The Real End

In their situation room, the Bank of Japan devised a plan to “cap” long-term interest rates. In a surprising move, the governor, Ueda, explained the Bank decided to slow quantitative tightening and mulled what to do with “super longs”, which are Japanese bonds with 40-year maturity.

Since their QT began, long-term Japanese yields have tripled, and just recently, with a verbal intervention, yields backed off. Ueda placed a second verbal intervention to control rates, which inadvertently affected US Treasury yields.

Japan’s term premium, which is the difference between long-term rates and the BOJ’s interest rate and inflation expectations, is higher than its US equivalent. Since Liberation Day, Japan's term premium on tariffs has exploded, which has also driven up the US term premium, among other reasons, including the budget bill (Figure 1).

Still, the BOJ stopped short of announcing forceful measures such as ending QT altogether. Instead, Ueda emphasized that “market forces” determine yields, and the BOJ can only slow purchases to control for bond volatility, as there is no definitive answer to control rates. In other words, there is no real end to the (relentless) rise in Japanese rates.

Yet, the BOJ will react ‘nimbly’ to a sharp rise in yields, i.e., the threat of a quick verbal intervention will keep looming. JGB yields rose because a rate hike is still being considered, but Treasury yields declined moderately on the possibility of a real end to the conflict.

Going into the FOMC, markets view a Fed that is potentially incapacitated by tariffs and energy as a risk to Treasury yields, in contrast to the momentum in the economy.

Figure 1: Japan versus US Term Premium (%)

Source: Simex, CME, NY Federal Reserve

For example, the economic surprise indices for growth and inflation, which measure the upside or downside surprise in economic data relative to consensus forecasts, have been declining. Inflation has experienced a more pronounced decline than growth. Contrary to expectations for the Fed Funds rate, the market is pricing in less than two cuts for 2025 (Figure 2).

The divergence between the momentum of the economy (as expressed by the surprise indices) stalling and rate cut(s) pinned down by a message of the Fed that is falling behind the eight-ball, sets up for yields at risk of significant moves, in my view, to the upside as the BOJ is unable to stop tide in the JGB market.

Figure 2: Surprise indices and number of rate cuts

Source: CME, Citigroup

Going into the FOMC meeting, the straddle (long put and call position) on the 10Y Treasury implies a move of ten basis points (~1.1% change in price). Similarly, to stock option implied moves on earnings day, the 10Y yield change priced for FOMC reflects expectations of the Fed’s outlook for the economy.

The implied move on the 10Y is in line with the last few FOMC meetings; nonetheless, it is a larger move than what occurred in the previous three meetings (an average of approximately six basis points changes).

The volatility of yields remains elevated due to the economy (e.g., weak headline US retail sales but stronger control group) and developments in Japan, where bond volatility frequently spikes (Figure 3).

While the economy stays in doldrums, buckling under tariffs, Treasury yields will become more volatile, sustaining the upward trend with no real end in sight.

Figure 3: Yield volatility (%)

Source: Simex, CBOT