Japan rates: Weekly review

Markets continue to walk a tightrope between two contrasting scenarios: 1) the possible start of a JGB bear trend over an extremely long cycle; or 2) the potential for further BoJ easing in October. The risk of an abrupt swing is seen in sentiment and positioning toward one of these scenarios depending on data in the next one to two months. 

"We maintain our neutral stance direction-wise and continue to recommend a pay JPY 5yf5y swap + buy 20y JGB and a futures/20y flattener," notes Barclays. 

The JGB market has shown very little movement in the second half of this month, but yields have come down ever so slightly from their peak on 14 July. It appears that buying demand in anticipation of a summer rally during the quiet period following the 15 July BoJ MPM and Fed Chair Yellen's congressional testimony provided a slight downward push. 

That said, the weak result at BoJ buying operation on 29 July suggests there may be heavy selling demand with 10y JGB yield levels near 0.4%. That led to a modest correction. If data on exports to Asia and domestic consumption remain weak, the BoJ could still ease further in October on the prospect of two consecutive quarters of GDP contraction in Q2 and Q3. But if the market is not quite so pessimistic and the economy starts to turn up a bit, it would probably be difficult to expect a typical summer rally at a time when the US and UK appear poised to raise rates. 

The mild bull flattening trend in overseas yield curves appears to have reversed course following the FOMC meeting on Wednesday. This, particularly the flattening in the futures curve (low contango), suggests that market participants largely do not expect the decline in oil prices, seen as one factor behind the flattening, to give way to a sudden rebound as with January's oil downturn. The BoJ uses the Brent futures curve in its inflation forecast. That said, global bond market participants will remember all too well events in the first half of this year, when investors buying bonds on the assumption of a sustained downtrend in oil prices were badly burned when prices subsequently shot upward.