london jpy rates markets 091109

- G:\JEWS\Presentations - 11/6/2009 7:39:15 PM

Christian Carrillo [email protected] +81-(0)3-5549-5626 1

The Japan Fixed Income Market

Instruments, Key Players and Dynamics

09 November 2009

Christian Carrillo

Senior Rates Strategist, Asia-Pacific



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JGB Background Information

44%

15%

7%

20%

5%

8% 1%

Depositary Corps

GPF

Hholds

Lifers

Pensions

Foreigners

Others

-1000

-500

0

500

1000

1500

Jun 99 Jun 01 Jun 03 Jun 05 Jun 07 Jun 09

Government Households Depo Corps

Foreigners Corporates

JPY Tn

Ownership of JGB Market Japan’s Net Worth

Key JGB Issues

Tenor 2y 5y 10y 20y 30y 40y 10y 15yBBG Identifier JN JS JB JL JX JU JGBi JF

Coupon Fixed, Nominal Fixed, Nominal Fixed, Nominal Fixed, Nominal Fixed, Nominal Fixed, Nominal Fixed, RealFloating, Nominal

Yield convention Simple Yield Simple Yield Simple Yield Simple Yield Simple Yield Simple Yield Simple Yield N/A

Settlement, daycountT+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365T+3 Tokyo,

NL/365Issuance Monthly Monthly Monthly Monthly Quarterly Quarterly Varies VariesTrading Volume (JPY Tn) 3.5 3 9 0.7 0.5 0.1 0.5 1Outstanding (JPY Tn) 51.9 139.4 285.0 94.2 19.6 1.3 7.1 41.2Remarks Linked to non-

seasonally adjusted Japan CPI (ex-fresh foods.) Redemptions are not floored at par.

Coupon reset every 6M to most recent JB auction - alpha. Coupon is floored at zero. Price quotation.

Typical transaction size if JPY 5-10bn. Bonds are re-opened if they have the right maturity and a par coupon, otherwise a new one is issued. Final issue size depends on yield movements between first and last auction. Price competitive method for all bonds expect 40y and linker for which Dutch yield auction is used. All results announced at 12:45pm (Tokyo). Interest on book-entry transfer JGBs held by nonresident individuals or foreign corporations will be exempt from income tax.

The JPY Fixed

income market is very

domestic. We need to

know about JGBs

Source: BoJ and SG Fixed Income Research



JGB Issuance/Absorption Dynamics

JGB Issuance (JPY Bn)Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Total

1 1,900 1,900 1,900 2,300 2,300 2,300 2,300 2,500 2,500 2,500 2,500 2,500 27,400 2 2,000 2,000 2,000 2,400 2,400 2,400 2,400 2,400 2,600 2,600 2,600 2,600 28,400 5 2,000 2,000 2,000 2,300 2,300 2,300 2,300 2,400 2,400 2,400 2,400 2,400 27,200

10 1,900 1,900 1,900 2,100 2,100 2,100 2,100 2,100 2,200 2,200 2,200 2,200 25,000 20 900 900 900 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 12,600 30 500 - 500 - 600 - 600 - 600 - 600 - 3,400 40 - 200 - - 300 - - - 300 - 300 - 1,100

JGBi - - - - - - - 300 - - - - 300 Floater - - - - - 300 - - - - - - 300 Liquidity 300 300 300 600 600 600 600 600 600 600 600 600 6,300

7,600 7,300 7,600 8,500 9,400 8,800 9,100 8,900 9,800 8,900 9,800 8,900 132,000

Redemptions 1,512 1,622 9,409 1,629 1,646 10,502 1,594 1,552 10,382 1,700 1,631 12,397 55,575 Net Issue 6,088 5,678 1,809- 6,871 7,754 1,702- 7,506 7,348 582- 7,201 8,169 3,497- 49,025 BoJ/MoF 2,100 2,200 2,100 2,100 2,200 2,100 2,100 2,200 2,100 2,100 2,200 2,100 25,600 Market 3,988 3,478 3,909- 4,771 5,554 3,802- 5,406 5,148 2,682- 5,101 5,969 5,597- 23,425

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

Apr 09 Jun 09 Aug 09 Oct 09 Dec 09 Feb 10Net Issue 3M-MA

JPY bn

Japan’s Net Issuance and Seasonality

Even as headlines

focus on increasing

JGB issuance, non-

market support and

seasonality are critical

Source: BoJ, MoF and SG Fixed Income Research

Main Participants in the JGB Market

Banks, Lifers, GPF, BoJ and Foreigners



JGB Demand: Depositary Corporations

1-5Y

Banks44%

Lifers14%

Pension Funds20%

BoJ8%

Other14%

Banks

Lifers

Pension Funds

BoJ

Other

Short and mid-segments of the curve is where banks are most dominant. Depositary corporations own JPY 245tn worth of JGBs or about 21.3% of their deposit liabilities.

This JGB/Depo ratio was 10% in 2000 but has been stable around current levels since 2005. Deposits have continued growing as a result of Japan’s external surpluses and (relatively) high household savings rate.

Between 2000-05 increased JGB demand was merely offsetting a decline of private securities (Loans, corporate bonds, equities) in banks’ portfolios.

Yields between the 1y-5y segments of the curve only started rising after lending rose again in 2005. These dynamics have recently reversed owing to an economic recession.

The key variable too watch is cash available for securities investment (surplus liquidity.) This surplus is very cyclical so “natural” demand can vary from JPY -5 to +15tn per year.

JGB Ownership Short and Mid Sector

-

100200

300400

500600

700800

900


1020

1040

1060

1080

1100

1120

1140

1160

JGBs Private Securities Deposit Liabilities

LiabilitiesAssets

Depo Corp Assets and Liabilities (JPY Tn)

Source: BoJ, Bloomberg and SG Fixed Income Research



JGB Demand: Life Insurance

The Life insurance sector is dominant in the long and super-long segments of the curve. They own JPY 113tn worth of JGBs or about 45% of their insurance and pension reserves.

Lifers face two problems: being short-duration relative to requirements (12y-15y) and negative spreads owing to old fixed-return guarantees. Variable annuity exposure is small.

This mix means Lifers are constantly extending duration buying bonds and de-risking their portfolio. Target to buy 20y bonds or barbell of 10y and 30y is between 2.0-2.25%

Such a yield target is typically not enough to compensate for negative spreads but they are pushed in that direction by solvency rules set to be in place by 2011-12.

As those rules also encourage asset diversification, Lifers buy bonds opportunistically while shifting towards a greater JGB allocation. Natural demand for JGBs should be JPY 12tn per year given recent trends (see p. 29).

>10Y

Banks25%

Lifers40%

Pension Funds13%

BoJ7%

Other15%

Banks

Lifers

Pension Funds

BoJ

Other

0

20

40

60

80

100

120


215

220

225

230

235

240

245

250

255

260

JGBs Equities+Overseas Insurance/Pension Rsrvs

Assets Liabilties

JGB Ownership Super-Long Sector

Lifer Assets and Liabilities (JPYtn)




JGB Demand: GPF

0

20

40

60

80

100

120

140

Mar 04 Dec 04 Sep 05 Jun 06 Mar 07 Dec 07 Sep 08 Jun 09

Domestic Bonds Domestic Stocks

International Bonds International Stocks

ST Assets Total

JPY Tn

50%

55%

60%

65%

70%

75%

80%

Mar 04 Dec 04 Sep 05 Jun 06 Mar 07 Dec 07 Sep 08 Jun 09

Target Domestic Bonds/Assets

Allocation

Japan’s Government Pension Fund (GPF) is the largest single investor in Japan with JPY 121tn in assets. JPY 86.2tn are invested in domestic bonds (JGBs and Fiscal Investment Loan Program bonds.)

GPF is unusual in that its performance and (that of its external managers) is measured against the Nomura BPI. This means that it has a relatively low duration (7y) for a pension fund and provides an important bid to that sector.

GPF currently targets a domestic bond allocation of 67% +/- 8%. Currently we are close to the top of that allocation but this due mainly to a decline in equity portfolio valuations.

We do not expect GPF to have a larger allocation of JGBs but rather expand their holdings in line with growth of their liabilities and decline in FILP bond holdings. This limits potential demand to around JPY 5-10tn per year.

GPF investment holdings

GPF domestic bond allocation

Source: GPF and SG Fixed Income Research



JGB Demand: The Bank of Japan/MoF

0

20

40

60

80

100

120

Apr 98 Oct 00 Apr 03 Oct 05 Apr 08

JGBs Banknote

JPY Tn

40%

50%

60%

70%

80%

90%

Apr 98 Oct 00 Apr 03 Oct 05 Apr 08

JGB/Total

JGBs at BoJ vs banknotes issued The Bank of Japan is also another big holder of JGBs, JPY

71tn as of Oct-09 or about 64% of their liabilities.

The BoJ has always had a large proportion of JGBs in its balance sheet as this is how much of the issued money supply has been backed.

More recently purchases of JGBs have occurred as a support to the budgetary process through outright purchases of long-term JGBs. These were being phased-out since 2005 but were re-started in 2008 at JPY 2.1tn per month

The BoJ implemented the “bank-note rule” stating JGB holdings may not exceed banknotes issued as a notional limit. Such rule has not necessarily been held before.

In an emergency the BoJ could increase its net absorption of JGBs by about JPY 10tn in the short-term but would look to reverse this activity as soon as possible.

The Ministry of Finance also engages in pre-scheduled buybacks often supporting poorly received issues (JGBi, JF)

JGBs holdings as % of assets




JGB Demand: Foreigners

Another key participant - rather than sponsor - of the JGB market is the foreign sector. According to BoJ’s flow of funds foreigners hold about JPY 41tn worth of JGBs or about 15% of outstanding. True number is close to 7% as some represent foreigners in Japan using Japanese funds.

Steady foreign holders of JGBs would mainly include global asset managers either passive (tightly linked to a global benchmark) or active who historically kept a underweight in their JGB allocation. Most investments happens around 10y.

Data implies foreigners were close to neutral on JGBs than they had been in many years in 2008. It appears they are now back to being slightly underweight.

While the behaviour of major domestic JGB participants is well defined (banks’ surplus liquidity, GPF target allocation, Lifers target buying) that of foreigners is quite unpredictable.

A lot of volatility in JPY rates comes from shifts in foreigners’ (often ill informed) perceptions of Japan’s creditworthiness, BoJ policy expectations or simply crowded trades gone wrong.

5-10Y

Banks32%

Lifers24%

Pension Funds17%

BoJ4%

Other23%

Banks

Lifers

Pension Funds

BoJ

Other

-300

-250

-200

-150

-100

-50

0

50

100

150

200


JGBs Equities Net

JGB Ownership Long Sector

Foreign Investors Investment Position in Japan


Overview of Market Dynamics

Dynamics and Case Studies



A Long term look to the JGB market

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan 01 Apr 03 Jul 05 Oct 07 Jan 1010Y JGB 2Y_JGB 5Y_JGB20Y_JGB 30Y_JGB

Yield (%)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0 5 10 15 20 25 30 35 4011/3/09 4/27/06 6/12/03 Average

Yield

In spite of the deterioration of public finances seen over the last decade, JGB yields have been stable over this period. This is a puzzle to many observers.

There are strong stock and flow considerations that suggest during recessionary periods around JPY 30-40tn in net issuance can be absorbed by the market.

Peaks in JGB yields in recent years have all coincided with economic recoveries and, so far, failed exits from deflation.

Such recoveries led to a trinity of increased demand for loans, higher inflationary expectations and interest rate tightening. They all also happened amid fiscal consolidation.

Unsurprisingly, these meant that most of the action happened between 2y and 10y while super-long end rates have been on the whole unchanged.

A long(ish) history of JGB yields

Typical shapes of JGB curve

Source: Bloomberg and SG Fixed Income Research



The 10y JGB Futures

10y JGB Futures Inter-month JGB Spread Options on JGB Futures

Contract Standardized 6% 10-year JGBs 1st Nearest - 2nd Nearest 10y JGB Futures Call/put options on 10-year JGB futures

Contract Months Mar, Jun, Sep, Dec Mar, Jun, Sep, Dec 2 closest of Mar, Jun, Sep and Dec

Trading Unit JGBs with a face value of JPY 100mn 1 unit (1st component l 2nd component) 1 option to buy/sell 1 JGB futures contract

Minimum Fluctuation 0.01 point per 100 points (JPY 10k per contract) 0.01 point per 100 points (JPY 10k per contract) 0.01 point per 100 points (JPY 10k per contract)

Daily Price Limit +/- 2 points from previous settlement +/- 4 points from previous settlement +/- 2 points from previous settlement

Last Trading Day 7th business days prior to each delivery date Last business day of the 1st component Last business day prior of the month prior to the contract month

First Trading Day 1st business day following last trading day of previous contract month

Business day following the start of the second component

First business day of the 6th month prior to each respective contract month

Delivery Date 20th of each contract month N/A N/A

Deliverable Grade Interest bearing JGBs between 7y-11y remaining maturity as of the issue dated and delivery date

N/A N/A

Offsetting Must report transactions for offsetting which will be deducted from open long/shorts

N/A Must report transactions for offsetting which will be deducted from open long/shorts

Settlement Price Last sales price or, unavailable, last settlement price Same as each individual contract month TSE calculates daily theoretical prices for each option using market inputs with Black-Scholes.

Value Date T+1 T+1 T+1

Delivery Price Settlement price on last trading day N/A N/A

Settlement Method Delivery of JGBs Trading of underlying JGB futures Trading of underlying JGB futures

Trading Hours 9:00-11:00, 12:30-15:00, 15:30-18:00 9:00-11:00, 12:30-15:00, 15:30-18:00 9:00-11:00, 12:30-15:00, 15:30-18:00

Exercise Prices N/A N/A Start with 7 exercise prices but up to 11

Exercise Type N/A N/A American, All ITM options are exercised at expiration date

Expiration Date N/A N/A Later trading day

The 10-year JGB futures is the most important and active instrument for hedging and trading interest rate risk. A large proportion of foreign investors will only trade using this futures contract and its derivatives. There is trading in the JGB roll (inter-month JGB futures spread) and JGB futures’ options.

The main relative value measure the market would look at would be the implied spread to JPY IRS (the futures ASW.) Also the relative deviation of implied volatility compared to JPY IRS swaptions as well as the magnitude of the JGB roll relative to historical experience.

Source: TSE and SG Fixed Income Research



JPY Over-the Counter Interest Rate Derivatives Description

JPY Interest Rate Derivatives

JPY/JPY IRSUSD/JPY

CCS BasisJPY/JPY

3mx6m Basis JPY FRA JPY/Tonar Swaption Cap/Floor

Floating Rate

6m jpylibor 3m jpylibor/ usdlibor

n/a 3m/6m standard

mutan o/n rate

6m jpylibor 6m jpylibor

Floating Leg Basis act/360 act/360 act/360 act/360 act/365 act/360 act/360Quoted Leg fixed jpy side 3m + spread fixed fixed n/a n/aValue Date t+2 t+2 t+2 t+2 t+2 t+2 t+2Active Tenors up to 50yrs up to 50yrs up to 50yrs up to 2yrs up to 3yrs up to 50yrs up to 50yrsActive Expiries n/a n/a n/a n/a n/a up to 20yrs up to 20yrsTrading Size eur 35k eur 35k eur 35k eur 35k eur 35k eur 35k eur 35kTypical bid-offer 0.5bps 0.75bps 0.75bps 1bp 0.5bps 2bps 2bps

The most usual way of foreign access to the JPY rates market, other than JGB futures, is JPY/JPY IRS. This is one of the most liquid IRD contracts in the world and is easily accessible to most internationals investors.

There is active corporate issuance and investment hedging through the USD/JPY CCS basis as well as relative value trading around such hedging activity.



Typical Trades: 5y-7y-10y IRS

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

Dec 02 Jun 04 Dec 05 Jun 07 Dec 08

-20

-15

-10

-5

0

5

10

10y JGB 5y-7y-10y IRS

-20

-15

-10

-5

0

5

10

Dec02

Dec03

Dec04

Dec05

Dec06

Dec07

Dec08

0

20

40

60

80

100

5y-7y-10y IRS 5yfw d2y - 7yfw d3y (inv, right)

Why: This would be the alternative to being long/short futures for investors preferring IRS or needing a futures offset. It relates to the fact that under close to zero rates mid-sector butterfly spreads become highly directional.

How: Given the low level of JPY rates and design of the JGB futures contract, risk always falls on 7y. Thus the pay/receive the belly of a 5y-7y-10y IRS DV01 neutral butterfly is a natural hedge/offset to JGB futures positions.

Alternatives: A popular alternative among hedge funds seeking more volatility is to pay/receive the 5y2y-7y3y slope. The basic idea is the same only with about 4-times volatility on the quoted spread.

Risks: 5y-7y-10y IRS can de-correlate from direction which can happen if/when banks aggressively buy the 5y sector in case of sharp deflationary expectations.


5y-7y-10y a directional trade

5y2y-7y3y same idea, just more leveraged



Typical Trades: Short-Term Forward Steepener/Flattener

0.00

0.20

0.40

0.60

0.80

1.00

1.20

Dec 99 Sep 01 Jun 03 Mar 05 Dec 06 Sep 08

-10

0

10

20

30

40

50

60

70

80

6M JPY Libor 1y-3y

6M JPY Libor '1y-3y JPY IRS

-10

0

10

20

3040

50

60

70

80


1y Fw d 1y-3y 1y-3y

IRS Spread (bp)

Why: This is the classic bet on an exit from zero interest rates/deflation and is based on the observation that front-end IRS would steepen in anticipation of a BoJ rate normalization process. The attraction of this trade increases as forward starting dates are sometimes positive roll-down.

How: The idea is that the investor enters early enough (or the BoJ is late) so that most re-pricing occurs on the paid leg. Also this assumes banks would liquidate JGBs around 3y-5y sectors as rates move higher. Trade usually implemented as a 6m to 1y forward start 1y-3y IRS spread.

Alternatives: Can be implemented through outright or spreads on Euroyen futures contracts as well using OIS/Tonar swaps.

Risks: This trade has rarely been successful for long. This is partly because we have not observed a full normalization of short rates but also because the BoJ has been always an early hiker relative to macro conditions. As such long rates were stable and expected steepening never materialized.


Short-end forward steepeners a bet on BoJ exit



Typical Trades: Medium-Long Term Steepener/Flattener

1.00

1.20

1.40

1.60

1.80

2.00

Dec 02 Mar 04 Jun 05 Sep 06 Dec 07 Mar 09

40

60

80

100

120

140

160

180

10y JGB 5y-20y JGB

60

80

100

120

140

160

May05

Nov05

May06

Nov06

May07

Nov07

May08

Nov08

May09

85

90

95

100

5y-20y JGB JF34

5y-20y JGB Price

Why: Under close to zero-rates the directionality of slope spreads are very segmented. There is bull (bear) / flattening (steepening) in the short to mid sectors. However, the reverse is true between mid to super-long segments.

How: As the super-long end is perceived as more likely to price equilibrium rates/default risk while excess liquidity spreads through the 2y sector, the preferred trade is a 5y-20y JGB or IRS spread.

Alternatives: This view can be implemented as a 5y-10y-20y fly or outright received/paid position on 10y10y IRS. Also since much of volatility in 15y floaters relates to this segment, long JF positions are advised on a steepening view if the bond is theoretically cheap.

Risks: This trade has been relatively safe except with the exception when rapid withdrawals of exposure from banks on the 5y sector or de-risking of Lifer portfolios occurred. Positions expressed in 15y floaters can be riskier given their relative illiquidity as often MoF buybacks are the only available bid. Source: Bloomberg and SG Fixed Income Research

Medium-term slope is segmented from front-end

Medium-term slope is highly correlated to JF performance



Typical Trades: The JGB Inflation-Linked Bond

0.98

0.99

1.00

1.01

1.02

1.03

Dec04

Jun05

Dec05

Jun06

Dec06

Jun07

Dec07

Jun08

Dec08

Jun09

98

99

100

101

102

103

Index Ratio for JGBi1 CPI For JGB Linker

-400-350-300-250-200-150-100-50

050

100150

0.0 0.5 1.0 1.5 2.0 2.5

Post-Lehman Pre-Lehman Linear (Post-Lehman)

JGB1 Breakeven

JB258

Why: This comes from the notion that, at some point, the BoJ will generate (good or bad) inflation result of its balance-

sheet expansion. Also low potential growth versus increased inflation expectations should mean linker out-performance.

How: This would be done by simply going long the “cheap” JGBi against its corresponding nominal bond. On occasion the investor hedges “effective” duration of the JGBi using an empirical beta and selling a shorter nominal JGBs. Seasonality in CPI means some issues are structurally rich/cheap to others.

Alternatives: There is some activity in JPY inflation swaps but trading in that market is rare.

Risks: Contradictions on the instrument’s design as MoF purposefully chose not to provide a floor on the principal of the JGBi. Unlike JFs there is no obvious domestic buyer for JGBis thus market dislocations can occur depending on foreign positioning or repo difficulties.


JGB linkers not floored, CPI behavior is a risk

Current valuations show significant stress



Basis You Need To Know: Cross-Currency Swap Basis

-80

-60

-40

-20

0

20

40


20 10 5 2

IRS-CCS basis (bp)

-50

-40

-30

-20

-10

0

10

20

30


80859095100105110115120125130

5y-20y USD/JPY

IRS-CCS basis (bp) USD/JPY

The cross currency swap basis is a critical risk transfer mechanism for any economy with large balance of payments imbalances. Japan is an extreme case of this.

Historically, large negative basis reflected differential credit risk assessments between Japanese and foreign banks and corresponding access to USD funding. The normalisation of this basis in 2005-07 coincided with the consolidation of the Japanese banking sector.

Receive side key flows: hedging issuance of foreign yen bonds and of Japanese investments overseas. Pay side: FX asset swapping of super-long JGBs or expressions of the carry-trade such as PRDC issuance. The latter are leveraged pay JPY against receive FX fixed structures with a digital option on FX/JPY.

The turmoil of 2008 destabilized the USD/JPY CCS basis market. The most obvious example was re-hedging of PRDC notes exposure related to USD/JPY breaking lower. This situation is now slowly normalizing.


USD/JPY CCS basis have long history of volatility

Some normalisation already taken place



Typical Trades: JGB Swap Spreads

-60

-40

-20

0

20

40

60


7 30 5 2

IRS-JGB basis (bp)

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

Dec 99 Jun 01 Dec 02 Jun 04 Dec 05 Jun 07 Dec 08

-100

-80

-60

-40

-20

0

20

40

10y JGB 7y-20y ASW

10y JGB JGB ASW

Why: Investors can trade the notion of equilibrium level of implied repo-Libor spreads through JGB-IRS spread. This can be done by outright ASW for more macro views (supply, curve considerations) or relative value as ASW boxes.

How: Typically done through a long or short JGB position against matched maturity swaps (ASW or reverse ASW). Normally quoted on a yield-yield basis.

Alternatives: The most usual alternative is an ASW or reverse ASW using the 10y JGB futures thus bucketing risk around 7y. Most ASW box spreads or flies center around 7y to take advantage of the liquidity in that sector.

Risks: There is significant segmentation on the ASW curve from directionality of 7y sector, to Lifer demand around 15y-20y (in JGBs not IRS), to structural cheapness on 30y owing to lack of stable domestic demand and FX ASW interest. ASW can dislocate very severely in times of market stress.


JGB ASW also highlight market segmentation

Also can show strong dislocations in time of stress



Typical Trades: Super-Long Curvature

-80

-60

-40

-20

0

20

40

60

80

Jan 01 Apr 03 Jul 05 Oct 07 Jan 102y/5Y/10Y 5Y/7Y/10Y

5Y/10Y/20Y 10y/20Y/30Y

Fly (bp)

if USD>110 and NKY>10k

if USD>110 and NKY<10k

if USD<110 and 10Y NKY>10k

if USD<110 and 10Y NKY<10k

-90

-70

-50

-30

-10

10

30

50

70

85 95 105 115 125

10Y10Y-20Y10Y IRS (bp)

USD/JPY

Why: Play on the segmentation of the JPY market with banks dominating up to 10y against a super-long sector led by lifers and pensions with more stable investment targets. Foreigners are opportunistic players in relative value space.

How: The easiest expression is long/short 10y-20y-30y JGB fly. The key issue is whether onshore Lifers can achieve investment targets via long 20y JGBs or through a barbell combinations of 10y and 30y, and more recently 40y.

Alternatives: Can be expressed in IRS spot flies or forwards steepeners such as 10y10y-20y10y IRS. Also in swaption space through payer spreads on 10yx10y.

Risks: Key factor is Lifers asset allocation decisions. Also risks related to USD/JPY CCS basis as un-hedging of PDRC exposure extends duration of the notes thus cheapens flies and flattens forwards. Hedging of FX JGB ASW exposure also can impact this sector.

JPY curvature behaves very differently in super-long end

Influenced by exogenous factors such as FX and equities



Basis You Need To Know: JPY Tibor-Libor Basis

-30

-20

-10

0

10

20

30


2 10 5 1

Tibor-Libor JPY basis

80

90

100

110

120

130

140

Dec 99 Jun 01 Dec 02 Jun 04 Dec 05 Jun 07 Dec 08

-15

-10

-5

0

5

10

15

20

25

30

USD/JPY 1y-10y Tibor-Libor

USD/JPY Tibor-Libor

This basis reflects the existence of two different interbank fixings used for standard IRS contracts. The Tibor panel is dominated by Japanese megabanks thus there is a differential in access to liquidity and credit risk assessment.

Historically, large positive basis reflected concerns about Japanese banks’ creditworthiness relative to the (more international) Libor panel. The normalisation of such basis into 2005-07 coincided with the consolidation of the Japanese banking sector.

The turmoil of 2008 destabilized the Tibor-Libor basis as the credit assessment and liquidity access of foreign banks sharply deteriorated relative to megabanks. There was a segmentation of the Tibor-libor curve with the long-end remaining positive, probably owing to USD/JPY CCS basis receiving dominating flows.

It appears the enormous supply of liquidity globally by overseas central banks helped restoring balance in this market.

Tibor-Libor basis volaitlity an expression of relative liquidity

Tibor-Libor correlation to FX and CCS basis has changed



Basis You Need To Know: JPY 3mx6m Libor Basis

0

5

10

15

20

25

30

Feb 08 May 08 Aug 08 Nov 08 Feb 09 May 09 Aug 09

10 2 5 1

3mx6m JPY basis (bp)

-18

-16

-14

-12

-10

-8

-6

-4

-2

0

Feb 08 May 08 Aug 08 Nov 08 Feb 09 May 09 Aug 09

-20

-10

0

10

20

30

40

50

60

1y-10y 3mx6m Basis 1y-10y Tibor-Libor

3mx6m Basis Tibor-Libor



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