The Japanese Maginot Line

Could the Bank of Japan be the catalyst for the next stage of the Endgame?

The Bank of Japan is desperately trying to hold their defense against the odds. The cracks are forming in Kuroda’s Grand Strategy, and the consequences will be severe.

Here lies the Maginot Line.

A few short weeks ago, a seminal moment occurred in Japanese monetary policy. On July 28th, the Bank of Japan signaled the beginning of a gradual departure from years of extensive monetary stimulus. This move meant granting greater leeway for the country's interest rates to rise in accordance with rising inflation and economic growth- expanding the band of YCC which has been in place for over half a year. Rates on the 10yr JGB, which had been suppressed, were now allowed to rise to 1%.

As Weston Nakamura laid out in Market Depth-

 “The reaction from markets was intense, with the move causing chaos in FX and stock markets. The Yen was swinging up more than one percent plus then immediately gave up on those gains and found itself down over one percent. I'm not talking about like a knee-jerk algo move upon the first 60 seconds of the policy- I mean over like the entire PM session. How about in the equity market where at PM open the Nikkei index first pops upwards and then immediately plummets almost three percent down on the day to only then recover almost back to flat on the day…

Of course you know JGB yields spike on this but then you also see 10-year US treasury yields surge about four percent but then they pull back down into the three handle and back and forth. Again, this is all this it's a function of positioning, yes, but it's also very much a reflection of just pure confusion and directional disagreements and interpretations of the bank Japan policy that's whipping markets around directionally. That is what the Bank of Japan is aiming for with this.”

Soon after announcing the shift in policy that moved the cap on the 10yr up to 1%, the Bank announced an unscheduled bond buying operation to contain the volatility that ripped through their bond market. On Monday, July 30th, Japanese bonds experienced the worst daily drawdown in over 3 years.

A few days later, another unscheduled bond-buying operation was done to stem the yields that continued to rise, this time with the rate being pushed back down to 0.6%. As Nakamura describes, to maintain confusion (yes, confusion) among bond investors the Bank will not directly state when the rate is getting to the danger zone, but will machine gun fire the rate back down whenever they like- slamming the market back down with the AK-47 of the money printer.

Sometimes they intervene when the rate gets to 0.8%, and sometimes at 0.7%, but they never give an exact number as this would cause rates to teeter right on the edge of the line. Ideally, it appears that they want to keep it around 50bps, their previous cap.

The Bank had previously set the range between -0.5% and 0.5%, a move made last December. At the time, there was also an overabundance of positioning long JGBs, as traders did not expect bond prices to move out beyond the 10yr target yield of 0%. This move rocked bond markets and even incurred a massive margin call issued by the Japanese Securities Clearing Corporation (JSCC) that I tracked on Twitter.

Many traders were profiting from the so-called “Carry Trade”, an arbitrage where investors take advantage of differences between the relative interest rates between countries. By borrowing in Yen and buying USD assets or lending in USD, they can profit from the spread in rates, especially between Japan and the US as Japanese rates are historically low.

Essentially, Yield Curve Control, which is the policy that the BoJ has utilized under the direction of Kuroda, meant that the central bank would allow bond yields to trade in a tight range, specified by the bank and supposedly “not subject” to adjustments. The goal here is simple- control the moves of interest rates in secondary markets to suppress yields, to allow cheaper government borrowing, and an accommodative monetary policy stance.

This is necessary in the Upside Down of Japanese economics, with government debt to GDP reaching an eye-watering 263%, much higher than any other G7 country. Japan has always been at the forefront when it came to innovation in monetary policy. In fact, they were the first to undertake Quantitative Easing in March of 2001.