BOJ is likely to reduce bond purchases and hike rates

• We believe the Bank of Japan (BOJ) will most likely make significant headway on its exit from unorthodox policy at the July meeting by reducing bond purchases and hiking interest rates.
• In our view, BOJ will lay the path for a reduction in bond purchases. It is expected that the BOJ will size this adjustment to align with expectations so as to avoid any market disruptions.
• There is greater uncertainty regarding a potential rate hike as the BOJ has given limited guidance. However, we think recent data was “solid enough” for the BOJ to seize the opportunity to leave the zero-interest rate range.

The BOJ’s next challenge lies in substantiating the claim (through policy decision) that Japan's economy has normalised; experiencing inflation and wage pressures, without prematurely slowing down the economy through aggressive policy actions. The current economic data presents a mixed picture, with deceleration in growth and still sluggish private consumption on one hand, and accelerating broad-based wage growth and rising inflation expectations on the other. Given the relatively stable global and domestic growth outlook, we anticipate that the BOJ will take this opportunity to advance normalisation efforts at the July meeting.

We expect?the BOJ will increase interest rates to around 0.25% at the upper limit.

Although there has been no explicit guidance on this matter, and it may come as a surprise to the markets, we believe the BOJ will take advantage of the opportunity to exit the zero-interest rate range before external factors, such as a potential economic slowdown in the US, make this move more challenging. Governor Ueda has previously indicated a preference for not remaining in the 0-0.1% policy range for an extended period. Considering the current inflation levels, where real rates are deeply negative, the market is likely to absorb the rate hike sufficiently well. While there is concern about the potential negative impact on consumption due to rising rates, the need to stabilise the yen and prevent further yen weakness is also critical for consumption and sentiment. A rate hike could help this, whereas the absence of a rate hike may trigger renewed selling pressure driven by carry trades.

Additionally, we foresee a reduction in the BOJ's bond purchase schedule. This has been well-communicated by the BOJ, and there have been thorough discussions with key bond market participants recently.

We expect the BOJ to align closely with market expectations to avoid unnecessary market disruptions. The key aspects to monitor include the schedule, amount, and curve sectioning of the tapering. We predict that the BOJ will provide ample visibility on its future schedule to prevent market disturbances, possibly by outlining a plan for the next two years. The reduction amount is anticipated to be substantial to encourage the re-engagement of natural buyers, who have been hesitant recently due to uncertainties surrounding the tapering. A monthly reduction of JPY 3-4 trillion spread over the next two years seems plausible. As for curve sectioning, while guidance has been less definitive, concentrating on areas where previous purchasing was most intense, such as the 3-5 and 5-10 year sections, seems a reasonable assumption.

We take the following position: With the anticipated reduction in the bond purchase schedule, the BOJ's gradual exit from the bond market will have largely materialised. Although the BOJ will continue to be a major player, its withdrawal from here is unlikely to act as a mid-term catalyst for an increase in yields. We retain a prudent perspective on Japanese Government Bonds (JGBs), but we believe that the forthcoming changes have mostly been factored into the current prices, and we may consider neutralising this position shortly. In terms of Japanese equities, the enduring domestic structural drivers, coupled with the support from global growth, reinforce our persistently positive outlook. As for the Japanese yen, we are adopting a neutral stance for the time being. The recent strengthening of the yen is promising, but until there is more evidence of a slowdown in the US economy, the yen may face challenges in achieving significant gains. Moreover, the high negative carry could make maintaining a long position costly without imminent catalysts. As? the US situation appears to be shifting and more information on the Fed’s trajectory may become available at the next FOMC meeting, we are closely monitoring the situation.

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