Tokyo Exchange to offer meeting-based BoJ rate futures

A well-traded meeting-based contract would provide the yen market with a direct, quotable gauge of the likelihood of a BoJ rate increase at each gathering. This could lead to more measured yen fluctuations around policy meetings, with unexpected moves priced in earlier, and heighten responses to economic data and official remarks in between. Simpler hedging of near-term rate risk might also boost trading in short-dated Japanese government bonds and yen carry trades, where the expense of being surprised by a rate hike has increased. Ultimately, liquidity will determine success: a contract with low volume will generate erratic signals, not dependable odds.

Japan is about to receive its own equivalent of the instrument that Wall Street employs to wager on Federal Reserve moves, driven by the BoJ's accelerating pace of rate hikes.

Key details:

• TFX will launch the futures this month (the exchange has not yet announced a precise date) tied to the Tokyo Overnight Average Rate (TONA), the uncollateralised call rate that the BoJ targets as its policy rate
• The futures are intended to allow hedging or positioning for interest-rate changes during the interval between two BoJ meetings
• According to TFX, its current three-month TONA futures do not adequately serve traders now that the BoJ is altering policy more frequently
• Trading volume in the three-month contract dropped almost 50% in September from the same month a year prior, even though most market participants anticipated additional BoJ tightening
• A TFX official stated that interest-rate volatility is increasing and that demand for derivatives is growing

Japan is about to gain a more precise instrument for wagering on BoJ actions, with TFX readying futures that enable traders to take positions on rate movements at specific meetings.

Scheduled for release this month, the new futures are tied to TONA, the unsecured overnight rate at which banks lend and which the BoJ uses as its policy target. The contracts let traders hedge or bet on rate adjustments that occur between consecutive BoJ meetings, the exchange has stated.

The initiative reflects a shift in the BoJ's approach. Last month the bank lifted rates to a 31-year peak, and Governor Kazuo Ueda has indicated a new focus on keeping inflation from exceeding its goal, keeping the possibility of more rate rises open. While a central bank is on pause, investors rarely need to assess each meeting individually. But when it is in an active tightening cycle, every policy meeting becomes a potential event that traders seek to hedge.

TFX noted that its existing three-month TONA futures did not fill that requirement, as they do not separate the result of a single meeting. A director in the exchange's wholesale business commented that rate volatility has risen and derivative demand is on the rise.

The volume data reveal the shortfall. Even with widespread forecasts of additional BoJ tightening, trading in the three-month contract has declined in recent months; September volume was almost 50% lower than a year earlier. This indicates that traders are shifting their BoJ risk hedging to other tools rather than giving up on it.

Comparing with the United States provides a useful lesson. Fed funds futures support commonly cited metrics of the probability of Fed rate changes at each meeting, serving as a benchmark for markets and the press. A well-traded meeting-based TONA contract could eventually provide a like service for the BoJ, offering yen traders a more direct, immediate view of hike probabilities.

Success will hinge on adoption. The initial challenge will be the amount of trading activity the contract draws around upcoming BoJ decisions and whether its pricing accurately forecasts the bank's actual moves.

BoJ schedule: the next policy meeting is in late October.