Big Japanese banks have made a splash in the domestic government bond market, becoming one of the major sources of interest rate volatility since late last year by taking sizable bets on the market's direction.
Banks have pumped up trading activity to secure profits ahead of the end of the current business year in March, and are likely to feed market volatility in the months ahead to buttress weak earnings hurt by the credit crisis and tepid lending.
Japanese bank trading in yen bonds surged to nearly 30 percent of all transactions in November, the highest monthly share since 2005, and stayed near that high level in December, Japan Securities Dealers Association data shows. The bulk of yen bonds tracked by JSDA are government bonds, or JGBs.
"Lending by big banks is decreasing, and that may have caused them to expand their activities in securities trading," said Katsutoshi Inadome, a fixed income strategist at Mitsubishi UFJ Securities.
Japan's three biggest banks have so far reported $4.7 billion in losses from investments linked to US subprime mortgages, much less than their overseas rivals. But as the deterioration in credit markets takes a toll on earnings prospects, more will likely capitalise on trading in government bonds for profit. Sumitomo Mitsui Financial Group, Japan's third-largest bank, said last month the bank was able to offset much of a 99 billion yen ($915 million) loss related to subprime-related investments with profits from bond trading in the current business year ending in March.
"We are repeatedly selling and buying bonds to earn capital gains," said a senior dealer at another big Japanese bank. Japanese banks have tightened risk management compared with the past when banks held massive bond holdings to profit from a buy-and-hold strategy.
When the Bank of Japan kept short-term interest rates pinned at virtually zero, the banks could borrow funds from the central bank for almost nothing and buy JGBs with small, but positive, yields.
"Given the limited risks allowed these days, we rely on more short-term dealings. We act more like hedge funds rather than institutional investors," the dealer added. The banks had steadily cut back their JGB holdings to prepare for Bank of Japan interest rate increases, and foreign investors became the main the driver of JGB market swings. Foreign players topped both big Japanese banks and trust banks to post the biggest share of turnover after the BOJ scrapped its super-loose policy and raised rates from zero in 2006. Until mid-2007, foreign banks and players maintained their high presence.
MAKING WAVES, VOLATILITY UP: But Japanese banks have flocked back to government bonds as expectations increasingly dim for a BOJ rate hike after the credit market crisis erupted in August, analysts said.
The biggest Japanese banks are Mitsubishi UFJ Financial Group, Mizuho Financial Group, Sumitomo Mitsui and Resona Holdings. The impact from bank trading has been made waves in JGBs.
JSDA data showed big banks bought net 1.8 trillion yen ($16.6 billion) of yen bonds in November, their biggest net purchase since June 2004, indicating that the banks had made a drastic shift from their pre-BOJ hike strategy to cut bond holdings.
But they turned to sell a net 2 trillion yen of them in December, suggesting they sold back most of the bonds bought the previous month when the prices were lifted when the BOJ downgraded its assessment of the economy for the first time in three years and dampened expectations for a rate hike.
Analysts said the banks had probably resumed aggressive JGB buying in January when the two-year yield sank below the BOJ's policy rate target of 0.5 percent as expectations mounted for a rate cut after a plunge in the Tokyo share market.
The yield on two-year notes had jumped 13 basis points in two weeks after it hit a two-year low of 0.485 percent last month, another sign that the banks might have again reversed their positions.
Akihiko Yokoyama, chief strategist at J.P. Morgan Securities, said the high volatility in JGBs stems from the volatility in US Treasuries, depending on developments in the US supbrime mortgage market and financial troubles.
For example, Yokohama said the daily move on the 10-year JGB yield has averaged as much as 3.9 basis points this month compared with 1.5 basis points before the credit crunch hit in August. Yokoyama also said any revived expectations for a BOJ rate cut would create more possibilities for big JGB price swings.
Bank bond dealers said the kitchen-cleaning for the fourth quarter results might have peaked by now, but they are likely to stick to the active trading style and buy time until uncertainty over credit market turmoil and a BOJ rate hike clears away. "It is very likely that we keep the trading style the same even after the new fiscal year starts from April," said the bank bond dealer.