Japanese bond market liquidity improves as BOJ loosens ties

(Bloomberg) - Trading in Japanese government bonds has increased since the Bank of Japan stopped controlling yields last month, and there's at least one indicator in the market that liquidity is returning.

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After years of asset purchases, the Bank of Japan owns more than half of the 1,097 trillion yen (about $7.2 trillion) of outstanding securities on the market. BOJ Governor Kazuo Ueda has said that debt purchases will be curtailed at some point, which is necessary as the central bank's own surveys have shown the need for more market participants and increased trading volumes.

There are indications that the average bid-ask spread for Treasury trading has narrowed to its narrowest level in at least six months, suggesting that a large number of traders are looking to buy and sell Treasuries.

"I expect the BOJ to gradually exit the bond market," said Ayako Sera, a Tokyo-based market strategist at Sumitomo Mitsui Trust Bank Ltd. She said, "But the Bank of Japan must improve market liquidity and avoid unnecessary confusion caused by drastic cuts in bond purchases.

Read: Bank of Japan's bond reserves to shrink for first time since 2008

Trading in overnight index swaps suggests that the Bank of Japan will raise its policy rate to 0.2% by the end of the year from the current zero to 0.1%. The prospect of rising bond yields may attract local investors who have been looking for higher returns abroad.

Trading volumes of Japanese government bonds are also on the rise, a further sign that the once moribund debt market is coming back to life.

A number of market indicators continue to point to concerns that market distortions will not be eliminated soon. These include Bloomberg's measure of the extent to which government bond yields deviate from modeled estimates, which has risen from December's lows.

A survey of bond market participants conducted by the Bank of Japan shows that their perception of market functioning (a proxy for liquidity) has improved from its trough in February 2023, but is still below zero, a level that indicates normal market functioning.

"Mitsubishi UFJ Morgan Stanley Securities Co." They argue that the BOJ has purchased too many bonds compared to the volume of issuance, which has hurt the market.

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