Traders fret over ‘the curve’ as Japan upends world bond markets

Speculation that the Japanese central bank is about to undertake a shift in monetary policy is changing the shape of bond markets around the globe.
The difference between short- and long-term yields is widening globally on bets the Bank of Japan’s next monetary twist at its September 20-21 policy meeting will steepen the yield curve. Japan would achieve that by cutting its negative interest rate further, while simultaneously reducing purchases of long- term bonds, according to Morgan Stanley MUFG Securities Co in Tokyo, one of the nation’s 21 primary dealers.
Such moves have the potential to ripple across the globe by reversing this year’s collapse in Japan’s longest-dated yields, and the attendant flows of money from the world’s second-biggest bond market to the US and its juicier yields. A change in a leading central bank’s thinking also has the potential to influence investors and policy makers from other major economies. The shift is upending conventional wisdom in the Treasuries market, where the yield curve customarily flattens as the Federal Reserve raises interest rates.
“It’s contrary to everybody’s instincts,” said Yusuke Ito, senior investor in Tokyo at Mizuho Asset Management, which oversees $48.8bn. “Japan has been a front-runner of monetary policy. The Fed this time around is not that important.”
Traders have been speculating for days that BoJ Governor Haruhiko Kuroda will try to steepen Japan’s yield curve as a way to help the nation’s lenders and support the economy – even as he seeks to revive inflation that remains below the 2% goal brought in 3 1/2 years ago.
A steeper curve helps banks when they borrow for shorter terms and make long-maturity loans. It also provides savers greater returns for those willing to invest over several years.
A curve-steepening policy carries risks for bondholders. Investors facing negative yields on bonds due in a decade and less have spent 2016 gorging on long-term debt - the most volatile securities – as they seek income.
Now they’re left holding those bonds most vulnerable to a selloff just as analysts say the central bank is plotting a policy shift that will send prices down as yields rise.
In the US, the world’s biggest bond market, the spread between five- and 30-year yields widened to 130 basis points last week, or 1.3 percentage points, the most since June.
If the trend holds, it would break the usual pattern. The US curve has flattened in each of the Fed’s five courses of rate increases taking place over almost four decades.
That’s because short-term yields climb as the central bank raises its benchmark. The policy can also curb economic growth and inflation, which would tend to bring longer-term yields down.
Traders see less than a 20% chance of a Fed rate move this week, and about a 50% likelihood by year-end, based on the assumption that the effective fed funds rate will trade at the middle of the new target range.
“The US Treasury curve is basically telling me they don’t expect a rate hike this week at all,” said Martin van Vliet, an interest-rate strategist at ING Group in Amsterdam. “If anything, we don’t get a rate hike in the next couple of months.”
A US retail sales report released on Thursday showed a bigger decline than projected, bolstering the view the Fed is on hold, said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.
“The weaker economic data may take a Fed rate hike off the table, and that’s being manifested in the curve steepening trend,” Rupkey said.
Japan’s yield curve measured from five to 30 years widened to the most since March this week. Forecasts for the BoJ to act helped drive a 30% rally in the Topix Banks Index from early July through early September.
“The BoJ is front and centre right now,” said John Gorman, the Tokyo-based head of non-yen rates trading for Asia and the Pacific at Nomura Holdings, a primary dealer in Japan and the US. “The BoJ is actually doing something, and because markets are so closely intertwined, it’s feeding through to other curves.”