Bonds: Is the Japanese Government Bond Market Efficient?

■ The correlation between the Japanese government bond market and overseas government bond markets such as the US and Germany is declining.  

■ The delayed normalization of Japan's monetary policy is one reason, but the economic fundamentals also play a role. 
 
Government bond yields are mainly determined by its own monetary policy, as well as economic fundamentals such as potential growth rate and expected inflation rate. However, due to the influence of global economic cycle factors and arbitrage arising from cross-border relative value transactions, in efficient markets such as those in developed countries, where all information is quickly reflected in prices, government bond yields usually exhibit a globally correlated trend. However, due to Japan's long-term implementation of unconventional monetary policies such as large-scale asset purchases and long-term low-interest-rate guidance (yield curve control, YCC), the correlation between its government bond yields and overseas markets has been broken. Even after the shift to monetary policy normalization, the correlation with US and German government bond yields has not been fully restored. One reason is that the Bank of Japan's significantly increased presence in the government bond market has led to a decrease in government bond market liquidity, making it difficult for international arbitrage transactions to function; at the same time, the proportion of overseas non-bank financial intermediaries (NBFIs) and other investment funds that aim to speculate on the decreased efficiency of the government bond market is also constantly expanding. 
 
Since the escalation of tensions in the Middle East at the end of February, the divergence between Japanese, US, and German government bond yields has become more pronounced. Whether it's the 2-year bond yield, which strongly reflects expectations for monetary policy over the next two years, or the 10-year bond yield, which primarily reflects long-term economic fundamentals such as potential growth rate and expected inflation, Japanese yields have begun to exhibit a different trend than those of the US and Germany. In the US and Germany, rising energy prices have led to higher expectations of further interest rate hikes, resulting in a significantly faster rise in 2-year bond yields; however, the pace of increase in Japanese 2-year bond yields remained largely unchanged through the end of February. In contrast, the increase in US and German 10-year bond yields has been less than that of 2-year yields, while Japanese 10-year bond yields have continued to rise at a much faster rate than 2-year yields, reaching levels higher than the upper limit of the Bank of Japan's estimated nominal natural interest rate (approximately 1.1%–2.5%) since the end of April. Therefore, in the US and Germany, the spread between 2-year and 10-year government bond yields has been narrowing; while in Japan, it has widened to its highest level since 2005, with the yield curve exhibiting a clear bear market steepening characteristic (rising yields and a widening curve slope). 
 
There is currently no unified explanation for the significant divergence between the 2-year and 10-year government bond yield spreads. This author believes it reflects the bond market's concerns about Japan's fiscal and monetary policies. The 2-year government bond yield indicates that even in the face of rising prices and a depreciating yen, the Bank of Japan will not significantly adjust its monetary policy; however, at the same time, its side effects are driving a larger increase in the 10-year government bond yield through channels such as a medium- to long-term increase in expected inflation and a widening term premium. The underlying reason lies in the government's "high-pressure economy" orientation reflected in fiscal expansion under a loose monetary environment. In other words, the Japanese government bond market may actually be effectively reflecting these factors in prices.