Japan: This time may not be that different – BOJ’s endgame
September 19, 2023
KEY TAKEAWAYS
Conducting YCC with greater flexibility
On July 28, the Bank of Japan (BOJ) surprised the markets by announcing that they were adopting a more flexible approach to the conduct of Yield Curve Control (YCC). The title of the press release was “conducting YCC with greater flexibility” and in spite of all the initial excitement about a possible pivot, the BOJ meant exactly what it said. The BOJ left its policy rate unchanged at -0.10% while simultaneously holding the 10Y Japanese Government Bond (JGB) yield and target band steady at “around” 0.00% +/- 0.50%. The decision was unanimous. However, the BOJ said that these were not hard limits, and in its second fixed rate purchase operation, bought 10Y JGBs at 1.00% instead of 0.50%. The move remains confusing even one month after the BOJ’s announcement, while Japanese yen (JPY) volatility has remained elevated, prompting analysts to speculate what BOJ’s endgame might be.
In fact, the Yomiuri Shimbun published an exclusive interview with Governor Ueda on September 9, conjecturing what preconditions would be necessary for BOJ to end its YCC and Negative Interest Rate Policy (NIRP). Governor Ueda also clarified that the BOJ would not necessarily have to wait for next year’s shuntō wage negotiations to anticipate the sustainability of 2.0% inflation, stating that "it is not impossible that we will have enough information before the end of this year”. Although the tone of the interview was hawkish, it does not hint at an imminent shift in YCC or NIRP. This is not the first time that Governor Ueda makes seemingly contradictory comments, having made similar remarks after his first monetary policy meeting as Governor, on April 28. Ueda also precluded his comments by saying that “there is still some distance to go in achieving the inflation target” and confirmed that the bank would “continue to implement aggressive monetary easing”. However, the article endorsed an ongoing shift in the BOJ’s approach to conducting monetary policy, towards a more data dependent stance. It also highlighted concerns about a potential overshoot in inflation in Q4-23.
The shift in language around the need to introduce flexibility to the operation of YCC de-facto raises the target band to 1.00%. Theoretically, the BOJ will only intervene in case certain criteria are met, including speculative moves in JGB yields that are not supported by fundamentals. It has only been one month since BOJ introduced YCC with greater flexibility, so we still need to wait and see what this means in practice. However, these interventions have fallen short of reversing an upward trend in 10Y JGBs, which now hover around 0.70% (Chart 1).
High inflation and strong growth – a problem for BOJ?
Ueda is not the most avid proponent of YCC, that much is clear. However, he also does not wish to appear hawkish while the economy faces growth headwinds. On face value, the Japanese economy is soaring, inflation is rising and wages are increasing, calling for policy tightening. However, a more comprehensive reading of the data shows that this is far from true.
The Japanese economy expanded more than expected to a revised annualized rate of 4.8% q/q (1.2% SA q/q) in Q2-23, up from 2.7% q/q (0.7% SA q/q) in Q1-23. That upside can be almost entirely attributed to a positive net export position (1.8% SA q/q). Net exports rebounded sharply (Chart 2), but only because imports fell more than exports. The theme has extended into Q3-23. Export growth declined by -0.3% y/y in July, while imports collapsed at a much more spectacular rate of -13.5% y/y, driven by JPY weakness. As this gap narrows progressively, it will result in a weaker contribution to GDP growth in Q4-23.
In contrast, private consumption (-0.4% SA q/q) and investments (-0.1% SA q/q) remained contractionary. Preliminary data suggests that these will continue to drag in Q3-23. A recent survey by Japan’s Economic and Social Research Institute (ESRI) shows that household confidence remained below the watershed level of 50, at 36.2 in August. Similarly, household spending declined by -5.0% y/y in July, missing analyst estimates. Nationwide department store sales remained elevated at 8.6% y/y in July, but a lot of this reflects stronger tourism revenues. Meanwhile, the manufacturing PMI dropped to 49.6 in August, while machine tool orders remained very negative at -17.6% y/y. In other words, the Japanese economy is not booming. Going forwards, there is a risk that higher inflation throws into jeopardy a modest recovery in consumer sentiment.
This brings us to the second reason explaining BOJ’s latest actions. Ueda might be concerned about a potential overshoot in inflation over the coming months. Nationwide CPI remains elevated, reaching 3.2% y/y in August, downs marginally from July's 3.3% y/y. However, core CPI, which excludes volatile food and energy prices, was flat for a third consecutive month at 4.3% y/y, the highest level since 1981. Although core and headline numbers remain above target, the BOJ views higher CPI as being mostly being “transitory”. To this avail, the BOJ revised its CPI forecasts for the current fiscal year to 2.5% y/y, up from prior 1.8% y/y. In contrast, the BOJ revised its CPI forecast for the next fiscal year down to 1.9% y/y, below the elusive 2.0% target.
Looking forward, the data is mixed. In sequential terms, CPI was flat at 0.3% m/m; while core CPI recovered to 0.3% m/m. Most of the upside continues to be driven by food (8.6% y/y), furniture and household equipment (7.1% y/y) and clothing and footwear (4.4% y/y). Risks are tilted to the upside in the remainder of the year. The yen has continued to depreciate (USDJPY down -1.5% in the past month), which compounded with rising crude oil prices (WTI up +7.55% in the past month) could fuel rising cost-push inflation. We believe that CPI will likely rebound again in Q4-23 if global oil prices move above USD 100 / bbl (likely at this juncture). Oil is Japan’s largest import by value and tends to act as a leading indicator for CPI (Chart 3). We expect CPI to average 3.0% in 2023, before declining to 1.5% in 2024. Risks remain tilted to the upside, while disinflationary pressures will only come into force from Q2-24 onwards.
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In spite of Ueda’s hawkish comments on the Yomiuri Shimbun, we don’t think that the BOJ has gathered enough evidence to suggest that stronger wage growth will warrant a structural shift in inflation. According to figures by the Japanese Trade Union Confederation (Rengo), the pay hike of 3.8% in March 2023 constituted the highest level in 28 years. However, this was predominantly focused on large conglomerates, with SMEs (68% of the private sector labour force) increasing wages at a more sluggish pace. Additionally, wage growth has not kept up with inflation, with average monthly real cash earnings declining by -2.5% y/y YTD. A recent paper by BOJ (Kurozumi and Oishi, 2022) shows that the persistence of inflation expectations formation is higher and trend inflation is lower in Japan than in the United States (US). Japanese firm’s price-setting behaviour is more cautions, reflecting the purchasing attitude of Japanese consumers, who are more sensitive to price increases. This induces, through the highly persistent formation of inflation expectations, low expected future inflation and low trend inflation through the Phillips curve.
Implications for investors
BOJ introduced YCC because it had reached the limit of quantitative easing. In other words, it was running out of bonds to buy after amassing more than 50% of the market. YCC offered advantages as it allowed the BOJ to buy bonds when needed, while tapering bond buying in times of market calm. Another benefit of YCC is that it suppresses short-term rates (which affect cash-rich corporates) without impacting returns for pension funds and lifers insurers, the largest owners of JGBs after BOJ (Chart 4).
YCC worked well when inflation was low. However, it has become cumbersome against the backdrop of an unprecedented tightening cycle in the US and rising global inflation. In March 2021, the BOJ widened the band to 0.25% to breathe life back into the market. BOJ doubled that in December 2022 to 0.50% under a speculative attack from investors. We don’t exclude the possibility of another tweak to the YCC target. Specifically, we anticipate that the BOJ could widen the band (formally) by another 25 basis points to 1.00% in December. After all, 10Y JGBs have already started converging towards that level. For this to happen, the BOJ needs to see substantial cyclical pressures via an overshoot in cost-push inflation and higher US 10Y yields. But that’s as wild as it gets.
Scrapping YCC altogether is less likely until the BOJ completes its policy review in 2024. Similarly, NIRP is here to stay. Japan's fiscal health is the worst amongst OECD economies, with government debt exceeding 260% of GDP. BOJ's aggressive buying of JGBs has helped contain the country's debt servicing costs. Given the lack of progress on structural reforms, the cost of servicing Japan’s debt will only increase over time. According to the Ministry of Finance, every percentage increase in the assumed rate will boost debt servicing costs by JPY 700 bn (USD 4.8 bn). At 1.3%, this would total JPY 26.8 tn (or 5% of GDP) in FY24. The BOJ will continue to find justifications for unorthodox policy, as its endgame remains monetising this debt.
In terms of markets, even in case Ueda outright cancels YCC in December, widening rate differentials with the US will continue to fuel depreciation. BOJ has intervened verbally, but material interference is not likely until the level of USDJPY 152 is breached. Meanwhile, Japanese equities are negatively correlated with the exchange rate, as most listed companies are large conglomerates than earn USD and report back in JPY. Compounded with measures to boost corporate governance (buybacks for listed companies with P/B ratio < 1), this supported a 30% rally in Japanese equities YTD. The index is now trading slightly above its 10Y average (17x P/E), but the fundamental drivers remain intact. This means Japanese equities may continue to rally before conditions inflect, possibly in the second half of 2024.
[This article is reposted from a report published by UBP on September 19, 2023]
Author:
Carlos Casanova
Senior Economist, Asia
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