BoJ intervention only a first step before its yield curve control policy needs to be reviewed

On February 10th, the Bank of Japan (BoJ) announced the immediate intervention in the Japanese Government Bond (JGB) market. Namely, the BoJ committed to purchasing 10-year JGBs so as to keep their yield below the 0.25% ceiling set on 10-year yield with a 0.0% target, as part of its Yield Curve Control (YCC) policy. The market started pushing up the long end of the JGB’s curve from mid-December in line with the movement of the US 10-year Treasury yields. The BoJ’s decision to intervene happened right before the expected high US inflation data resulted in a bond market sell-off accelerating the push towards the 0.25 ceiling in 10-year JGB yields. Such pre-emptive action has led to a market correction which the BoJ surely welcomes?(Chart 1).

Still, this was only a sprint and the BoJ will need to face a marathon as the Fed begins to hike in March. Against the background of a likely 40 basis points hike according to consensus, the BoJ is unlikely to continue to defend the 0.25% ceiling and will need to review its YCC policy. The BoJ will not be the first central bank to do so, as the RBA has also disposed of its own YCC and is in the midst of tapering.

For the BoJ, the reason to lift the 0.25% ceiling on the 10-year JGB is related to the much weaker Yen that would result if the BoJ does not react. A much weaker yen will imply importing inflation with the related deterioration of household income. For sure, Japanese companies have been cautious in transferring higher costs to their customers, containing headline inflation but this has led to meager corporate profits so that companies will not find it easy to support wage increases. For these reasons, the BoJ should not have much incentive in supporting the divergence between US and Japanese government yields and will rather prefer to re-design its YCC.

There are a number of ways to go about it. First, the BoJ could shorten the maturity at which it controls the curve. But it might be hard to sell to the public since the BoJ’s mandate – namely reaching a 2% inflation has not yet been reached?(Chart 2). More importantly, this would increase the risk of a surge in the long-term yield, which could potentially destabilize the financial system. The BoJ could also follow the RBA and abandon YCC but the expected volatility of long-term yields would be even larger and, therefore, too disruptive. The third action, and most likely in our view, is?an expansion of the band within which 10-year JGB yields can fluctuate. In fact, the BoJ’s announcement to intervene in the JGB market a few hours before the release of the US CPI report can be interpreted as their acknowledgement that the long-term yields are sensitive to global market developments and that a widening of the curve is just a reflection of such global factors having changed. With a similar reasoning, the BoJ already expanded the band from 10 bps to 25 bps in March 2021 while still keeping the target at 0.0%. This time around, the BoJ might need to decide to change both the band and the target as it will be extremely difficult to anchor expectations at that low level after the German has moved to positive territory very rapidly.

All in all, we expect the BoJ to increase the ceiling on the 10-year JGB yield at 1% (i.e., 75 basis points) and possibly lift the 0% target within such band. This will give BoJ much more leeway than it has now to tighter global monetary conditions and avoid too rapid Yen rapid depreciation while still keeping an accommodating monetary policy to achieve its 2% inflation target. If it were to happen, such announcement should be followed by a rapid rebound of the yen.