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The Bank of Japan's policy shift through 3 key lenses
On Tuesday, the Bank of Japan (BoJ) announced a change to its yield curve control (YCC) policy, allowing the Japanese 10-year government bond to trade up to 50bps above or below its 0% target, versus 25 bps previously.
This article analyses the BoJ’s decision through three key lenses: the yield curve; the yen; and inflation.
The yield curve
In announcing its decision, the BoJ outlined that it intends to promote a smoother formation of its entire yield curve, with the BoJ stating that the relative relationships amongst bonds of different maturities had deteriorated.
With the 10-year bond under YCC, it stuck out significantly from its surrounding maturities. The 10-year yield was trading below the 8- and 9-year bonds, whilst longer-dated bonds had MUCH higher yields, with the yield curve seeing an extreme steepening post the 10-year bond. This indicated that the BoJ’s 25bp cap on the 10-year bond was SIGNIFICANTLY out of step with where it would be priced in the absence of YCC.
Figure 1: Japan’s yield curve on 19 Dec 2022 — a day before adjusting its YCC policy
After the BoJ’s announcement, the 10-year yield closed the day a huge 61.3% higher (as per Investing.com data), highlighting how out of step the 25bp cap was with the market. This contributed to the yield curve seeing some flattening, with a less steep rise now seen between between the 10-year bond yield and longer-dated maturities.
By allowing the 10-year yield to trade within a +/-50bp range of its 0% target, the BoJ thus made some progress towards ensuring a smoother formation of its yield curve. Nevertheless, the relationship between the 8- and 10-year bonds continues to not display a smooth incline.
Figure 2: Japan’s yield curve on 21 Dec 2022 — a day after its YCC policy adjustment
A consequence of the BoJ’s extremely dovish monetary policy amidst significant tightening from most other central banks, has been a significant depreciation in the yen against many other currencies. This includes the USD, with the yen falling significantly as the differential between the US and Japanese 10-year bond yields saw an enormous increase since its 2020 trough.
Figure 3: US and Japan 10-year yield divergence vs USD/yen relationship
While the yen has recovered somewhat from its October trough in light of US yields falling, it remains well below levels seen during 2020 and 2021. With the Fed indicating that it intends to increase interest rates further to above 5%, and maintain them there for all of 2023, the BoJ is likely mindful of the potential for further yen weakness at a time when Japan’s inflation has risen to its highest level in decades.
In order to help strengthen the yen, one of the key things the BoJ can do is to try and reduce the spread between US and Japanese 10-year bond yields. Allowing the Japanese 10-year bond to trade as high as 50bps versus its previous cap of 25bps, is thus an important measure that can help to support the yen. Indeed, the shift to a larger target band has seen the yen trade materially higher vs the USD, with the USD/Yen falling 3.8% (i.e. each US dollar now buys less yen than it previously did) on the day of the BoJ’s announcement.
Figure 4: USD/YEN
Though longer-term, the outlook for the yen remains less clear. For whilst the BoJ can alter the outlook for the Japanese 10-year yield, this is only half of the equation. The other half of the equation is the US 10-year yield.
While Japan’s 10-year bond yield surged on the day of the BoJ’s YCC announcement, the US 10-year yield also rose. Even though it rose by far less in percentage terms, given that the US 10-year yield is trading from a much higher level, the basis point differential continues to remain in its recent range.
Figure 5: Recent spread between US and Japanese 10-year bond yields
With Japan’s 10-year bond currently limited to trading as high as 50bp, and US bond yields trading in a much wider range, whether or not the BoJ's decision will be enough to support the yen longer-term, largely depends on where US bond yields head.
If the Fed really does raise rates to 5.1%, and really does maintain these rates across 2023 (such as in the event that inflation really does prove to be as stubborn as some continue to believe), then the US 10-year yield may move higher, pressuring the BoJ to further loosen its YCC in order to avoid further depreciation in the yen.
Alternatively, the inverse is also true. If US inflation falls significantly over the year ahead (as I believe that it will), alongside a sharp deterioration in the US economy, US yields may fall significantly, meaning that the spread between US and Japanese yields may compress, strengthening the yen without the BoJ needing to undertake further hawkish monetary policy adjustments.
For many years Japan has been trying to STIMULATE inflation, believing that after long periods of low inflation, as well as relatively frequent bouts of deflation, that higher inflation would ignite spending and economic growth. This has included negative short-term interest rates, huge amounts of QE, and YCC.
Figure 6: Historical 1-month Japanese bond yields
In a case of be careful what you wish for, Japan is now suddenly dealing with its highest inflation in decades. While it may have wanted 2% inflation, the BoJ isn’t targeting a spiraling higher of inflation. This is what makes supporting the value of the yen all the more important, as an ongoing devaluation would risk a further rise in inflation.
Figure 7: Japan CPI — YoY change
Of particular note also is that unlike in the US, where the recent trend has been for a deceleration in inflation, the rate of inflation in Japan has been ACCELERATING in recent months. Therefore whilst YoY CPI growth rate is 3.7%, the annualised rate of growth over the past 6-months is 4.4%, whilst the annualised rate of growth over the past 3-months is 5.6% — pointing to higher YoY CPI growth in the months to come.
In summary, while the BoJ specifically called out the shape of Japan’s yield curve as a key reason for its decision to widen its YCC band, the value of the yen, and the outlook for Japan’s inflation rate, are also key considerations. Each of these things also happen to be interlinked with each other, making each factor a necessary consideration for the BoJ when formulating policy, as well as for economic observers and investors, who seek to try and anticipate where the BoJ’s policy may head.
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