Basis trade is back in Japan’s bond market as BOJ meeting nears

AN arbitrage trade that rattled Japan’s bond market last year looks to be back.

The spread between the prices on Japanese 10-year debt and similar-maturity futures has swelled in recent weeks, providing room for so-called basis trades that try to take advantage of the difference. The gap widened as the Bank of Japan (BOJ) bought bonds to support prices in an effort stave off growing wagers that its yield-curve-control policy will end as soon as its meeting this week.

“Some arbitrage trading seem to be going on that involves short positions on cash bonds and long positions on futures,” said Ataru Okumura, a rates strategist at SMBC Nikko Securities in Tokyo. “The very low amount of bonds left in the market and the increase in BOJ lending of the securities suggest arbitragers may be borrowing bonds” from the central bank to engage in basis trades, he said.

Back in June, a surge in basis trades led to a blowup in Japanese bond markets. The episode began with a small tweak to the BOJ’s debt-purchase plan, which triggered off an unwinding of arbitrage trading in which investors had gone short so-called cheapest-to-deliver 10-year bonds and long bond futures.

Record lending

Japan’s 10-year futures rose for the first time in five days on Monday (Jan 16), causing the spread with cash bond prices to narrow, indicating arbitrage trading was underway.

A further sign that basis trades are being put on can be seen in rising demand from investors for the BOJ’s debt-lending programme. The amount of government debt lent out by the central bank, possibly to short sellers, jumped 53 per cent on Monday to a record 7.95 trillion yen (S$82 billion).

The nation’s 10-year yield climbed as much as one basis point to 0.51 per cent on Monday, breaching the top of the BOJ’s targeted selling at 0.5 per cent for a second day. Ten-year bond futures finished the overnight session up 18 ticks at 144.82.

Japanese bond yields are coming under upward pressure amid speculation the BOJ will abandon its yield-curve control policy at its two-day meeting ending on Wednesday. The central bank’s decision to widen its trading band for 10-year bonds last month was meant to improve market functioning but has instead fuelled bets on further changes. This has required the BOJ to make even greater debt purchases, threatening to reduce liquidity even more.

“If a restoration of bond-market functioning was really the main reason for the BOJ’s policy tweak last month, the central bank would have to abolish yield-curve control this week,” Kazuhiko Sano, chief bond strategist at Tokai Tokyo Securities, wrote in a research note. “An end to yield-curve control would prompt the market to price in an end of the negative-rate policy and a few more rate hikes, threatening to push yields higher.”

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The BOJ purchased a combined 1.4 trillion yen of debt across maturities ranging from one year to 25 years on Monday and offered to buy an unlimited amount of two-year notes at a fixed yield of 0.03 per cent. These are on top of its daily offer to purchase unlimited quantities of 10-year bonds and futures-linked securities at 0.5 per cent. BLOOMBERG