A mere $280 million in trading volume managed to push Japan's government bond market, with a total value of $7.2 trillion, to the brink of collapse.
On Tuesday, prices for Japan's benchmark ultra-long-term bonds plummeted. The total transaction value related to this sell-off was only $2.8 billion, yet it resulted in a $41 billion evaporation of value in the Japanese government bond market. This sharp decline also triggered significant volatility across global markets.
The selling pressure drove Japanese government bond yields to record highs, sparking fears of a "Truss moment" for Japan. U.S. Treasury Secretary Scott Bessent also sought assurances from Japanese officials regarding this extreme volatility, which he described as a "six-standard-deviation" event.
The severe disconnect between the massive market value wiped out and the actual trading volume underscores how this bond market, often plagued by insufficient liquidity, has become a weak link in the global financial system. Following years of market dominance by the Bank of Japan's massive bond-buying program, the fragility of the world's third-largest bond market is intensifying as the central bank gradually exits these purchases.
Shoki Omori, chief desk strategist at Mizuho Securities Co. in Tokyo, stated, "This is not a paradox. In a market with insufficient depth, constrained dealer balance sheets, and where prices are determined by marginal trades rather than volume-weighted averages, this is precisely the outcome you would expect."
Data from Japanese bond trading firms compiled by Bloomberg shows that on Tuesday, the trading volume for Japan's most-watched 30-year bonds was a mere $170 million, while the 40-year bond volume was just $110 million.
Although this volume was higher than in recent trading sessions, it was a drop in the bucket compared to the $41 billion trading volume of Japanese 10-year bond futures on the same day.
Japan's 30-year and 40-year bonds were the hardest hit in Tuesday's trading, with multiple market participants calling it the most chaotic trading session in recent memory. During the sell-off, yields on both bonds surged by more than 25 basis points, although trading subsequently stabilized.
This week, a Bloomberg index measuring the deviation of Japanese government bond yields from their theoretical values soared to a record high, a signal that pricing distortions in the JGB market are continuing to worsen.
A New Normal
Traders and analysts in Tokyo have yet to pinpoint the main driver of this sell-off, with speculation pointing to primary dealers, hedge funds, and domestic Japanese life insurance companies.
However, there is a broad consensus on the overall trigger: Japan is adapting to a high-inflation environment, which is pushing interest rates higher and shattering years of calm in the bond market. Plans by Japanese Prime Minister Sanae Takaichi to suspend the consumption tax on food and beverages, a move apparently aimed at garnering support for next month's snap election, have further exacerbated concerns about Japan's fiscal policy.
Investors are now being forced to adapt to a historic shift in the trading dynamics of Japanese government bonds.
Analysts at JPMorgan Chase & Co. wrote in a report this week that market depth indicators, which measure the impact of price volatility on trading volume, deteriorated significantly this week. This implies that even minor fund flows can have a massive impact on long-term bond prices, a stark contrast to the robust market depth seen in U.S. Treasury and German bund markets.
Data from the Japan Securities Dealers Association shows that foreign investors now account for approximately 65% of the monthly spot trading volume in Japanese government bonds, compared to just 12% in 2009. This market, once dominated by domestic life insurers, is increasingly being driven by investors with much shorter holding periods.
Stefan Angrick, a senior economist at Moody's Analytics, commented, "This is not a problem unique to Japan; similar issues are emerging in the United States. The U.S. Treasury market today is also increasingly dominated by buyers with holding periods far shorter than traditional investors, and this situation is likely to persist for some time."
The aforementioned data does not encompass the full trading volume of Japanese bonds on Tuesday. Furthermore, some trading occurs in so-called off-the-run bonds, but these typically have extremely low liquidity. Additionally, some investors use interest rate swaps to bet on the direction of rates.
Tuesday's sell-off in the Japanese bond market triggered a chain reaction: some hedge funds rushed to close out losing positions, life insurance companies were forced to sell bonds, and at least one corporate bond investor halted a multi-million dollar transaction.
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