the bank would encourage further falls in nominal interest rates. Given the rise in bond yields since, says Naka Matsuzawa, chief strategist at Nomura Securities, an investment bank, “you can say that the easing by the Bank of Japan has in one sense already failed.”

The nub of the problem is that the bank’s twin aims—generating inflation and bringing down yields—are somewhat contradictory. Holders of low-yielding government bonds who believe that the BoJ will achieve its inflation target of 2% in two years may respond by selling. Their sales over the past few weeks have pushed up nominal yields far more quickly than the BoJ expected. Higher inflation, which would bring down real rates, has not yet arrived. Pessimists therefore argue that borrowing costs are rising, posing a threat to any early economic recovery.

Optimists see things differently. First, they point out, bond yields may have simply returned to their recent trading range; at around 0.3% just before the BoJ’s April announcement they were unusually low, even for Japan. Second, the bank’s aim to generate inflation expectations seems to have succeeded (at least in the case of bond traders). And third, higher volatility in bond yields is to be expected after such a big intervention by the central bank.

Both Taro Aso, the finance minister, and Mr Abe last week called on the BoJ to reassure the bond market. Mr Kuroda has made some confusing statements. On May 22nd he said that the spike in rates would not affect the economy. But he also argued that the central bank does not have full control over long-term rates. After plunging stockmarkets compounded worries about bond-market volatility, Mr Kuroda pledged to do more to keep rates stable.

A particular fear is that higher volatility could provoke a repeat of the value-at-risk shock of 2003, when market-risk models spurred further selling once volatility triggers had been breached. The worst scenario is that bond-market volatility could focus attention on Japan’s public debt, which stands at nearly 250% of GDP. Owning so many government bonds, banks are heavily exposed to any rise in yields: an increase of only one percentage point would mean a loss of ¥10 trillion for Japan’s banks overall, according to J.P. Morgan.

“So far there is no connection between volatile bond yields and the fiscal position,” says an official at the finance ministry. Mr Kuroda reminded the government this week that it, too, has a role to play in reassuring bond investors—by pursuing fiscal consolidation. It soon has to decide whether to go ahead with a planned rise in the consumption tax in April 2014 to boost tax revenues. A package of structural reforms to boost long-term economic growth, the details of which will be announced soon, would also calm nerves.

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