Extreme volatility in the Japanese government bond market could trigger a sell-off on a par with what happened throughout the third quarter of 2003, when local banks and foreign investors were forced to dump their JGB holdings after heightened volatility caused the assets to exceed internal value-at-risk (VaR) limits.
According to analysts at J. P Morgan, the threat of a so-called "VaR shock" highlights one of the unintended consequences of quantitative easing, and the situation could be exacerbated this time around. "The proliferation of risk parity investors and funds, which are strict value-at-risk investors and are heavily invested in bonds currently, is likely raising the sensitivity of bond markets to self-reinforced volatility-induced selling," said Nikolaos Panigirtzoglou, head of flows and liquidity for Europe at J. P Morgan, in a report.
Last month, Japan's central bank confirmed plans for a liquidity injection of at least 120 trillion yen (US $1.19trn) that is intended to boost inflation to 2% over the next two years. The result has been a surge in JGB volatility and rising yields on anticipation of widespread shift from fixed-income to equities.
"It's an example of the pro-cyclicality of markets. Those with mechanical VaR-based limits will increase positions as vol reduces, and cut positions as vol increases, just like in 2003," said Guillaume Amblard, global head of fixed-income trading at BNP Paribas.
"It creates a snowball effect and it's exacerbated by the fact that there are some big leveraged positions in JGBs." J. P Morgan analysts note that 60-day standard deviation of the daily changes in 10-year JGB yields has doubled to 4bp since the BoJ confirmed its monetary easing strategy on April 4 - the highest level since 2008.
Those levels remain some way from where the 2003 sell-off was triggered. At that time, 60-day standard deviation jumped from 2bp to more than 7bp between June and September as 10-year yields tripled from 0.56% to 1.58%.
However, the strength of the current equity bull market and corresponding pressure on JGBs could drive large shifts relatively quickly. Since the liquidity injection was confirmed in early April, 10-year yields jumped from 0.5% to hit a one-year high of 0.895% last Wednesday.
"We think that hitting 1% on the 10-year JGB will prove to be an important psychological level. There's still some way to go, but we wouldn't be surprised to [see a] test very soon. It's a very strong bear market that we're seeing," said Mathieu Gaveau, global head of IR options, solution and inflation trading at BNP Paribas.
Whether the situation now is directly comparable to 2003 is a matter of debate, especially bearing in mind the safety net provided by central bank intervention.
"It's difficult to see a rout in JGBs when you've got the biggest buyer in the world supporting the market," said a rates trader at one European house. The potential for a 2003-style catastrophe is also reduced because bank investors have had some time to prepare.
J. P Morgan's Panigirtzoglou believes that regional and co-operative (or shinkin) banks are the most vulnerable to rate increases as the maturity mismatch between assets and liabilities is currently running at all-time highs for such entities. Analysis shows that a 100bp yield curve shift results in a loss of seven trillion yen for regionals and co-operatives combined, which equates to 35% of Tier 1 capital.
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