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Tail risk 4: Bo) triggers curve steepening and vol rise Bo) keeps yield curve anchored out to 10y: 1y10s20s conditional bear steepener The Bank of Japan (BoJ) has faced a tough 2016. Having switched its policy target from quantity to interest rates at its September Monetary Policy Meeting, it tacitly acknowledged that negative rates and JGB purchases were potentially approaching their limit in terms of policy effectiveness. Inflation expectations fell and the yen strengthened as a consequence as the market got accustomed to fading dovish pronouncements from the Bank of Japan. Bo) Governor Haruhiko Kuroda himself said “Central banks are, admittedly, not omnipotent." The Bo) introduced yield curve control, taking into consideration negative effects of great decline in yields and curve flattening on financial institution earnings or financial markets. If the Bo) keeps purchasing at the current rate, however, yields will sooner or later feel downward pressure. We believe the Bo) is likely to reduce its long-term )GB purchase gradually. For the time being, JGB yield guidelines are probably around 0% for the 10yr, 0.4% for the 20yr, and 0.5% for the 30yr JGB. However, the Bo) appears to be concerned about the deterioration of financial institution earnings caused by flattening of the yield curve. Kuroda said that even if superlong-term yields rose slightly, he did not believe they would have to be lowered. He went on to say he was also giving consideration to investors in superlong-term bonds, and that he did not think it was good for the yield curve to get continually flatter. Based on these and other remarks, we expect long-term JGB purchase operations to be reduced and the curve to gradually steepen (Rates forecast: Attention on Bo) operations when yields decline). Before that can happen, however, preconditions most likely include steady progress in US rate hikes, avoidance of excessive yen appreciation, and some degree of recovery in the inflation rate. With a Republican clean sweep, US fiscal easing is now a foregone conclusion and “Higher rates and higher dollar” may support our view for yen rates. If JGB purchase operations were reduced and yen rates rose in the wake of higher US Treasury yields and USD/JPY appreciation, that could easily be explained by fundamentals. Yen rates volatility is still low; however, purchasing cuts by the Bo) could add to volatility risk amid declining liquidity in the super long-end (Chart 78). Even if risk-off sentiment pushes down the yield curve, the Bo) may lower the 10yr JGB yield target from zero to keep the curve steep. This kind of policy change also could increase volatility. In either case, the 10yr is expected to be anchored and movement is expected in the long end. We believe 1y10s20s conditional bear steepener may mitigate this risk. Trade recommendation: Long S5bn 1y20y @0.62% (atm+11bp) payer vs Short 9.9bn 1y10y @0.18% (atm) payer. This position is zero cost, PVO1 neutral, and zero carry. Risk Is the curve remains flat due to a deflationary backdrop. Chart 78: JPY Swap 10y and 20y rate and 1y20y volatility , AO) JPY Swap 10y JPY Swap 20y 9 ———‘y20y Volatility (RHS) (bp}y 1 50 08 40 06 30 04 02 ad ") 10 -0.2 0 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Source: BofA Merrill Lynch Global Research BankofAmerica <2” 46 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 . Merrill Lynch HOUSE_OVERSIGHT_014776