Bank of Japan's yield targeting suppresses speculation in JGB futures

By Junko Fujita

TOKYO, Feb 7 (Reuters) - The Bank of Japan's aggressive market operations to defend its policy band for yields has not only sapped liquidity in the government bond market but also drastically limited scope for speculation in bond futures.

Years of bond buying by the BOJ under its yield-curve-control (YCC) policy have distorted the Japanese government bond (JGB) market by artificially suppressing parts of the curve and causing illiquidity as the BOJ's ownership of benchmark bonds has ballooned.

That illiquidity has affected the futures market, which banks and investors use not only to speculate on bonds but also to hedge their interest rate risks.

A surprise adjustment to BOJ policy in December was supposed to improve the operation of the market but hardly did so. In that move, the central bank widened the band in which 10-year yields could move a 50 basis points either side of zero from 25 basis points.

"The BOJ said it widened the upper end of the 10-year bond yield to correct the market function," said Kentaro Hatono, fund manager at Asset Management One. "But instead, to defend its 0.5% cap it destroyed the market function."

The move only heightened market speculation that the BOJ would further loosen or abandon its yield-control policy, forcing it to buy even more bonds to defend its new upper limit. (For more on how YCC works, see)

Traders say betting on such policy change through futures has now become prohibitively expensive.

They cannot profitably short-sell the nearest three-month futures contract, maturing in March, because the BOJ owns most of so-called cheapest-to-deliver bonds that the futures contract is pegged to. In April, the BOJ began buying unlimited amounts of 10-year bonds daily and then in June widened that policy to the cheapest-to-deliver bond, of seven years' duration.

By Jan. 31, the BOJ owned 103.1% of the 358th series of 10-year bonds that the March futures contract is tied to, Keisuke Tsuruta, a strategist at Mitsubishi UFJ Morgan Stanley Securities wrote in a note to clients.

In a typical transaction to bet on higher yields, traders would sell futures, wait for a fall in the futures price - which moves inversely to yields - then settle the contract at maturity by delivering physical bonds or futures.

As investors rushed to buy back the March futures, the price of that contract has risen sharply.

That has meant that speculators cannot even roll over their March short positions to June without paying heavily.

"We have to buy back March futures at an unreasonably high price, and sell June futures at an unreasonably low one," said Hatono. "With the spread this wide just for three months, returns from hedging are wiped out."

The spread between futures maturing in March and June stood at 1.30 yen on Monday, after widening to much as 2.34 yen on Jan. 23, the biggest gap since Sept. 1999. In early December it was 0.6 yen.

The central bank bought a record 23.69 trillion yen ($182 billion) of bonds in January through its outright purchase operations, the latest BOJ data shows. Because it also lends those JGBs to banks, and they sell bonds to other investors who then sell some back to the BOJ for cash, it ends up owning more than 100% of some bond issues.

(Reporting by Junko Fujita; Editing by Vidya Ranganathan and Bradley Perrett)