What a move in Japanese Government Bond yields over the last three days!  The chart below shows the yield on 10-year JGBs since the beginning of March, which had been holding steady around 0.60%, but just spiked up to 0.86%:

Here’s a longer (2-year) view of the same 10-year JGB yields.  Note we’ve blown through the 50, 100, and 200 day moving averages – next resistance at 1.00%?

A 26bps move in the last three days was a welcome sight for people short these JGBs (see here for investment vehicles to implement this), providing about a 2% gain.  The move, however, goes against Bank of Japan Governor Kuroda’s asset purchase goal of keeping the long end of the yield curve low (Japan’s version of quantitative easing).  Why such a large move up in yields if Japan’s central bank is buying substantial amounts of bonds?

Here are four possible explanations:

1.   Over the past year, the Japanese inflation rate has averaged about -0.3%.  That means a small amount of deflation, though the magnitude has been larger recently (-0.9% CPI for March).  If nominal yields are 0.6% (on 10-year JGBs) as they were recently, that means a real yield of 0.9% based on recent inflation values.*  The Japanese central bank recently announced an inflation target of 2%; combined with the 0.6% nominal yield, this produces an implied real yield of -1.4%, a very unappealing number.  For those investors focused on real yield,  the nominal yield will need to rise to make these bonds attractive.  See the chart below for real yields in Japan over the past 20 years (bottom left panel); they have rarely been negative.

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2.   Japanese equities have gone gangbusters this year, up 42% YTD.  This is partially in response to the devaluation of the yen, which has fallen from 80 to the dollar in November to 102 today.  Expectations are that Japanese corporations will be able to profit handsomely from the weaker yen, making equities much more appealing than JGBs with a negative real yield.

3.   The role of the JGB as a safe-haven asset may be compromised.  (As an example, JGB yields fell 20bps in the summer of 2011 as the European crisis flared up, and back in 2008 they fell 70bps during the global meltdown – both clear safe-haven indications.)  But a foreign investor now might not view the JGB as safe if losses will mount due to currency devaluation, or hedging the currency risk is viewed as too expensive.  Better to invest in a “safe” country that is not trying to depreciate its currency.  Some data to back this up:  Bloomberg reports that in March, overseas investors cut their JGB holdings by the largest amount in three years (no April data yet to show whether this divestiture has continued).

4.   On the same devaluation note, Japanese investors may want to diversify into overseas assets as the yen depreciates.  Below is a chart of the yen in dollar terms over the last 40 years.  It’s reasonable to think that the yen could depreciate another 20-30% from here and still be on the low side of the historical range.  I’ll be interested to see the flow of funds data for Japanese investors to verify whether this is the case.

Although this was a big move in a short time, and I expect volatility in JGB yields in both directions, I think the short JGB trade still has room to run.  Don’t forget that Japan’s government debt is 250% of GDP, the largest in the world.  This is a longer-term issue for the government, but sometimes longer-term issues get accelerated to the near-term by markets.

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*Note that we are mixing apples and oranges to some extent, since the JGB is a 10-year yield (long term) and the CPI is a recent short-term value.  Ideally, we’d like to calculate real yields based on longer term inflation expectations.  However, one could view Kuroda’s 2% inflation target as a longer-term expectation