After Nikkei futures rose as high as 13,225 earlier (up 6.3% from Thursday's close), they have taken a sharp turn lower following the release of the minutes from the Bank of Japan's May 21-22 policy meeting.
Right now, the Nikkei is trading around 12,995, up *only* 4.4%.
Part of the minutes focuses on the volatility in the Japanese government bond (JGB) market that has spilled into equity and currency markets as well in recent weeks.
In early April, the Bank of Japan launched the largest central bank bond buying program ever (relative to the size of its economy).
The size of the bond purchases the Bank of Japan is making, combined with the infrequent and sporadic nature of the purchase schedule, has overwhelmed the JGB market.
"Although the BoJ's easing measures were aimed at absorbing duration and keeping yields stabilized at low levels, at this point, all they are doing is injecting volatility into the market ," said BofA Merrill Lynch interest rate strategists Shogo Fujita and Shuichi Ohsaki last month.
Here are the key paragraphs from the minutes:
Members next discussed developments in the bond market. They agreed that the recent rise in long-term interest rates in Japan was attributable to such factors as the increase in U.S. and European long-term interest rates, the rise in Japanese stock prices, and the further depreciation of the yen. A few members noted that, reflecting speculation that the Federal Reserve would reduce the pace of its asset purchases earlier than expected, the responsiveness of U.S. long-term interest rates to economic indicators was increasing, and therefore due attention should be paid to how these developments would affect Japan's long-term interest rates. On this basis, members shared the recognition that the Bank's massive JGB purchases, through the reduction in risk premia, were restraining upward pressure on interest rates that stemmed from an improvement in perceived business conditions and a pick-up in expected inflation rates. Some members added that the effects of compressing risk premia were likely to strengthen as the Bank proceeded with JGB purchases, and therefore it was difficult to expect a surge in long-term interest rates for the time being. Meanwhile, many members pointed out that, if the bond market remained highly volatile, this could increase the amount of interest rate risk incurred by banks and other financial institutions, thereby further boosting sales of JGBs. These members then expressed the opinion that it was appropriate for the Bank to make various operational adjustments, with a view to encouraging the stable formation of long-term interest rates by suppressing an increase in volatility and an excessive rise in interest rates. Some of these members added that, in deciding quantitative and qualitative monetary easing on April 4, the framework for the Bank's JGB purchases was designed to allow for flexible operations; for example, by allowing the average remaining maturity of its JGB purchases to be in the range of about six to eight years. Based on this discussion, members shared the view that, as for JGB purchases, it was important for the Bank to conduct operations flexibly to promote the permeation of policy effects by adjusting -- as necessary -- the parameters of its JGB purchases, such as frequency, pace, and allocation of purchase amounts by maturities, while continuing to carefully monitor developments in the bond market and maintaining a close dialogue with market participants.
With regard to the relationship between the government's fiscal conditions and long-term interest rates, one member noted that it was essential that fiscal discipline be firmly maintained with a view to ensuring stability in the bond market. In relation to this point, a different member said that it was also important for the Bank to continue to explain thoroughly that its JGB purchases were not conducted for the purpose of financing the fiscal deficit.
Meanwhile, some members pointed out that the recent rise in long-term interest rates in Japan might be attributable to the possibility that the expected period for which short-term interest rates remained virtually zero would shorten to some extent, as the rise in stock prices and the depreciation of the yen progressed and positive developments in economic activity and prices came to be observed. One member added that it was not desirable to shorten the policy duration in a premature manner. A few members, including this member, expressed the view that it was vital for the Bank to firmly anchor short-term interest rates at low levels by clearly communicating that it was providing the monetary base on a large scale through various short-term funds-supplying operations, in addition to JGB purchases. A different member noted that the Bank's communication regarding the timing at which the price stability target would be achieved and the time frame for continuing quantitative and qualitative monetary easing might be destabilizing expectations for the bond market, and this in turn seemed to be increasing volatility. This member continued that, if the Bank were to change the expression representing its commitment by stating that the time frame for continuing quantitative and qualitative monetary easing should be restricted to about two years, and that thereafter it would review the monetary easing measures in a flexible manner, this would contribute to the restoration of stability in the bond market.
Fujita and Ohsaki delved into why the BoJ's new bond purchase program was wreaking such havoc in May (emphasis added):
The problems with its purchases are that (1) the large amounts have taken away market liquidity, (2) they have been surrounded with uncertainty because no schedule of operations has been announced, and (3) they are not frequent enough.
A regime of monetary easing large enough to control the market has made the secondary market dysfunctional. The market has changed from being a platform for managing portfolios to being a mechanism for managing JGB inventory in the interim between the MOF's auctions and the BOJ's buying operations. Such an inventory management mechanism cannot function without knowledge of the specific schedule of operations as well as the amounts to be bought in each maturity sector (i.e., of each product type). Now that there is no assurance of liquidity in the secondary market, no institution wants to engage in the inventory management business without knowing the timing and amount of the operations. The hedge market is also becoming less functional, and liquidity in the swap and JGB futures markets is declining. Of course, shifting toward not holding positions is the best inventory management hedge of all.
Morgan Stanley MUFG's Le Ngoc Nhan and Miho Ohashi described it similarly.
"While bond dealers normally play an important part as market stabilizers via risk facilitating and efficient price discovering, they have been rendered increasingly irrelevant by the existence of a single big buyer (the central bank) and a single big seller (the Ministry of Finance), with uncertainty surrounding the timing of BOJ operations also impeding their risk-taking capacity," wrote the pair. "This increase in volatility has also triggered a vicious cycle in which VaR-driven selling by investors catalyzes further rises in JGB yields."
Clearly, it's got the Bank of Japan's attention.
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