Why Japan's Kinky Yield Curve Matters for Investors

Sometimes central banks trade on their credibility, as when Mario Draghi promised to do whatever it takes to save the euro. His statement was so widely believed that the European Central Bank ended up having to spend nothing.

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Sometimes, central banks may act in ways that undermine their credibility. For example, the Bank of Japan.
The Japanese government set out in December to try to fix the distortions in its government bond market that were caused by its yield-curve control policy. It lifted the cap on the 10-year yield, allowing it to rise. However, this did not solve the problem and in some cases made it worse. The government ended up spending large amounts of money with no results, and ended up with tighter monetary policy than it wanted.

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The Bank of Japan's December policy move achieved two things that were not explicitly intended, but which are important to the rest of the world: it strengthened the yen and it moved fairly smoothly to higher interest rates, without causing a crisis. If and when the BOJ eventually bows to market pressure and allows bond yields to rise freely, the shock will be smaller as a result, reducing the risk of financial failures.

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Japanese yields matter for a few reasons - it's a large market, the cap has attracted foreign speculators, and Japan's savers will be tempted to sell their foreign assets and reinvest at home if domestic bonds become more attractive.

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The BOJ’s goal was to improve the bond market. The most apparent goal was to get rid of the kink in its yield curve, which is a graphical representation of bond yields from short- to long-term maturity (as seen in the chart). Because the BOJ only caps the 10-year yield, traders who were betting on higher rates were able to push up the eight- and nine-year yields to a much higher level than the 10-year, creating a kink that did not make sense economically. The BOJ (rightly) worried that this could affect the 10-year’s role as a benchmark and damage corporate bond issuance.

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The solution has failed, as predicted. The policy of giving a little by lifting the 10-year yield cap from 0.25% to 0.5% and throwing money at the problem by offering to buy bonds other than the benchmark 10-year has not worked. Overall bond buying will rise from 7.3 trillion yen a month, equivalent to $55 billion, to 9 trillion yen a month, but this has not kept yields down. Instead, they have risen across all maturities, and the problem remains.

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Two days before the BOJ acted, the eight- and nine-year yields were both 0.03 percentage points above the 10-year yield. This was a big difference on a yield that was then meant to be capped at 0.25%. The nine-year yield is now back in line, with a yield slightly below the 0.5% cap. However, the eight-year yield is still 0.03 points higher. This situation was far worse until the benchmark switched to a new issue a couple of days ago.

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Governor Haruhiko Kuroda is also working to fix other issues in the Japanese financial system that have arisen from the distorted yield curve. He is concerned about the large and oddly variable gaps in yield between the latest issue, known as the on-the-run bond, and older bonds with very similar maturity dates gaps which are even bigger now than before the change in policy. This problem not only applies to bonds that have just gone off-the-run, but also to far older bonds that now mature at the same date. Additionally, issues in the money market created by traders using swaps to bet on higher yields have continued.

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These distortions are not good for Japanese financial markets and its big corporate borrowers. However, for the rest of the world, they matter much less than the reduced threat of a blowup.

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The yen's extreme weakness posed a risk to global stability. Getting it back to reasonable levels helps avoid the sort of gigantic swings and financial collapses that accompanied the Swiss National Bank's ditching of its currency cap in 2015, when the Swiss franc leapt by a third. A slow path to higher yields rather than a sudden shock is easier to cope with.

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The credibility of the BOJ has been hit by this move. Few traders believe that the stated aim of the BOJ is to repair the yield curve. Instead, they think that the move was just easing the way to tighter policy after Mr. Kuroda leaves in April. Even if they did believe the BOJ, its new policy hasn’t worked so far. The choice between thinking the central bank’s statements are misleading and thinking it is a failure is not a happy one.