No Longer the last man standing

Last week, the Bank of Japan (BOJ) said in its monetary policy statement that it would offer to purchase 10-year Japanese government bonds (JGB) at 1% through fixed-rate operations, effectively loosening its Yield Curve Control (YCC) Policy (double the current band of 0.5%). This resulted in an immediate strengthening of the Yen against major currencies and sent the yields higher across several developed markets.?

As Central Banks worldwide have gone on a rate tightening spree in the last 18 months or so, Japan has been a clear outlier and held on to its easy rates policy. However, this has come at a cost and the Yen bore the brunt of this disconnect, as it depreciated severely against the Dollar contrary to its safe haven status (Figure 1: USDJPY almost touching the 150 level). Consequently, markets have been expecting the BOJ to tighten monetary conditions and push the 10-year bond yields higher, testing the tolerance bands set by the BOJ (Figure 2). The JGB market went into limbo, with some days not recording even a single trade. Given this, the BOJ’s action seemed inevitable, although the timing definitely surprised the markets.?

Figure 1: USDJPY downward trend accelerating in 2022?

Figure 2: 10 Year JGB Yields trading very close to the 0.5% band last year?

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YCC in Japan?

BOJ employs a Yield Curve Control (YCC) policy, which targets the short-term rate at -0.1% and the 10-year rate at 0%. In addition, it defines a tolerance band (+/-0.5% for the 10-year) within which it allows the rates to fluctuate.??

In January 2016, the Central Bank had taken the short-term rate to the negative territory to combat disinflation. However, this had severe negative ramifications and the bond yields were dragged down lower. So, in September 2016, it introduced the YCC policy to arrest the downward slide in yields by defining tolerance bands. Of course, in the current context of higher inflation regimes, the pressure on the rates has flipped and is on the upper end of the tolerance band.??

Market implications?

The BOJ policy has a wider impact on the market globally, the reason being that decades of ultra-low yields in Japan have meant that a very large amount of excess savings is invested abroad, mainly in the US Treasuries (north of a trillion $). An increase in the local yields could mean repatriation flows out of these foreign-denominated assets and hence a stronger Yen, weaker Dollar and higher USD rates.??

Also, several market participants engage in carry trades backed by the Yen. The idea is to borrow Yen at lower interest rates and invest in higher-yielding currencies such as BRL, TRY, MXN etc. and pocket the difference, with the view that Yen would not appreciate. This view is often embedded in structured note issuances and may exacerbate market moves.??

Naturally, any shift in BOJ policy poses heightened risks to the macro/portfolio views that investors may hold and hence is watched very closely.?

How to read the move?

Does the latest move indicate that the days of easy monetary policy in Japan are over? Not quite, according to the BOJ Governor, who says this is just a step to enhance the sustainability of the YCC.??

In fact, this is not the first time that BOJ is tweaking the policy bands. It revised them in 2018 (+/-0.1%), 2021 (+/-0.25%) and 2022 (+/-0.5%). The reason is that, over the years, the BOJ had to buy large quantities of bonds to keep the yields within the range, which has resulted in it holding nearly 51% of the entire 10-year JGB issuance. To ensure proper market functioning, it widens the bands from time to time.??

Whether this marks the beginning or the end of monetary easing in Japan will depend on how the medium-term inflation expectations play out. The latest move may very well be a one-off tweak in the policy that we may see for quite some time. But by the Governor’s own admission, the risk of completely abandoning the YCC is non-zero. Hence this will remain high on the market participants’ radar in the near to medium term.??