Japanese bonds encounter coldness again: 10-year "no one cares," 5-year demand hits lowest since 2020

The Japanese bond auction has once again cooled, with increasing concerns about the Bank of Japan's tightening policy expectations and insufficient market liquidity.

This Wednesday, the demand for Japan's five-year government bond auction hit its lowest level since 2020, with the auction results pushing bond prices lower, and the five-year yield rising by 3 basis points to 1.07% at one point.

The bid-to-cover ratio for this auction was only 2.96 times, significantly lower than the previous auction's 3.54 times and the 12-month average of 3.74 times. The summary of opinions from the Bank of Japan's policy committee indicates that the central bank may raise interest rates again before the end of the year, which has weakened investors' interest in the current yield levels.

On Tuesday, according to data from institutional brokers, there were no trades for the benchmark 10-year government bonds throughout the day, marking the first occurrence of this since March 27, 2023. The overnight index swap has fully reflected the possibility of a 25 basis point rate hike by the Bank of Japan before April next year.

Weak Auction Demand Reflects Rate Hike Expectations, Liquidity Concerns Intensify

The poor performance of the five-year government bond auction is mainly due to investors' expectations of further tightening policies from the Bank of Japan.

Miki Den, a senior interest rate strategist at SMBC Nikko Securities, stated, "Considering the possibility of the Bank of Japan raising rates later this year, a yield level of 1% is not sufficient."

Technical indicators for this auction also showed insufficient demand. The tail difference (the gap between the average price and the minimum accepted price) was 0.03, up from 0.02 in last month's auction. The cutoff price was 99.71, lower than Bloomberg's survey estimate of 99.72.

Naoya Hasegawa, chief bond strategist at Okasan Securities, pointed out that while political uncertainty makes it difficult to predict when the central bank will next raise rates, once the situation becomes clearer, the environment will be more favorable for further tightening. Under these conditions, the current yield levels appear insufficient.

Additionally, a Bloomberg index measuring the deviation of intraday yields from fair value has surged significantly since early April, currently far exceeding the peak reached during the 2008 global financial crisis.

The five-year overnight index swap has risen relative to the yield of bonds of the same maturity, with the spread narrowing by half from a recent low of negative 13 basis points on August 1. This indicates that investors are using swaps to hedge bond positions against rising costs of the Bank of Japan's policy tightening.

Multiple Factors Pressuring Bond Market Outlook

Meanwhile, the increase in risk appetite brought about by the rising stock market may weaken demand for safe assets. The Japanese stock market has risen for the sixth consecutive day, with the Nikkei 225 index reaching a historic high on Tuesday.

Takuji Aida, chief economist at Credit Agricole, stated that the improvement in economic sentiment brought about by rising stock prices could be another influencing factor. He believes that rising interest rates, including ultra-long-term rates, will benefit Japan in completely overcoming structural deflation and recession Strategist Mary Nicola warned that Japanese government bonds will face new selling pressure. Inflation risks remain high, with the year-on-year increase in the Producer Price Index in July slightly exceeding expectations. The GDP data to be released later this week may exacerbate stagflation concerns.

In a global context, relatively moderate U.S. inflation data supports expectations for the Federal Reserve to cut interest rates next month, leading to a slight decline in U.S. short-term yields. This stands in stark contrast to expectations for interest rate hikes in Japan, further highlighting the trend of divergence in monetary policies between the two countries