Risk Update: December 2022 – Restoring Market Function

“If something cannot go on forever, it will stop.” Stein’s Law.

Herbert Stein has been proven prophetic, yet again, at least as it relates to the Bank of Japan’s (BOJ) commitment to holding their 10yr Government Bond (JGB) yields at 0.25%.

By now, most will be well aware that the BOJ announced at their December 20th, 2022, Policy Committee Meeting the widening of the intervention band around their YCC (Yield Curve Control) target of 0.00% for the 10yr JGB yield from +/- 0.25% to +/- 0.50%. For practical purposes, this raised the ceiling (ie. BOJ’s commitment to buy unlimited bonds) from 0.25% to 0.50%. This despite vociferously claiming that no such thing would happen and firmly sticking with their policy of JGB purchases, both in the form of Fixed Amount Rinbans and Fixed Rate Operations, right up through the morning of the announcement.

Indeed, in the month of December, through to the morning just prior to the announcement, the BOJ bought circa $76bn worth of JGBs across various maturity buckets, including nearly $7bn the morning of the Policy Meeting, after a whopping $22bn the day before. Shortly after the results of the respective morning Rinbans, including a 0.25% Fixed Rate Operation on the 10yr JGB, the BOJ came out with this simple announcement:

“10-year yield can move freely between -0.5% and +0.5%”

Figure 1: JGB 10y Yield (white), JPY 10y Swap Rate (blue), Old 10y YCC Ceiling (red-dashed), New 10y YCC Ceiling (green-dashed)

Source: Bloomberg

BOJ Governor Kuroda went to great (Orwellian) lengths in the statement https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2022/k221220a.pdf, as well as the post meeting press conference https://www.reuters.com/markets/rates-bonds/japan-set-keep-ultra-low-rates-doubts-over-yield-cap-grow-2022-12-19/, to assure markets that this move was not indicative of a change in policy.

“BOJ’s basic framework hasn’t changed at all.”

“Today’s adjustment not meant for an exit or to quit YCC.”

“This measure is not a rate hike”

“Today’s step is aimed at improving market functions, thereby helping enhance the effect of our monetary easing.”

“This change will enhance the sustainability of our monetary policy framework. It’s absolutely not a review that will lead to an abandonment of YCC or an exit from easy policy.”

The gist being, Governor Kuroda stressed that the whole point was to restore market function. Clearly, the widening of the YCC band, on its own, was not sufficient to restore market function. In the afternoon session the BOJ announced Fixed Rate Operations and included for the first time 2yr and 5yr bonds, along with 10yr bonds, as being eligible. They bought another circa $7.5bn of bonds that afternoon. They continued on such that they purchased a full $62bn worth of JGBs over the final days of December, to maintain market function, after their YCC band-widening. For those keeping score, that works out to circa $140bn for the month of December. Things that cannot go on forever…..

As we were quoted on the day in the eponymous and legendary market commentary, Grant’s Interest Rate Observer, “In what world did the central bankers get it into their head that this is their job?”

We devoted a chunk of our March 2022 Update, “The Most Dangerous Peg in the World” https://convex-strategies.com/2022/04/26/risk-update-march-2022/, to the coming challenges for the BOJ. If you want to understand what is happening in Japan, we strongly suggest you read (or reread) this note. Therein we noted as follows:

“We say that the BOJ’s peg of the JGB is the most dangerous peg in the world because nothing else has had both its level and its volatility so proactively suppressed for such a long time. Japan is the birthplace of the short-volatility embedded structured product world. It is the original, and still the most attractive funding leg of carry strategies. Moreover, it will be the last central bank providing endless freshly printed liabilities in the world, fuelling, right to the inevitable end, the propping of the sandpile ever higher. The sensitivity to a change in the long-established regime of total suppression, is difficult to fathom.”

We laid out our “holding-a-beach-ball-under-water” analogy in our September 2022 Update, “Is Sharpe World Closing” https://convex-strategies.com/2022/10/18/risk-update-september-2022-is-sharpe-world-closing/ (it is a broadly important read, if you have not yet had the chance). The above picture gives an excellent visualization of the path with which the beach-ball-holding dilemma is likely to be resolved. Again therein we noted:

“Think of the white line, the JGB 10yr yield, as a beach ball that the BOJ is trying to hold below an arbitrary line they have drawn on the rocks of Tokyo Bay. The JPY 10y Swap rate is the surface level of the water in Tokyo Bay. The levels of the USD 10y swap and the EUR 10y swap are indicative to the general rise of sea levels around the globe. Lastly, things like the USD/JPY exchange rate and Japan CPI changes are indicative of the transmission from the global seas persistent rising onto the level of water in Tokyo Bay. It gets harder and harder to hold the beach ball in the same place under the rising water. When one lets go of a beach ball held ever further under water, it does not merely float to the surface. We say again, the most dangerous peg in the world.”

We do, however, feel that the beach ball behaviour, on the back of the YCC widening, is likely to be but one early step along said path. If we broaden out and update some of our pictures from the March and September pieces, we get a better perspective.

Figure 2: JGB 10y Yield (white), JPY 10y Swap Rate (blue), USD 10y Swap Rate (orange), EUR 10y Swap Rate (purple), Old 10y YCC Ceiling (red-dashed), New 10y YCC Ceiling (green-dashed)

Source: Bloomberg

Figure 3: JGB 10y Yield (white), JPY 10y Swap Rate (blue), Japan Tokyo CPI yoy% (yellow), Old 10y YCC Ceiling (red-dashed), New 10y YCC Ceiling (green-dashed)

Source: Bloomberg

They have raised the line below which they are committed to holding the beach ball, but they haven’t solved the problem. Contrary to their long-delivered claims, it turns out that they just may not be totally immune to the rising levels of the global seas.

Figure 4: CPI yoy%: Japan Tokyo (white), US (orange), UK (yellow), ECB (purple)

Source: Bloomberg

Each and every one of their global central banking peers have one thing in common; once they admitted that they needed to make a policy response to the challenges posed by their price stability measures (aka inflation), they quickly realized that they were going to have to do a lot more than they likely had originally thought. It is hard to imagine that Japan will be any different.

Figure 5: JGB 10y Yield (white), Policy Rates: BOJ (blue), Fed (orange), BOE (yellow), ECB (purple)

Source: Bloomberg

Where it really stands out the most is probably with 2yr yields. You can see in Figure 6 below, across US/UK/Eurozone, it was just a year and a half ago when they had all converged at or below zero. The adjustment from there, once the realization of the need to remove the extreme accommodation kicked off, is eye-popping. It makes the BOJ’s addition of the 2yr JGB to their Fixed Rate Operations, since the widening of the 10yr band, where they stand ready to buy unlimited amounts at circa 3bp, look unbelievably generous. It is worth noting that, along with regularly including 2yr and 5yr JGBs in their Fixed Rate Operations, the BOJ also added a new 2yr Lending Facility, offering tranches of 0% lending to banks in chunks (thus far) of JPY1-2tn (we will touch on this a bit more later).

Figure 6: 2yr Interest Rate Swaps: JPY (white), USD (orange), EUR (purple), GBP (yellow)

Source: Bloomberg

Arguably, from our narrow perspective, the greatest fragility can be seen in the price of implied volatility in the JPY interest rate markets. Below are reproductions of charts we’ve shown over and over again, in this case the 1y10y normal implied swaption volatility for JPY, USD and EUR.

Figure 7: 1y10y Swaption Implied Vol: JPY (white), USD (orange), EUR (purple)

Source: Bloomberg

Looking at those again, but on a normalized basis, it really jumps out that the relative move in risk pricing for the JPY swaption market is already outsized, despite the fact that the interest rate, compared with the other two, has hardly even moved (yet).

Figure 8: 1y10y Swaption Implied Vol: JPY (white), USD (orange), EUR (purple). Normalized

Source: Bloomberg

In the words of Minsky “stability is destabilizing.”

We can cut a similar comparison, updating a view we showed back in the March ’22 Update, between JPY rate volatility and JPY FX volatility. Same story. USD/JPY has moved all over the place, from circa 115.00 back in March, up to multi-decade highs of 150.00 and now back down nearer 130.00. Meanwhile, the 10yr JGB yield was held at 0.25% since March and finally allowed to adjust to 0.50%, where it is still officially re-pegged. Clearly, the “fear” of potential moves (kurtosis, you might say) in the rates world has been a much bigger driver of implied volatility than has been the realization of volatility in the FX world. 

Figure 9: JPY 1y10y Swaption Implied Volatility (white) vs JPY FX 1yr Implied Volatility (blue). Normalized

Source: Bloomberg

Call us skeptical, but we think that there is more going on here than just a one-off tweak to the YCC-band, simply meant to restore market function. As most readers will be aware, Governor Kuroda is coming to the end of his current term in April of this year. Undoubtedly, behind the scenes, the decision as to who shall be his replacement is well advanced by this stage. We don’t have any particular insight, beyond general market speculation, who the next governor will be; Nakaso, Yamaguchi, Amamiya or somebody else? What we can speculate on is, if any of us were to be offered the job, we would certainly demand a house-cleaning before the transition took place.

Nakaso and Yamaguchi have both made public comments, over the years, about the “appropriateness” of such extreme policy measures as YCC and NIRP (Amamiya, what with still being the Deputy Governor on the job, would tend to keep his personal thoughts a bit more to himself). We would postulate that the December 20th YCC-band widening is very possibly the beginning of this process. If we are correct in this assumption, and it would seem we are not the only watchers with such an opinion, there very well may be further adjustments to, maybe even evacuations from, the most extreme policies of YCC and NIRP between now and the official end of Kuroda’s terms.

We stress the “official end” as we all remember the lame duck period of the previous governor’s term (Shirakawa) and how Kuroda, via Prime Minister Abe, basically orchestrated the abandoning of Shirakawa’s policy platform and the early transition to the BOJ’s leg of the new Abenomics stool. We wonder if, already, the successor-designate isn’t whispering into the ear of PM Kishida the instructions that are passing through to outgoing-Governor Kuroda. Regardless, it seems enough that the market is questioning the sustainability of the unsustainable. Put most simply, the more yen the BOJ prints to buy bonds, the less willingness the market has to own those bonds, necessitating ever more bond buying. Clearly a critical state scenario.

It was one thing to print yen to suppress yields when your stated battle was against measures of inflation that were too low. The market will let you get away with that. On the other hand, when you are printing money to suppress yields when your inflation measures are running away to the upside, you might find that the market thinks your money printing makes bond ownership increasingly less attractive. Ask the RBA. As we’ve asked more times than we can count; “What if it works?”

Why have we dubbed the JGB the most dangerous peg in the world?

  1. Unprecedented scale of explicit and implicit leverage built up after decades of suppression.
  2. Never before seen levels of Govt Debt as % of GDP, with sustained high levels of fiscal deficit spending.
  3. World’s largest net foreign creditor. Estimated at something like $3tn.

We have discussed Point 1 over various past notes, and in countless conversations. Just some quick visuals and comments on Point 2.

According to Wikipedia “as of September 2022, the Japanese public debt is estimated to be approximately US$9.2tn (JPY1.28 quadrillion), or 266% of GDP, and is the highest of any developed nation. 43.3% (our note: and growing!) of this debt is held by the Bank of Japan.”

We found this great little visual on a Refinitiv website. We can’t vouch for the precise accuracy, but it gets the point across.

Figure 10: Japan’s Dilemma. Lowest Rates. Largest Deficit. Enormous Debt/GDP

Source: https://lipperalpha.refinitiv.com/2022/12/news-in-charts-is-japans-debt-about-to-become-unsustainable/

The simple interpretation of the above picture is that Japan cannot tolerate higher interest rates (obviously the same can be said about many of the other bubbles, just not with the same severity). Yet, from all of our above analysis, Japan is going to get higher interest rates. The more BOJ tries to resist it, the worse it gets in the longer run, ie. Sandpile Theory. Bit of the old Catch 22.

This brings us around to our long running theme of “who is going to own the 40?” and are they going to “close the exit gates of Sharpe World?” How is Japan going to finance all of this debt, at manageable interest rate levels, when doing so with the BOJ’s printed money is no longer an option? We answer our own question about closing the gates of Sharpe World with the affirmative. The names that should not be spoken seem increasingly like inevitabilities: Financial Repression and Capital Controls.

Rest assured, we are not forecasting, just observing. We observe that the BOJ’s policies are unsustainable. Left to the market to determine, interest rates likely settle rather significantly higher than where they have been under the current monetary policy regime. Those levels of interest rates DO NOT WORK for a government with 266% Debt/GDP and an 8% of GDP annual fiscal deficit. Therefore, Financial Repression and Capital Control, at the very least, seem likely to enter the discussion.

What might that financial repression look like? We don’t know, but we might conjecture something that looks like a relative disincentive to hold other fixed income instruments in favour of your own sovereign debt. All are already quite familiar with this game, in the banking world the focal Sharpe World tool for relative incentivization of holding one asset versus another is commonly known as a Risk Weight Asset (RWA), as defined within the constructs of Basel III (there are, of course, its equivalents in the respective worlds of insurers, asset managers and pension funds). Give one class of assets slightly beneficial RWA treatment relative to another and the Sharpe World practitioners will, lemming-like, dutifully allocate (other people’s) capital as desired. Again, think mortgages in the US, or peripheral government debt in Europe.

The difference in this scenario is that it needs to be a domestic-specific incentive. Hypothetically, one could imagine Japan imposing a country specific guideline that, as is currently the case, JGBs on bank balance sheets are assigned a 0% RWA, but other OECD Sovereign Bonds shift from being 0% RWAs and are, now within the confines of Japan, assigned to be 10% RWAs (and the equivalent across the other regulated insurers, asset managers, pension funds).

This brings us to Point 3 above. There is some obvious logic for Japan to try to shift some of that $3tn of capital holding foreign assets back to the home-market. Or even to shift domestic capital away from non-government debt over to the public coffers. This conceivably could be some of the concern behind the sharp reversal in the USD/JPY FX rate. Is the FX market starting to wonder about who might have to step in for the BOJ as the marginal buyer of JGBs and where that capital might currently be parked?

Figure 11: Spot USD/JPY FX Rate

Source: Bloomberg

We don’t know. We are simply curious as to the implications of Japan joining the other side of the competition for ever more scarce funding. For the last many years, the shortage of appetite, after the Sharpe World practitioners were satiated, to hold government debt has been made up for by the central banks. The last fully active proponent of limitless QE, the BOJ, seems on the verge of pulling the plug. If, as we fear, this results in the need to arm-twist private sector participants to step into the breach and absorb these bonds, it might also mean those countries that have been the recipients of the Japanese largesse of foreign asset ownership might need to consider the implications on their own fixed income markets. One could imagine one country’s Financial Repression being met with retribution from another. And so on.

There is a great quote referenced in Edward Chancellor’s epic book, “The Price of Time”, attributed to John Maynard Keynes from 1933, as relates to Economic Nationalism: “let all goods be homespun, and above all, let finance be primarily national.”

This train of thought logically brings us to the Eurozone.

Turns out we aren’t alone in our thoughts about locking people/capital inside Sharpe World. Fellow Asian Crisis veteran, Russell Napier, gave this fantastic presentation that is available on YouTube.

He goes step by step through the ways in which he expects the Eurozone, in particular, to meander out of the Admin Office and start locking the exit gates. It is spectacular.

On the bright side, over at the ECB, Chief Economist Philip Lane and his team have finally done it! For the first time since September 2020, they have managed to hit, on the dot, their same quarter (Q4 2022) projection for the annual percent change for their HICP price stability measure. Well done! Maybe this finally is the year Mr. Lane’s DSDM (Draw a Straight-line Down Model) final comes into its own.

Figure 12: Eurozone HICP yoy% (blue) vs ECB quarterly forecasts through December 2022

Source: ECB website, Convex Strategies

Staying with Europe, last month we linked to, and showed some pictures from, a presentation given by ECB General Council member, Isabel Schnabel.


We thought it was worth highlighting a couple more of the pictures this month. Her slide on page 15 of the presentation shows various measures of inflation expectations. We want to particularly focus on the two charts in the right halves of the next two figures. The forecasts of the professionals was notably in the general shape of a Normal Distribution, particularly back in Q2 2022, and has since been shifting to something that is clearly right-tail skewed. The distribution of the expectations from consumers is diametrically different.

Figure 13: Eurozone Inflation Expectation. Professional Forecasters

Source: ECB Speeches of the Board Members.

Figure 14: Eurozone Inflation Expectations. Consumers

Source: ECB Speeches of the Board Members.

To make it even clearer, we have reconstructed her Consumer Expectations Survey chart, grouping together everything that is 0% or lower. Now we get the below, that looks nothing like a Normal Distribution. In fact, it looks a lot like our old friend, Shannon’s Entropy curve.

Figure 15: Eurozone Inflation Expectations. Consumers Regrouped

Source: ECB Speeches of the Board Members. Convex Strategies. Bloomberg.

We can’t help but wonder if this is an example of “skin in the game”. The professional forecasters are focused on probability of frequency, there is little impact on them if the actual outcome diverges from their simplistic estimates of likely frequencies. The consumers, on the other hand, are focused on risk management. Preparing for the ‘average’ future inflation is irrelevant. Preparing for the impact of an extreme outcome, in either direction, is where people’s heads are at. It seems a classic example of Nassim Taleb’s IYI (Intellectual Yet Idiot) vs Fat Tony or your grandmother.

If you overlaid those two charts on top of each other, they would look a bit like this!

Figure 16: Normal Distribution vs Shannon’s Entropy Curve

Source: Convex Strategies

We are very much in the same camp as the European consumers. We don’t know what is going to happen. We do know that magnitude matters more than frequency in a compounding path, so you are much better off preparing investment portfolios that are resilient in the wings. Just like the thinking of the European consumers.

Everybody is well aware that it was a, historically in some cases, tough year for traditional investment strategies. Below, we just whipped up on Bloomberg some easy to produce compounding lines of some common strategies that we reference regularly.

Figure 17: Compounding Paths: Put Protect Index (blue), Put Write Index (red), Risk Parity Index (purple), Bloomberg 60/40 Index (orange)

Source: Bloomberg

Then we made a quick grid of various performance measures and added in a couple of our sample ‘Barbell Portfolios’, the Always Good Weather (AGW) of 40/40/40 S&P/Nasdaq/LongVol (CBOE Eurekahedge Long Vol Index) and the Dream Portfolio consisting of 60/20/40 of S&P/Gold/LongVol. We generated numbers for 3yr, 5yr and 10yr time series.

Amazingly, we see a lot more ‘2023 Outlooks’ that are advocating “the recovery of 60/40” or the “opportunity to sell volatility” or the “benefits of capturing risk premium”, than we see advocates for adding convexity to your portfolio. Sharpe World is strong!

How do you imagine Sharpe World based investment strategies are going to work if the European consumer forecasts, and the equivalent all round the world, turn out to be correct, in one extreme or the other? As we point out over and over again, Sharpe World strategies, like Risk Parity,  underperformed consistently even when the economic and financial environment was as conducive as it could be, ie falling interest rates, low volatility, stable correlation, and central banks ever ready to trigger the key ingredient of negative bond-equity correlation right when you needed it. All that still wasn’t enough to make it an attractive investment strategy versus something with some convexity embedded in it.

Figure 18: AGW 40/40/40 (blue) vs Risk Parity 10vol (red) – Compounding View

Source: Convex Strategies, Bloomberg

As ever, we ask, where does the ‘cost’ of the Long Vol bother you? As we say, negative carry is no more a ‘cost’ than positive carry is a ‘revenue’. The former allows for the benefit of taking on non-recourse leverage, while the latter earns a fixed fee for providing somebody else with the benefit of non-recourse leverage. As regards the latter, we could not be more confident that earning a ‘carry’ to forego the upside, while accepting the downside, of investment risk, is no way to compound capital. The relative convexity of the scattergram and return distribution skew make it clear where the superior compounding is coming from.

Figure 19: AGW 40/40/40 (blue) vs Risk Parity 10vol (red) – Scattergram and Return Distribution

Source: Convex Strategies, Bloomberg

Will the BOJ lose control of interest rates in Japan and trigger a shockwave through uncapitalized tail-risks lurking in the canopy of derivative risk in that market? We don’t know, but strikes us, through our observations, that they have a heck of a tricky minefield to navigate at the moment. If the Japan bond market blows up, will there have to be a Financial Repression type solution to sustain the government’s ability to fund themselves. Again, we don’t know, but some basic math sure makes us wonder. Could such a circumstance trigger issues in foreign markets where Japanese investors are major providers of capital? We don’t know! Is the potential dislocation of the Japanese bond/rate market of a scale that it could have the sort of contagion impact that Thailand did in 1997, or Lehman in 2008. We think the answer to that one is obvious.

Finally, we will use one more quote from Mr. Chancellor’s book (as usual, Bill White best describes our thoughts on this book with his back cover quote – “I wish the Price of Time were the book that I had written”). In a piece written in 2014 by the BIS’ Claudio Borio, in reference to where the culmination of the extreme manipulations of central bank policies would lead, he wrote then as follows:

“…..triggering an epoch-defining seismic rupture in policy regimes, back to an era of trade and financial protectionism and, possibly, stagnation combined with inflation.”

And we thought we were foresightful in describing what was to come in Japan…….

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