BOJ Considers Reducing Bond Purchases Amid Market Volatility

Key Takeaway

• BOJ's potential reduction in bond purchases is causing volatility, with 10-year yields hitting 1.1% last month before retreating.
• The BOJ bought ¥4.5 trillion ($29 billion) of government bonds last month, the lowest since March 2013.
• Implied volatility for 10-year bond futures rose to 4.06%, above this year’s average of 3.60%, indicating market uncertainty.

BOJ Considers Reducing Bond Purchases

Investors are preparing for potential increases in yields and volatility in Japan’s sovereign bond market as the Bank of Japan (BOJ) contemplates reducing its substantial debt holdings. Last month, the BOJ purchased only ¥4.5 trillion ($29 billion) of government bonds, marking the lowest amount since March 2013, according to recently released data. A majority of BOJ watchers predict that the central bank will decide on June 14 to cut the amount of sovereign notes it buys. Sources familiar with the matter have indicated that such a shift is under consideration.

Benchmark 10-year yields have experienced significant fluctuations, reaching as high as 1.1% last month, a level not seen since 2011, before retreating to about half of that gain. The spread between overnight-indexed swaps used for hedging and 10-year notes has narrowed to its smallest margin since 2022, reflecting concerns about reduced BOJ debt buying. Implied volatility on debt futures has risen above this year’s average.

“With the current volatile market, the BOJ is unlikely to give a strong forward guidance so that they can keep policy flexibility,” said Shoki Omori, chief desk strategist at Mizuho Securities Co. in Tokyo. “Investors will continue to expect further bond-buying cuts in the future, putting upward pressure on yields.”

Market Functioning and Investor Sentiment

The BOJ has accumulated more than half of the nation’s government debt, primarily due to its two decades of quantitative easing. The persistent weakness in the yen is adding pressure on the central bank to lift interest rates, a move that would likely support the Japanese currency. However, many analysts are revising their forecasts for when the BOJ will hike rates, pushing expectations further into the future. This comes at a time when the European Central Bank has cut rates, and other central banks are also considering similar actions.

Japan’s extensive easy-money policy has weakened many mechanisms that help investors price and trade bonds, as there was less need for these mechanisms when authorities were injecting cash into the market. Despite this, a BOJ survey showed that many Japan debt investors still feel the bond market isn’t functioning properly in areas like pricing debt and maintaining sufficient volume. However, the main gauge for the market’s functioning has been improving since May 2023, as the BOJ dismantled its yield-curve-control and negative-interest-rate policy.

Volatility and Policy Changes

Swings in debt prices are becoming more severe as the BOJ weighs further policy changes. This is highlighted by the 4.06% implied volatility for 10-year bond futures on Friday, which is higher than this year’s average of 3.60%. The BOJ cut back on bond buying at one of its regular operations for the first time this year on May 13. Although the bank still kept purchases within its planned range and hasn’t reduced buying at other recent operations, the move fueled speculation that the BOJ may officially decrease monthly purchases from the current ¥6 trillion. Monthly bond buying has already slowed sharply from a record ¥23.7 trillion in January 2023.

“If they change the amount now and heighten volatility, it will be difficult for the bank to raise interest rates to normalize policy,” said Takashi Fujiwara, chief fund manager at the fixed-income department at Resona Asset Management Co.

Currency market players are paying attention to changes in the amount of bond purchases, while rates market players are closely watching which maturity bonds will see reduced buying, said Hideo Shimomura, senior portfolio manager at Fivestar Asset Management Co. “A decrease in the buying of long-end securities will put further upward pressure on their yields,” he said.

Street Views

• Shoki Omori, Mizuho Securities Co. (Neutral on Japan's bond market):

  "With the current volatile market, the BOJ is unlikely to give a strong forward guidance so that they can keep policy flexibility. Investors will continue to expect further bond-buying cuts in the future, putting upward pressure on yields."

• Takashi Fujiwara, Resona Asset Management Co. (Cautiously Optimistic on BOJ's policy normalization):

  "If they change the amount now and heighten volatility, it will be difficult for the bank to raise interest rates to normalize policy."

• Hideo Shimomura, Fivestar Asset Management Co. (Bearish on long-end securities in Japan):

  "A decrease in the buying of long-end securities will put further upward pressure on their yields."