Last week’s BoJ meeting did not meet expectations of trying to soothe the Japanese bond market.  Yields have shot up, with 10y yields 50% higher in May as of this morning, largely a consequence of the BoJ succeeding in raising inflation expectations.  However, of more consequence in the short term is the sharp rise in bond volatility.

Banks are the single largest holder of JGBs in Japan.  Interest rate sensitivity has remained the same for the major banks, but has increased for Regional and Shinkin banks (bottom chart).  A 100bp parallel rise in rates would create losses of about 10% of tier 1 capital for the major banks.  However, the figure for the regional and shinkin banks is much higher, at 30-40%.

This is due to QE, which has lowered yields, increasing portfolio sensitivity to yield in its own right, and has caused mainly the non-major banks to increase their bond-portfolio duration to try to eke out a higher return (in a “reach for yield”).  It is the Regional and Shinkin banks, rather than the majors, that tend to perfunctorily sell positions when volatility rises.  This can be self-reinforcing.

One of the channels through which conventional QE works is using the commercial banks’ balance sheets as a positive lever, with central bank reserves serving to encourage the creation of loans.  Japan risks anti-QE, where the banks are forced to push the lever the other way, contracting their loan books as falling JGBs destroy their capital ratios (please click on graphics for larger view).

img1

img2

Source: BoJ