* Short-squeeze feared on 2-year JGBs in Thursday auction
* 2-year bonds are scarce as BOJ owns 87 percent on them
* Traders fear chaotic volatility at the short end
By Hideyuki Sano
TOKYO, Sept 14 The Bank of Japan faces an early
test of the limits of its radical stimulus programme on
Thursday, when a small corner of the Japanese bond market may
run out of bonds to sell, forcing those shorting the debt into a
"squeeze," scrambling to buy them at any price.
The crunch could come in a 2.5 trillion yen ($24 billion)
352nd issue of two-year Japanese government bonds (JGBs)
expiring next May.
Though it is only a small part of the $10 trillion JGB
market, two-year bonds are dominated by the central bank's
massive asset purchases and could offer global investors a
glimpse of what might happen when the Bank of Japan (BOJ) runs
out of policy options.
The BOJ has been buying bonds of all maturities since 2013
as part of measures aimed at spurring economic activity.
Three years later the economy is still floundering and the
BOJ's bond purchases have siphoned liquidity out of the market
to the point where it now owns 87 percent of two-year bonds,
making it one of the scarcest JGBs for investors.
"Clearly the shortage of certain JGB issues exemplifies
falling liquidity in the market. And it will only get worse,"
said Naoya Oshikubo, a yen rates strategist at Barclays.
This scarcity affects short sellers who borrow JGBs and then
sell them, with a view to buying them back at a profit when they
have to deliver on the trade.
With virtually no two-year bonds on offer, these short
sellers have been relying on a BOJ lending scheme since July 5
that allows them to borrow bonds from any particular issue for
up to 50 business days.
The problem is that the 50-day deadline passed on Wednesday
and Thursday's auction will be on the 51st business day, meaning
some borrowers can no longer rely on the BOJ's scheme.
Short sellers may have to buy back the bonds at a
prohibitively high price. Or they could rely on another BOJ
special scheme that allows them to keep borrowing - at a very
high cost - for another 21 days.
This suggests an instant scarcity of the debt on Thursday
and chaotic moves in one- and two-year notes.
The Bank of Japan could not be immediately reached.
Any immediate impact will likely be limited to this slice of
the market, but it is a problem that the Bank of Japan will face
across the curve if it continues its bond buying, market players
Central bank Governor Haruhiko Kuroda insists there are no
limits on the BOJ's policy, but the bank's 80 trillion yen a
year of JGB purchases means it now owns almost 40 percent of
JGBs. That is expected to rise above 50 percent next year and to
75 percent by 2020.
"It's impossible for the BOJ to increase buying in two-year
bonds. Even if you want to buy two-year JGBs, there aren't bonds
available for you," said Tadashi Matsukawa, head of fixed income
investments at PineBridge Investments in Tokyo.
The shortage of short-term bonds gives a twist to the Bank
of Japan's reported plan to try to steepen the yield curve to
reduce the damage to financial institutions from the BOJ's
negative interest rates.
A steeper curve helps banks' loan business because they
borrow short-term and lend long-term.
The most obvious way for the BOJ to steepen the yield curve
would be to increase buying in short-term notes while reducing
purchases of long-dated bonds, but that move would worsen the
chronic scarcity of some two-year bond issues.
Given the risk of further deterioration in liquidity, some
market players also expect the BOJ to relax its bond lending
scheme at its next policy meeting on Sept 20-21.
Sources have told Reuters in recent days that the BOJ will
consider making negative interest rates the centrepiece of
future monetary easing and are mulling ways to widen the gap
between short- and long-term interest rates.
($1 = 103.1700 yen)
(Additional reporting by senior IFR analyst Takahiro Okamoto;
Editing by Eric Meijer and Nachum Kaplan)