Japan’s $9 trillion bond market is facing potential disruptions due to a shortage of bonds caused by the central bank’s extensive purchases. The Bank of Japan’s massive buying spree has made it the majority owner of the country’s national debt, leading to a lack of liquidity in the market and an unappealing environment for investors. As the BoJ attempts to normalize markets by reducing its balance sheet, the slow and challenging process of reviving trading in the Japanese debt market is becoming evident.
As the BoJ reduces its balance sheet, a test is looming in the futures market as 10-year contracts will be linked to government bonds that are 95% owned by the central bank. This scarcity of bonds in the open market is expected to complicate the settlement of derivatives contracts crucial for trading smoothly and pricing accurately. The lack of availability of these bonds will make it difficult for investors to hedge risks against rising rates, affecting trade, speculation, and government bond auctions.
The dysfunction in the derivatives market is due to the scarcity of the cheapest-to-deliver bonds needed to settle futures contracts. Japanese government bond futures play a vital role in allowing participants to speculate on interest rate movements or offset exposures. Unlike stock futures, JGB futures sellers must physically deliver bonds at the end of a contract, leading to challenges with the availability of specific bonds required for settlement.
The scarcity of the cheapest-to-deliver bonds is reminiscent of a previous distortion in JGB futures when a surprise BoJ intervention disrupted the market. The central bank’s ownership of over 95% of specific tranches leaves futures sellers scrambling to find these bonds or opt for more expensive alternatives. The situation highlights the fragility of the market and reflects the adverse effects of the BoJ’s easy monetary policy, causing challenges for large JGB traders and impacting the overall bond market.
The likelihood of the shortage of bonds persisting next year due to the BoJ’s ownership of subsequent tranches indicates a bearish outlook for bonds and delays in the normalcy of Japan’s debt markets. The process of normalizing the market, which has been ongoing for about two years, may take an extended timeframe to reach its full potential. Overall, the slow and bumpy process of transitioning towards market normalization in Japan’s bond market reflects the long-term impacts of the BoJ’s previous policies and the challenges faced in reviving trading and liquidity.
