Steen Jakobsen
The Bank of Japan has abandoned quantitative easing and the European Central Bank may taper its bond-buying programme, so what is the role of central banks in 2017, asks Saxo Bank’s chief economist Steen Jakobsen.
Article / 03 August 2016 at 2:25 GMT

Japan bond selloff could be a sign of things to come

Managing Director / Technical Research Limited
New Zealand

  • Yen spikes, Japanese stocks set to fall after stimulus fails to excite markets
  • Japanese bond yields expected to open close to –0.5% vs –0.3% before
  • Rock bottom global yields mean a sharp correction could occur any time

By Max McKegg

The fiscal stimulus package announced by Japan’s Prime Minister Shinzo Abe yesterday matched expectations but didn’t beat them, and in this climate, that was enough to send the yen sharply higher. 

USDJPY is opening under 101 in the early Asian trading session today, with added impetus from a weak US dollar. Japan’s stock market had closed by the time details of the package were released but futures prices suggest it will open down about 1.5% in a couple of hours time. 


 Bond yields may be on a new trajectory, led by the Japanese. Photo: iStock

Perhaps the most significant action has been in the bond market. The yield on the 10-year Japanese Government Bond (JGB) was minus 0.30% before last Friday’s underwhelming policy easing by the Bank of Japan, but will open today closer to minus 0.5%. That represents a big change in price. 

max 1
Source: Bloomberg/Financial Times

The selloff in JGBs has had a global impact, with yield curves steepening in all the major bond markets. This is the flip side of the “convergence” trade that had become popular in recent months: investors chasing higher yielding markets, thereby narrowing spreads over the big three – the US, Germany and Japan. In most markets the term premium – the reward for taking the risk of buying long-dated securities – has virtually disappeared as a result.
Still, it’s early days yet: as this chart of the US 10-year Treasury yield shows (click to enlarge). 

Support held at record lows, but the move up is not yet convincing.

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 Source: Metastock

With global yields at rock bottom, a sharp correction could occur any time, especially if markets start to price in realignment of policy towards fiscal stimulus rather than further monetary easing. 

It would be appropriate if the Japanese kick-started that process, given they have gone further out on a limb than anyone else with monetary policy. However, for a global bond market sell-off to gain momentum it would have be fed by central bank tightening at the short end of the curve.
There’s little sign of that happening – in fact, some countries are still easing: the Reserve Bank of Australia cut its policy rate to 1.5% yesterday and its counterpart in New Zealand is sure to follow suit on August 11. 

The prime candidate to get the ball rolling with rate hikes is, of course, the US. But after last week’s low GDP number, yesterday’s flat personal consumption expenditure (PCE) inflation readings, and little chance of a game-changing jobs report this Friday, market pricing suggests only a 40% chance of a rate hike before Christmas. 

This is best illustrated by the federal funds futures chart below (Click to enlarge). The Federal Reserve doesn’t have a spot policy rate, rather a target range, currently 0.25%-0.50%. Usually the market settles each day close to the middle of the range, although recently fed funds have been trading slightly higher at 0.40%.

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 Source: Metastock. Create your own charts with SaxoTrader; click here to learn more.

Therefore, if the Fed makes no change to the target range this year, December fed futures will close out close to 99.60 (0.40%), as shown by the top line in the chart. 

If they are to hike by 25 basis points in December (an increase in the target range to 0.50%-0.75%) and the market traded in the middle as per usual, then the futures will close out close to 99.35, shown as the bottom line in the chart. 

Today the market is trading above the middle (dotted) line, suggesting a 60% chance the close-out in December will occur at today’s fed funds rate (and therefore a 40% chance of a rate hike) although the actual calculation is more complicated than that).
The spike above the top line occurred immediately after Brexit when US markets briefly priced in a rate cut by the Fed this year.
Asset class valuations across the board are being supported by historically low bond yields. Term premiums have evaporated, leaving yields susceptible to a knee-jerk reaction if there is any change in sentiment. 

Most think that could only happen if central banks tighten, but another trigger could come from a change in emphasis away from monetary policy in favour of fiscal stimulus. Japan may have been the first cab off the rank. 

– Edited by Caroline Shone

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
03 August
Patto Patto
I think you mean today's yield is -0.05%. Not -0.5%. Perhaps a typo..........As for a global bond sell-off, I can only see it driven by the US because the other Big Three markets (Japan and Germany) still have central bank support. However, there was a very sharp correction in bunds at one stage last year and we could see the same thing happening across the board.
03 August
Max McKegg Max McKegg
yes Obvious typo!


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