Despite repeated assurances that the Bank of Japan would do whatever monetarisms it could to calm the Japanese bond markets, the persistent stain of selling pressure has not abated, rather it has increased. While to this point it had been relatively benign in the most obvious correlations, the Nikkei has risen steadily throughout, for example, there have been signs of stress – including perhaps gold.

The intentions of the Bank of Japan have been absolutely clear, that it would do whatever it took to “create” inflation. However, it was equally clear about how it expected to achieve that goal – 2% in 2 years time. In other words, this was to be a gradual incline into a more functioning financial economy/real economy system.

In a very strict sense, Japan’s monetarist idea contains some consistent logic. Markets, including ZIRP-bound credit markets, can handle adjustments, even large adjustments. Going from near zero interest rates to something more “normal” is certainly possible and realistically achievable if allowed to correct naturally. If driven by intrinsic properties, rising interest rates can actually be beneficial.

The key to such a benign shift is the measured pace, thus the Bank of Japan’s plan to “add” inflation slowly over time. The Bank of Japan, indeed any central bank, aims to intervene without disruption. The bane of central banking is a disorderly shift.

That is what we have seen in the Japanese bond market since QE-steroids was put in place; disorder. It is not the nominal price of the bonds, nor the yields that are creating so much turmoil. The recent rise in the JGB 10-year, for example, has brought the yield back to where it was only thirteen months ago.

The means by which such selling has manifested, however, has been decidedly disorderly, particularly when compared to the buying spree of last year. Thus, volatility has risen dramatically.

But volatility is manifestly far more important in modern finance (as opposed to economics) than even nominal yields and prices. Volatility is the key to liquidity, or its opposite. The modern banking system is defined by mathematical measures of volatility as a starting point for everything from hedging to repos. Banks themselves define their own risks in terms of it. VaR(Value at Risk) is nothing more than a delta and gamma of volatility expectations.

But it is in the repo markets that volatility can become truly sinister toward orderly transformations. Here again volatility is the fixing or anchoring of the price of collateralized lending. Haircuts are set and adjusted on the expected price changes of underlying collateral, thus a direct function of volatility expectations.

As a cash lender, your primary protection is the collateral against which you lend that cash. If such collateral is less prone to large swings in price, the haircut you apply is far less than if large changes in price are expected. The reason is simply that cash lenders need to quickly sell collateral in the event of a default; so to guard against volatile price changes, haircuts are tailored by volatility expectations as the prime risk management tool. But these are not static variables, haircuts, as we well know from the panic in 2008 which was largely a run on repo markets, adjust with volatility because cash lenders do not want to get stuck with a rapidly depreciating collateral asset.  In such a case, collateral loses its meaning by putting the lender at great risk.

Cash lenders will guard against rising volatility by increasing haircuts. That functions as a margin call on additional collateral. However, in many markets this margin call coming after a period of extended stability is drastic. Financial firms reduce their margin of safety due to persistently low VaR and other modeled measures of risk. Despite a heavy inventory of credit, firms are unable to easily meet margin calls because they have become overextended in their use of repo leverage and other collateralized funding techniques. That was the case in the structured finance market in 2007.

Repo markets in Japan have not developed and overtaken more traditional forms of liability management as they have in the US, UK and Europe, but they are estimated to be about ¥70 to ¥80 trillion ($1 trillion) in stock, with monthly volumes of about ¥300 to ¥600 trillion ($4 trillion to $8 trillion). So, Japanese repo is not unimportant. Indeed, at the margins of funding, repo changes can be crucial.

According the Japanese Bankers Association, 99.7% of all Japanese repo are conducted with Japanese government bonds as collateral. That makes sense since JGB’s are about the only sizable, liquid credit market in that country. But that means this flare of volatility in JGB is going to directly effect the entire repo market in Japan.

Almost all of Japanese repo is conducted via tri-party settlement with the Japan Government Bond Clearing Corporation.  However, haircuts and repo rates are not uniform across the platform. This bespoke nature leaves certain counterparties vulnerable to haircut changes or “shocks”. We know this indirectly through the Bankers Association determined stand against the Financial Stability Board’s plan to impose “minimum” haircuts on JGB and other repos in Japan:

“If the minimum haircut requirements are uniformly applied, and simply estimating its impact on liquidity by using the sovereign haircut for those with over 1 year and up to 5 years residual maturity of collateral (i.e. 2%) specified in the consultative document, the demand for additional collateral would amount to trillions of yen (or tens-of-billions of dollars), having a significant impact on liquidity. This level of impact cannot be accepted by core market participants in Japan, and therefore the uniform application of minimum haircuts should be avoided.” [emphasis added]

In the current context of haircut changes imposed on the system due to volatility, the end result is the same. The Japanese repo market is uniformly leveraged due to extremely low haircuts that are not consistent with recent volatility in JGB price. The reason is simply that the JGP market has rarely experienced volatility, and expectations have been uniformly consistent with only rising prices.

There is a peripheral issue as well here. The increasing purchases of JGB’s by the Bank of Japan, very much like the Fed’s QE in UST, removes marginal collateral from the repo system at exactly the moment where volatility may be increasing its demand. Given these factors Japanese and foreign holders of JGB’s may instead opt to lock in gains in JGB prices by outright selling to meet any haircut adjustments or margin calls instead of buying more JGBs. It may turn out to be the same snowball effect that took down the MBS market in the eurodollar space beginning in August 2007.

The end result is potentially the same with Japan QE as it has been under US QE.  This is very much like negative convexity in structured finance, where falling interest rates actually decrease the value of MBS. QE in credit markets, through the magic of repo machinations, actually depresses liquidity in opposition to its stated intent. Last night’s activity on that side of the Pacific may have been another hint of that.  If that is actually the case, the yield curve in Japan is in jeopardy – and so are many other connected markets.

 

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