Japan’s massive bond market, valued at a staggering $9 trillion, is on the cusp of a significant disruption. The root cause lies in the Central Bank’s aggressive buying spree, which has led to a scarcity of paper. This shortage is expected to wreak havoc on the settlement of derivatives, crucial for investors and dealers who underwrite the nation’s debt sales.
Decades of battling deflation have driven the Bank of Japan to amass a colossal balance sheet, surpassing the country’s $4 trillion economy and dwarfing the US Federal Reserve’s holdings relative to GDP. This has artificially suppressed yields, rendering Japan’s bonds illiquid and unreliable as a benchmark for interest rates.
As the BOJ begins to normalize markets by paring back its balance sheet, the long-awaited revival of trading in the debt pool is proving to be a slow and bumpy ride. A critical test looms in December, when 10-year contracts will be linked to the government bond #366 tranche, a staggering 95% of which is owned by the BOJ.
Market participants warn that the scarcity of this bond in the open market will severely impede the buying of ‘cheapest-to-deliver’ bonds, essential for settling derivatives contracts at maturity. This could lead to a breakdown in the smooth functioning of the market, making it difficult for investors to hedge against rising rates.
The ripple effects will be far-reaching, affecting not only trade and speculation but also government bond auctions. Primary dealers, who bid at these auctions, rely heavily on futures to offset their exposure. With the BOJ embarking on a rate hike path, investors are scrambling to find the cheapest bonds to settle short positions in futures, making distortions in the derivatives market a major concern.
Experts caution that a shortage of these bonds will render hedging with futures ineffective, leading to a dysfunctional derivatives market. The situation is eerily reminiscent of the June 2022 distortion in JGB futures, which caught dealers off guard and resulted in some of the poorest auction results in over 30 years.
Unless the BOJ relaxes rules or the finance ministry reopens the tranche to sell more debt, the pressure on the market will persist. This fragility is a stark reminder of the adverse effects of the BOJ’s easy monetary policy, which is likely to cast a long shadow over Japan’s debt markets for years to come.
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