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Foreign players' bets on BOJ tightening lift yen interest rates in London

[TOKYO] Expectations that the Bank of Japan may tighten policy and steepen the yield curve sooner rather than later are lifting long-dated Japanese interest rates in London, but not at home.

The divergence in yen interest rates between London and Tokyo reflects perception gaps between Japanese and foreign players on the likelihood of a BOJ policy change in coming months, market players said.

"Foreign players appear to think that as central banks wind back stimulus globally, the BOJ too will at some time point lift its bond yield target," said Yusuke Ikawa, Japan strategist at BNP Paribas.

"On the other hand, many Japanese players are cool to the idea. They think any BOJ policy change will depend on inflation and they see no momentum there."

The product in question is yen interest rate swaps. Under the swaps, traders exchange cashflows from a floating interest rate, such as six-month LIBOR (London Interbank offered rate), with those from a fixed "swap" rate.

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They are one of the most common financial derivatives widely used by investors to hedge or speculate on future interest rate moves.

But yen swap rates now have different price tags in Tokyo and London, with the market effectively split between Japanese in Tokyo and foreigners in London, based on which clearing house they use.

Japanese players use a domestic clearing house, Japan Securities Clearing Corp (JSCC), while most foreign players use London-based LCH, and there are few participants who trade in both markets.

The so-called clearing spreads, the gap between rates at which swap transactions are traded and settled in London-based LCH and in Tokyo, have widened in recent weeks, reflecting rising expectations of a BOJ policy tightening among some foreign players.

The spread in the 10-year rate has widened to 4.375 basis points from around 0.75 basis points in late June.

In recent weeks, BOJ officials have dropped some hints that it could tweak its policy.

Many investors think the BOJ could eventually lift its 10-year bond yield target, currently around zero per cent, by 25 basis points.

Still, the domestic bond market has hardly reacted, partly because the BOJ's massive buying is making shorting JGBs a risky bet for traders. That also helped to cap JSCC-cleared yen swap rates.

Most Tokyo market players expect the BOJ to stand pat through the first half of 2018.


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