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Analysis-Bond vigilantes and the BOJ are breaking Japan’s bond market

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© Reuters. FILE PHOTO: A Japan Yen note is seen in this illustration photo taken June 1, 2017. REUTERS/Thomas White/Illustration

By Tom Westbrook and Alun John

SINGAPORE/HONG KONG (Reuters) -Japan’s government bond market is being pushed to breaking point in a contest between foreign speculators and the Bank of Japan, creating challenges for loan pricing and bond sales and raising the prospect of government financing tangles down the track.

Extreme stress was evident on Wednesday, when the Bank of Japan (BOJ) spent more than 700 billion yen ($5.2 billion) buying bonds to defend its 10-year yield ceiling, only to see 10-year futures suffer their steepest plunge in almost a decade. [JP/]

Prices have since rebounded, but liquidity is low, the yield curve is kinked at the 10-year tenor – diminishing its relevance as a pricing benchmark – and market makers fret that futures could become an unreliable hedge against other market risks.

“If you lose the function of the futures market, that’s a huge problem for (JGB) auctions – you cannot really hedge your auctions … dealers will all go away,” said Naka Matsuzawa, a strategist at Nomura in Tokyo.

The long-somnolent market is suddenly creaking as speculators ramp up bets that the BOJ is going to adjust or abandon a de-facto cap of 0.25% on the 10-year yield.

Policymakers are under pressure since Japan is finally seeing the inflation that the ultra-easy settings were designed to achieve and as the yen tanks against almost every other currency as global central banks have been raising rates quickly.

“The BOJ doesn’t really have to do anything, it has cover for not doing so and nothing is going to force its hand,” said Ian Samson, a portfolio manager at Fidelity.

“But one pretty reasonable option is to start by widening the band to 0.5% as that helps take some heat out of the yen weakness and doesn’t give too much to the speculators.”

Samson said Fidelity opened some short bets on the 10-year government bond earlier in the week, figuring it was unlikely to rally much and could be dumped very hard if policy settings shift.

The BOJ concludes a two-day meeting on Friday with no changes expected but with government and other sources saying that further yen declines could prompt a response.

WILD WEDNESDAY

The trigger for Wednesday’s rollercoaster ride was the BOJ’s surprise buying at the seven-year tenor.

Market participants saw it as an attempt to squeeze out shortsellers from the futures market, since typically bonds with seven years to maturity are delivered to close futures contracts, and driving up their price was intended to force that trade.

But the opposite occurred. Shorts kept selling and spooked dealers dumped their holdings too, sending the 10-year futures price down two full points to 145.58. The contract has since recovered to 147.21.

“Now that the function of the futures is in question they needed to shut their positions right away,” Nomura’s Matsuzawa said of investors or dealers using futures as a hedge.

Wednesday’s turnover was the highest in a year, but the unusual moves have also highlighted the backdrop of a market that has long been declining in functionality as BOJ buying has swollen its holdings to more than 40% of the entire market.

Monthly turnover has steadily dropped from more than $4 trillion in 2013 to less than $3 trillion in March, according to data portal Asian Bonds Online. Yield curve controls also mean the market is losing its relevance as a benchmark for debt pricing and loans.

“If that isn’t working, that should be bad for the financial market as a whole,” said Deutsche Bank (ETR:DBKGn)’s Japan economist Kentaro Koyama.

“Lower functionality could lead to lower participants … from a long-term perspective it is challenging for stable public financing.”

The trend is unlikely to reverse unless the BOJ does, with downward pressure growing on the yen in the meantime.

“Without verbal intervention, expectations could become even more pessimistic,” said Joey Chew, a senior currency strategist at HSBC in Hong Kong in a note to clients.

“Ultimately, actual change to the yield differential is needed for a sustainable correction in dollar/yen, and that could come from changing market views about BOJ, the (Federal Reserve) or recession probability.”

($1 = 134.3000 yen)

Forex

The ‘Big Package’: How Russia was driven to default

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© Reuters. FILE PHOTO: European Commission President Ursula von der Leyen arrives for the European Union leaders summit, as EU’s leaders attempt to agree on Russian oil sanctions in response to Russia’s invasion of Ukraine, in Brussels, Belgium May 30, 2022. REUTERS

By Marc Jones

LONDON (Reuters) – Russia’s first major international debt default in over a century, which Washington said became a fact on Monday, follows months of co-ordinated Western sanctions that left Moscow with cash but no access to the international financial network.

Below is a summary of the key moments that have led up to this point.

THE “BIG PACKAGE”

At around 11.30 p.m. (2230 GMT) on Feb. 25, the day after Russian troops entered Ukraine, European Union’s experts in Brussels said a set of sanctions they had worked on for days, or the “Big Package” as they called it, was ready.

Just before midnight, the European Commission announced https://www.consilium.europa.eu/en/press/press-releases/2022/02/25/russia-s-military-aggression-against-ukraine-eu-imposes-sanctions-against-president-putin-and-foreign-minister-lavrov-and-adopts-wide-ranging-individual-and-economic-sanctions the measures.

While emergency Group of Seven and EU meetings earlier made clear a response was coming, the package named Vladimir Putin and his top diplomat Sergei Lavrov personally, and, as it later became clear, froze some $300 billion of the Russian central bank’s reserves.

“That was really the moment when we said, okay, well we’ve done it,” one European source told Reuters. “That was, I think, a very pivotal moment for a lot of people around a table.”

Graphic: EU’s Von der Leyen lays out Russia sanctions- https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrmloapm/Pasted%20image%201656346091349.png

SWIFT ACTION

Days later, on March 2, the EU struck again by banning seven Russian banks from SWIFT, an international financial messaging system crucial for cross-border transactions.

Booting Russian lenders from SWIFT had long been considered a ‘nuclear option,’ but the invasion put it on the table and when the EU decided to activate it, those at SWIFT headquarters just outside Brussels were ready.

The only question was how long they had to implement the move, “five days or five minutes?” another source said. In the end is was 10-12 days.

FIRST CUTS, BUT NOT THE DEEPEST

Credit rating agency, S&P Global (NYSE:SPGI), already stripped Moscow of its coveted investment grade rating on Feb. 26 and Russian bonds were slumping, but a heavier blow followed on March 15, when the EU told top credit agencies to stop rating Russian dept or risk losing their licenses to operate in the bloc.

“We were caught flat-footed, certainly we were not given any advanced warning,” one senior rating agency analyst said. “Basically the question was, does this mean we can’t rate Russia any more?” It turned out the answer was yes.

Graphic: Driven to default Driven to default- https://graphics.reuters.com/UKRAINE-CRISIS/RUSSIA-BONDS/mopanryzgva/chart.png

DEFAULT DEADLINE ONE

With so many hurdles being erected, expectations built that Russia would default on its first post-sanctions’ bond payments either on March 16, or a month later at the end of a 30-day “grace period.”

However, a special “waiver” in the U.S. sanctions granted by the Treasury’s Office of Foreign Assets Control allowed payments to go through.

UNINTENDED CONSEQUENCES

On April 8, a week before the EU ban on Russian ratings was due to come into force, S&P declared Russia in “selective default” after Moscow said it planned to make upcoming bond payments in roubles rather than dollars, their issue currency.

On May 3 though, shortly before the payment was due, the Kremlin U-turned and paid in dollars.

SHOCK TO THE SYSTEM

Days later, Russia had stumbled, though.

On May 11, sharp-eyed creditors spotted that Moscow had failed to add $1.9 million of extra interest that had built up on bonds that only got paid in their grace periods rather than on time. They contacted the clearing house Euroclear and then bond market equivalent of an insurance payment arbiter – the Credit Derivative Determinations Committee https://www.cdsdeterminationscommittees.org/cds/the-russian-federation which ruled that a “credit event” had happened.

The sum was too small to trigger default clauses in all of Russia’s international bonds, but it did mean some investors expected to receive default insurance payments.

But when the U.S. Treasury clarified on its website that buying Russian bonds on the open, or ‘secondary’ market, was banned, that credit default swap (CDS) insurance process had to be halted as it was no longer clear what to do with the bonds involved.

“It is a bit like if your house burns down and the insurance company turns around and claims it was the wrong kind of fire,” said Joe Delvaux, emerging markets distressed debt portfolio manager at Europe’s largest fund manager Amundi. “The reality is that these sanctions are a shock to the system.”

INTENDED CONSEQUENCES

The step that made Russia’s default unavoidable though was Washington’s May 24 decision to let the waiver that had allowed U.S. bondholders to receive Russia’s payments, expire.

A week later, the EU also sanctioned Russia’s domestic paying agent, its National Settlement Depository (NSD), which it had been using to make the payments.

Moscow has blamed the West for forcing an “artificial default”., with its finance minister Anton Siluanov calling the situation a “farce.”

However, veteran global policymakers involved in the process say they sanctions are unprecedented but fully justified.

“They were very significant actions that responded to the magnitude of the actions that Russia undertook,” Agustin Carstens, the head of the world’s central bank umbrella body, the Bank for International Settlements, said.

Graphic: Biden stresses power of U.S. sanctions- https://fingfx.thomsonreuters.com/gfx/mkt/zjvqkloyovx/Pasted%20image%201656321187075.png

(This story refiles to fixe typo in 1st paragraph).

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Forex

The “Big Package”: How Russia was driven to default

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© Reuters. FILE PHOTO: European Commission President Ursula von der Leyen arrives for the European Union leaders summit, as EU’s leaders attempt to agree on Russian oil sanctions in response to Russia’s invasion of Ukraine, in Brussels, Belgium May 30, 2022. REUTERS

By Marc Jones

LONDON (Reuters) – Russia’s first major international debt default in over a century, which Washington said became a fact on Monday, follows months of co-ordinated Western sanctions that left Moscow with cash but o access to the international financial network.

Below is a summary of the key moments that have led up to this point.

THE “BIG PACKAGE”

At around 11.30 p.m. (2230 GMT) on Feb. 25, the day after Russian troops entered Ukraine, European Union’s experts in Brussels said a set of sanctions they had worked on for days, or the “Big Package” as they called it, was ready.

Just before midnight, the European Commission announced https://www.consilium.europa.eu/en/press/press-releases/2022/02/25/russia-s-military-aggression-against-ukraine-eu-imposes-sanctions-against-president-putin-and-foreign-minister-lavrov-and-adopts-wide-ranging-individual-and-economic-sanctions the measures.

While emergency Group of Seven and EU meetings earlier made clear a response was coming, the package named Vladimir Putin and his to diplomat Sergey Lavrov personally, and, as it later became clear, froze some $300 billion of the Russian central bank’s reserves.

“That was really the moment when we said, okay, well we’ve done it,” one European source told Reuters. “That was, I think, a very pivotal moment for a lot of people around a table.”

EU’s Von der Leyen lays out Russia sanctions https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrmloapm/Pasted%20image%201656346091349.png

SWIFT ACTION

Days later, on March 2, the EU struck again https://www.consilium.europa.eu/en/press/press-releases/2022/03/02/russia-s-military-aggression-against-ukraine-eu-bans-certain-russian-banks-from-swift-system-and-introduces-further-restrictions by banning seven Russian banks from SWIFT, an international financial messaging system crucial for cross-border transactions.

Booting Russian lenders from SWIFT had long been considered a ‘nuclear option,’ but the invasion put it on the table and when the EU decided to activate it, those at SWIFT headquarters just outside Brussels were ready.

The only question was how long they had to implement the move, “five days or five minutes?” another source said. In the end is was 10-12 days.

FIRST CUTS, BUT NOT THE DEEPEST

Credit rating agency, S&P Global (NYSE:SPGI), already stripped Moscow of its coveted investment grade rating on Feb. 26 and Russian bonds were slumping, but a heavier blow followed on March 15, when the EU told top credit agencies to stop rating Russian dept or risk losing their licenses to operate in the bloc.

“We were caught flat-footed, certainly we were not given any advanced warning,” one senior rating agency analyst said. “Basically the question was, does this mean we can’t rate Russia any more?” It turned out the answer was yes.

Driven to default Driven to default https://graphics.reuters.com/UKRAINE-CRISIS/RUSSIA-BONDS/mopanryzgva/chart.png

DEFAULT DEADLINE ONE

With so many hurdles being erected, expectations built that Russia would default on its first post-sanctions’ bond payments either on March 16, or a month later at the end of a 30-day “grace period.”

However, a special “waiver” in the U.S. sanctions granted by the Treasury’s Office of Foreign Assets Control allowed payments to go through.

UNINTENDED CONSEQUENCES

On April 8, a week before EU ban on Russian ratings was due to come into force, S&P declared Russia in “selective default” after Moscow said it planned to make upcoming bond payments in roubles rather than dollars, their issue currency.

On May 3 though, shortly before the payment was due, the Kremlin U-turned and paid in dollars.

SHOCK TO THE SYSTEM

Days later, Russia had stumbled, though.

On May 11, sharp-eyed creditors spotted that Moscow had failed to add $1.9 million of extra interest that had built up on bonds that only got paid in their grace periods rather than on time. They contacted the clearing house Euroclear and then bond market equivalent of an insurance payment arbiter – the Credit Derivative Determinations Committee https://www.cdsdeterminationscommittees.org/cds/the-russian-federation which ruled that a “credit event” had happened.

The sum was too small to trigger default clauses in all of Russia’s international bonds, but it did mean some investors expected to receive default insurance payments.

But when the U.S. Treasury clarified on its website that buying Russian bonds on the open, or ‘secondary’ market, was banned, that CDS insurance process had to be halted as it was no longer clear what to do with the bonds involved.

“It is a bit like if your house burns down and the insurance company turns around and claims it was the wrong kind of fire,” said Joe Delvaux, emerging markets distressed debt portfolio manager at Europe’s largest fund manager Amundi. “The reality is that these sanctions are a shock to the system.”

INTENDED CONSEQUENCES

The step that made Russia’s default unavoidable though was Washington’s May 24 decision to let the waiver that had allowed U.S. bondholders receive Russia’s payments, expire.

A week later, the EU also sanctioned Russia’s domestic paying agent, its National Settlement Depository (NSD), which it had been using to make the payments.

Moscow has blamed the West for forcing an “artificial default”., with its finance minister Anton Siluanov calling the situation a “farce.”

However, veteran global policymakers involved in the process say they sanctions are unprecedented but fully justified.

“They were very significant actions that responded to the magnitude of the actions that Russia undertook,” Agustin Carstens, the head of the world’s central bank umbrella body, the Bank for International Settlements, said.

Biden stresses power of U.S. sanctions https://fingfx.thomsonreuters.com/gfx/mkt/zjvqkloyovx/Pasted%20image%201656321187075.png

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Forex

Dollar Edges Lower as Investors Weigh Powell Testimony

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© Reuters

By Scott Kanowsky  

Investing.com — The U.S. dollar slipped slightly on Friday, as investors remained cautious of the impact of tighter central bank policies around the world aimed at curbing soaring inflation.

As of 02:35 AM EST (0635 GMT), the U.S. dollar index – which tracks the greenback against a basket of six currencies – was marginally in the red, down 0.16% to 104.27. The index is trading below a two-decade peak of 105.79 reached on June 15 following a 75 basis point interest rate hike by the Federal Reserve.

The dollar is moving lower from that elevated level due to concerns that such aggressive monetary tightening may end up sparking a recession.

Fed Chair Jerome Powell warned in a testimony on Capitol Hill earlier this week that while it does not intend to cause a wider slowdown, “it’s certainly a possibility” despite his confidence that the U.S. economy will be able to withstand a sharp rise in borrowing costs. On Thursday, Powell added that the Fed has an “unconditional” commitment to fighting inflation.

The U.S. 10-year Treasury yield eased to 3.087% in the wake of Powell’s comments.

Meanwhile, GBP/USD remained firm, edging slightly higher by 0.05% to $1.22, following data on Friday that showed U.K. retail sales volumes declined by 0.5% in May, but were above analyst estimates.

Elsewhere, EUR/USD rose 0.19% to $1.05 ahead of statements from European Central Bank speakers later today and business confidence data in Germany.

USD/JPY was down 0.11% to trade at ¥134.79 after Japanese inflation came in above the Bank of Japan’s 2% target, casting some doubt on the bank’s loose monetary policy stance.

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