Financial markets "hear but don't listen to" BOJ's rosy talk

Thu May 29, 2014 4:39am EDT

* BOJ and markets have different views on inflation, economic outlook

* Neither side is likely to change their views in near future, leading to market stalemate

* Market volatility, now at historic lows, will likely jump later this year

By Hideyuki Sano and Lisa Twaronite

TOKYO, May 29 (Reuters) - "I hear but I don't listen to," Wim Duisenberg, the first president of the European Central Bank, famously said in 2001 when asked about pressure to cut interest rates.

More than a decade later in Japan, it is financial markets that hear but do not listen to the central bank, and the perception gap between the two is likely to lead to a huge spike in market volatility down the road.

Although the Bank of Japan has beaten the drum for its optimistic economic forecast in the past several weeks, playing down the need for additional stimulus, financial markets have hardly reacted, with many investors still sticking to hopes of more easing.

"At the moment, there's about a 70-30 split between people still looking for the BOJ's second round of easing and those who are not looking for the BOJ to move until autumn or towards the end of the year," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.

Even as one of the BOJ's most dovish board members, Deputy Governor Kikuo Iwata, went so far as to mention possible tapering in the BOJ's massive asset purchases this week, markets gave the notion a cold shoulder, with the yen, Japanese bonds and stocks showing no reaction.

"The BOJ thinks Japan's inflation is on course to hit the 2 percent target. Markets think 2 percent will be difficult without additional easing. At some point in the future, either the BOJ or markets will have to correct their views. That's when volatilities are likely to rise," said a senior currency option trader at a major Japanese bank.

For now, neither the BOJ nor markets are ready to concede, having good reason to believe in their own scenarios.

The central bank says inflation has been rising in line with its projection and that the jobless rate has fallen steadily to 3.6 percent, a level some economists think is close to full employment - where companies will be forced to increase wages to hire employees.

Many investors think, however, the rise in inflation so far is caused mostly by the yen's weakening, the impact of which is expected to wear off from now. Some investors also question if domestic consumption will recover as quickly as the BOJ expects from the blow of a sales tax hike in April.

Both sides agree that inflation will plateau around 1.3 percent for the next months and the difference lies in what will happen after that, which suggests the final verdict is still a few months away.

This has resulted in stalemate in markets, with volatility in the yen, Japanese bonds and stocks markets falling to historic lows.

The yen's actual volatility in the past month was around 4 percent, near its 2007 low. JGB futures' volatility is a mere 1 percent, also near a record low hit in 2012. Stock volatility has fallen sharply over the past few months.

Option markets are also pricing in a very low level of market fluctuation. One-month implied volatility on dollar/yen options hit a record low around 5.5 percent this month.

Traders say speculators have shown scant interest in buying options even as they have become so cheap, because none of them can come up with a plausible scenario for rising market volatility just yet.

But that could change in a few months.

If the BOJ is indeed right on inflation, then its buying of government bonds and some riskier assets will need to be scaled back, and the impact on JGBs would be huge.

So far this fiscal year from April, the 10-year JGB yield has moved in a narrow nine-basis-point range around 0.6 percent.

"If you look back, it's not uncommon that the JGB yield moves about one percentage point within a few months. A move of that magnitude happens once every 10 years or so. It's hardly a tail risk," said the head of fixed income at a U.S. brokerage firm. (Reporting by Hideyuki Sano; Editing by Kim Coghill)

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