- Investment Director
United Kingdom, Institutional
Change
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Ever since the Bank of Japan (BOJ) tweaked its yield curve control (YCC) regime in December 2022, investors have been expecting further policy normalisation. The nomination of Kazuo Ueda as BOJ governor in February and his taking the reins in April prompted speculation that such a change was imminent, only for investors to be disappointed as the BOJ continued with its accommodative policies. Now the BOJ has announced a further adjustment that may well be the game changer that markets have been waiting for, with significant implications for global investors. Here is why.
What has changed?
The latest statement on monetary policy marks a formal and meaningful step towards normalisation against a backdrop of:
- wage growth in Japan reaching levels last seen in 1994;
- headline inflation that currently exceeds US levels; and
- strong momentum in the service sector.
For the first time, the BOJ mentions upside as well as downside risks to inflation and while the YCC band remains technically unchanged at ±0.50%, the BOJ has confirmed it will allow yields to reach 1%.
Why is this important?
YCC has been a key element of monetary policy in Japan, as the BOJ aims to control the yield on Japanese government debt up to the 10-year point by purchasing bonds in the open market. The stated objective of the policy is to stave off deflation and encourage inflation. The BOJ has long been explicit in targeting a “deliberately irresponsible” policy mix to stimulate economic growth and help inflation to return to the Japanese economy.
The BOJ formally changing tack constitutes an initial acknowledgment from policymakers that inflation is returning into the Japanese economy. Globally, inflation may be starting to come down from the heightened levels seen last year, but in Japan prices are still accelerating — for instance, the latest Tokyo CPI figure surprised at 4%, the highest rate since 1982.
The de facto widening of the YCC band is expected to push the yield on the benchmark 10-year Japanese government bond (JGB) decisively higher — already since the announcement, yields have reached levels last observed in 2014. While the BOJ remains sensitive to the need for financial stability and will be monitoring the speed with which rates adjust to 1%, market consensus is that such an adjustment is now all but inevitable.
Over time, it may also go some way to strengthen the Japanese yen (JPY), which has depreciated (Figure 1). In October 2022, the BOJ’s unchanged stance even saw the USD/JPY exchange rate cross the psychological barrier of JPY150, prompting the Ministry of Finance to prop up the currency with significant market interventions. However, in the short term we may see continued JPY weakness as the currency becomes the release valve for ongoing differences between Japanese policy and the rest of the world.
Figure 1
What are the likely broader implications?
We think this reset in policy has several wider implications for investors, most notably:
- Continued support for Japanese assets — Our team’s projections suggest that Japan’s nominal growth may reach 4% to 6% over the coming years, meaning that the revised policy remains very loose and supportive of Japanese assets, particularly equities.
- Lower hurdle for higher global yields — The biggest impact will likely be felt in global fixed income markets, which lose their most important anchor as JGB rates are likely to move up from here. Already we have seen bund rates — the other historical anchor of bond markets — increase significantly over the course of 2022. Figure 2 illustrates just how much Japanese yields have diverged from the rest of the world. A meaningful pickup in JGB rates removes another important constraint on higher global yields.
Figure 2
- Reversal of capital flows — Slowly, Japanese bonds will become a more attractive solution to domestic institutions, which are significant investors in international bonds and equities. Over time, these investors could relinquish international markets and reinvest in the domestic Japanese market. If this vital source of global capital were to dry up, it could mean increased funding costs and lower valuations for other markets.
- Potentially steeper curves — In parallel, central banks such as the US Federal Reserve and the European Central Bank have started to sound more dovish, despite little evidence that their economies are on track to pull inflation sustainably back to target. With front-end rates still pinned down in Japan and potentially plateauing in the rest of the world, we could see the long end of global yield curves inch upwards as higher inflation expectations become embedded in the system.
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