The Bank of Japan is likely to stay on hold

Comments from Gregor MA Hirt , Global CIO Multi Asset, ahead of the Bank of Japan meeting on 27-28 July

While many international central banks are already in the final stretches of their policy tightening cycle, the Bank of Japan (BOJ) has not yet taken any meaningful steps towards policy normalization. Changes to the policy rate and an end to quantitative easing still are far off based on the communication of the BOJ. We would thus expect the accommodative policy to continue for the time being. Adjustments to yield curve control (YCC) either by widening the corridor further, shortening the target maturity or the removal of YCC appear to be the next likely steps. If they occur, they would likely be conducted in a dovish context and represent no departure from an easing stance. We do not expect this to happen as part of the July meeting, for three reasons.

Firstly, Governor Ueda made a statement at the G20 summit in India, which we would see as indicating that the BOJ will remain on hold. He stated that “if our assumption (that sustained achievement of 2 percent inflation remains distant) is unchanged, our overall narrative on monetary policy remains unchanged”. We would argue that so far there is insufficient evidence that the BOJ is convinced it has achieved its target. This is further supported by comments in the media over the last few days. These appear to strongly indicate that the BOJ is seeing no immediate need for change at this time and already led to some pronounced market movements.?

Secondly, domestic core inflation shows first tentative signs of plateauing. Indeed, the most recent national CPI excluding energy & fresh foods came in at 4.2 percent. While this is significantly above the BOJ’s 2 percent target, it represents a mild deceleration from 4.3 percent in the previous print. In addition, this comes at a time when inflation in many other regions is already slowing markedly. On the wage side, while average monthly cash earnings increased 2.5 percent year-over-year in July, there is still uncertainty if this does not represent mostly a “one-off”. In such an environment and considering the experience of years of deflation, we would expect the BOJ to wait for further data to confirm the current state of the growth-inflation mix and likely judge the risk of continued inflation overshoot as limited.

Lastly, there is less external pressure currently to force the BOJ to act. In fact, one important justification for the last YCC adjustment in December 2022 was the need to improve the functioning of the bond market. Based on the BOJ’s own market survey and on the shape and level of the yield curve, the market is actually functioning with limited distortions.

While “no change” is our base case, a YCC adjustment remains a distinct possibility, nonetheless. Governor Ueda himself stated that the instrument of YCC lacks the flexibility to finetune policy so that an eventual removal is likely. Also, new economic projections are released at the July meeting. The latter will be important to get a reading on key variables watched by the BOJ, such as the output gap, wages, and inflation expectations. Should the updated forecasts show a sufficiently strong upwards revision, markets might start pricing in the data more strongly and the BOJ would need to step in to defend YCC. A preemptive widening of the yield band at a time when markets are not pushing against the upper limit in combination with a dovish overall message would allow for a smoother transition. In the end, markets will need to be surprised about YCC changes, as widely discussed.

In terms of positioning, we believe that the longer-term structural developments, such as an eventual policy normalization, or reducing policy differentials and Fed policy changes, will be the stronger driving factors for Japanese Government Bonds (JGBs) and the yen than the event risk at the upcoming policy meeting, so we maintain our cautious view on JGBs and moderately constructive view on the yen.?

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