With over 17,000 confirmed cases of COVID-19 (as of June 8th), the Japanese finance ministry have announced the planned issuance of Japanese government bonds (JGBs) to the value of Y253tn ($2.3tn) for the financial year ending in March 2021, an increase from the initial plan of Y153tn and the third increase since April. This comes after the Japanese government approved a second economic rescue package in May to the value of Y117tn ($1.1tn), which Prime Minister Shinzo Abe hailed as the world’s largest pandemic response package. Japan has fallen into recession for the first time since 2015, with GDP shrinking at an annual pace of 3.4% between the months of January, Febru
ary and March. Meanwhile, Japan’s long term borrowing costs have skyrocketed to levels not seen in over a year – partly due to the government wanting to create the right economic conditions for growth and recovery beyond the impact coronavirus, but largely due to investors speculating over the impact a large influx of JGBs will have on profitability and how the government will use it’s unique policy of Yield Curve Control to kickstart the economy and get the country out of recession.
Introduced in 2016 to fight the problem of persistent low inflation in Japan, the Bank of Japan is the only major central bank to have operated a policy of Yield Curve Control in recent history. Along with policies like quantitative easing, forward guidance and negative interest rates, the Bank of Japan has been successful in lifting the rate of inflation through pegging the yields of 10-year JGBs to around zero percent. To hit this target, the central bank commits to purchasing any bonds on sale at a price that is consistent with the targeted yield rate to increase demand and depress bond price (which has an inverse relationship with bond yield rate) e.g. if private investors are occasionally reluctant to pay a certain price, the Bank of Japan purchases additional bonds to ensure yield rates remain in the target range. With rates of short term JGBs comfortably around 0% in 2020 and Japan being plunged in to recession, steepening the yield curve is seen by many as the most effective way to stimulate the economy once again.
Steepening the yield curve
A steepening yield curve illustrates the spread between long term and short term interest rates widening and the price of long term bonds falling relative to short term bonds. Generally, a steep yield curve is found at the beginning of a period of economic expansion and is indicative of rising inflation expectations (and in the future the raising of interest rates). This is as if investors expect inflation to rise in the near future, demand will fall for long term bonds as their value will be eroded by inflationary pressures. Instead, investors flock to the security of more short term bonds which provide the re-assurance that if interest rates are raised by the government to combat surplus to desirable levels of inflation, there maturity period will have passed and they will be able to purchase new and more profitable bonds at this higher rate of interest. The fear of being ‘locked in’ to owning long term bonds that will offer a lower yield if inflation expectations prove correct causes demand to fall and the curve to steepen. Although investors reducing their purchase of government bonds may appear detrimental to their effort of raising capital to fund new stimulus packages, sustainably steepening the yield curve can be of high benefit to a government. This is as when the yield curve is steep, banks are able to borrow money at a lower interest rate and lend at a higher interest rate, boosting their profitability and increasing the availability of credit in the economy, helping to boost aggregate demand and usher in a period of economic revival often caused by a flattening yield curve.
Situation in Japan
The speculation over how yield curve control will be used when the new JGBs are issued is one of the factors driving the gradient of the curve upwards. With the knowledge of Japan’s economic circumstance and the benefits of steepening the yield curve in alleviating Japan’s ecomomic position, investors are holding off purchasing long term bonds in the hope that they will be more profitable in the coming future than they are currently. There is also speculation over how the Bank of Japan will adapt their purchasing of JGBs in line with the increased issuance and whether there will be a supply gut in the market that drives prices down further. So far in 2020, the central bank has increased its purchasing habits of short and medium-tern bonds to help combat the potential impact a vast increase in supply could have on yield rates. However, its purchasing of bonds with a maturity over 10 years has largely remained the same. If similar policy is continued during the release of new bonds, investors would be right in anticipating bond prices to plummet and thus would be foolish for purchasing them now. Investors are also likely seeking a greater incentive to purchase bonds now if the economy is to undergo economic growth and subsequent rising inflation.
Are investors right to speculate about the central bank’s behaviour like this? Its behaviour up to now in its increased purchase of short-dated bonds certainly has sent strong signals to the market that they intend to steepen the yield curve. Akio Kato, the general manager of strategic research and investment at Mitsubishi UFJ Kokusai Asset Management Co said ‘The Bank of Japan has made it clear and the market understands that the central bank wants to steepen the yield curve’, ’any signal of increasing purchases in super-long maturities could be taken as a major policy shift and hence the Bank of Japan would want to be very careful about that’. By ensuring a steeper curve, fears of bank profitability being crushed by negative interest rates and a flattening curve are somewhat quashed. Other institutions that are dependent on the spread between short term and long term interest rates being substantial enough to remain profitable such as insurance firms, pension fund managers and private savers are also provided some reassurance. Through the manipulation of the yield curve, the Bank of Japan is apparently looking to re-energise domestic credit channels to stimulate the economy by giving lenders more incentive to make loans.
Looking to the future
Some have argued that the yield curve could steepen even further than current speculation is anticipating. ‘The market might currently not be pricing in a further increase in supply should the current issuance plan underestimate the drop in tax revenue from weaker economic activity’ said Société Générale economist Takuji Aida. In rebuttal to this, Sayuri Shirai, a former Policy Board Member at the Bank of Japan, highlights how as the Bank of Japan has been purchasing a substantial amount of government bonds sinde 2013, excess demand in the bond market has been created which generates substantial downward pressure on government bond yields. As a result, when the new issuance of JGBs comes in to place, this could quickly be met with demand and halt a sharp steepening of the yield curve. What more, the bank of Japan operates a policy of monetary easing while maintaining persistently low inflation. This would suggest that a large fiscal stimulus through the Bank of Japan’s mass holdings of JGBs is unlikely to cause a sharp rise in yields.
I predict that the speculation in the market is correct and the central bank will refrain from purchasing a proportionate amount of newly issued JGBs to allow the yield curve to steepen in a bid to usher in a period of economic growth and get the Japanese economy out of their coronavirus-induced recession. However, there will come a point where the government will likely seek to ‘put the brakes on’ the economy if it is experiencing rapid expansion that is unsustainable. As banks become more incentivised to provide credit by greater profitably offered by a steep yield curve, this increased credit in the economy could cause inflation to rise above the Japanese targeted rate and lead to the government raising the interest rate. The yield curve then begins to flatten as the rate of return offered on short term JGBs rises. Furthermore, as inflation is being targeted by the government to fall, there is less need for investors to be offered a premium to purchase long-dated bonds as there is less of a threat of the erosion of its value that is usually caused by inflation. Therefore, my advice to investors is to purchase the new JGBs as close to Japan’s peak in this current economic cycle as possible. While long dated JGBs may offer the highest yield seen in years at the moment, once the impending stimulus package has been implemented and has delivered in bringing the economy back in to upcycle, investors should expect to see this yield fall and become less profitable relative to short-term JGBs as the Japanese government no longer sees it necessary to stimulate aggregate demand so rapidly.