Alone among major central banks, the Bank of Japan (BoJ) has stuck to its expansionary monetary policy, but at the cost of a depreciating yen and rising inflation. The incoming governor of the BoJ looks set to overhaul Japan’s approach to yield control; if he does, the implications for global markets could be significant.
While most central banks were tightening policy aggressively last year in response to mounting inflation, the BoJ held on doggedly to its expansionary monetary stance. Behind this decision lay Japan’s 40-year history of battling deflation and its sluggish post-pandemic economic performance.
Under YCC, the BoJ fixes the rate of its 10-year Japanese government bond (JGB) with the aim of influencing long-term interest rates. The policy has been in place since 2016 and proved workable in an era of low and stable interest rates. During 2022, however, interest rate rises in the US, EU, UK and elsewhere caused the yen to depreciate rapidly which, when combined with rising energy prices, has driven up Japan’s rate of inflation.
Coming under pressure from investors and government officials to find a solution, the BoJ surprised the markets in December last year by widening the permissible range around its YCC target. This both bolstered the value of the yen and opened the door to the possibility of monetary tightening.
BoJ faces mounting pressure for change
Since then, pressure for further action has grown. Non-Japanese investors are gaining confidence that Japan’s era of extremely loose monetary policy is ending. Many have sold their JGB holdings and taken out short positions across the Japanese curve, thereby forcing the BoJ to increase its purchases of JGBs in order to defend its YCC policy target. The BoJ’s balance sheet is expanding at a blistering pace and is not far off levels seen at the height of the pandemic in 2020.
These purchases have global implications because they are larger than the reduction in the balance sheets of other major central banks. Following the YCC adjustment, the BoJ’s net assets have increased by more than US$900bn, while their JGB holdings have increased by US$742bn. The BoJ now holds roughly 55% of all JGB issuance and, at its current rate of purchases, will own 100% of the JGB market within five years’ time. This situation is clearly unsustainable.
Will Mr Ueda sweep clean?
The incoming Governor of the Bank of Japan, Kazuo Ueda, has signalled his discomfort with the current policies. It is likely that under his leadership the BoJ will remove YCC altogether and replace it with a quantitative easing (QE) programme. This would allow long-term interest rates to be more freely set by the markets, leaving the BoJ to manage rate volatility through QE. While the BoJ manages this transition, we believe that short-term yields are likely to remain negative and near their current level of -0.1%, while the 10-year JGB yield is likely to rise to above 0.5%.
Any evidence of financial stress caused by the removal of YCC could prompt the BoJ to expand the scope of its QE initiative to include more asset classes – as it did in December 2022, when it purchased ETFs, Japanese REITs and credit.
Tighter BoJ policy will reduce the availability of global liquidity and act as a headwind for risk assets, potentially at the same time as the US Federal Reserve (Fed) toughens its monetary stance in response to stubbornly strong inflation data.
Rising Japanese bond yields would increase the attractiveness of Japanese bonds for domestic investors, and could result in Japanese institutions selling a meaningful portion of their large (c.US$1tn) overseas bond holdings. If JGB yields rise faster than expected, we are likely to see non-Japanese assets being sold at an accelerated pace, triggering elevated global rates volatility.
Higher bond yields could also pressure Japan’s fiscal position if losses on the BoJ’s gargantuan balance sheet need to be recapitalised by the Japanese Ministry of Finance (MoF) and/or rising yields lead to a higher fiscal interest cost burden. This could raise concerns about Japan’s fiscal sustainability, threaten Japan’s “safe haven” status and even spark wider contagion in global financial markets. However, we believe that these risks should prove manageable for the BoJ: our modelling suggests that even if 10-year rates move to around 1% - i.e. double the 10-year JGB yield that we expect to see post-YCC - this would not produce excessive balance sheet losses and government debt service costs.
It ain’t necessarily so
Of course, our assessment could be wrong. Mr Ueda is viewed as a pragmatist, and he may opt for more cautious tinkering or even maintain YCC in its current form. In addition, if inflation data and inflation expectations are lower than expected, then the BoJ might give YCC a stay of execution for the time being or find alternative ways to adjust its policy stance. For instance, the incoming governor may first decide to shorten the target maturity of the YCC programme from ten years to five years to assess the effects on the economy and financial markets. This, however, appears unlikely given recent rhetoric from the BoJ and Japan’s Ministry of Finance.
In any case, the international backdrop may well force Mr Ueda’s hand, because rising yields in the US and renewed yen depreciation will only add to the case for tighter BoJ policy. Higher domestic inflation, higher US interest rates and rising energy prices are not beyond the bounds of possibility. The BoJ could be obliged to tighten more than expected – and even raise short-term interest rates out of negative territory.
 Source: Macrobond, Bank of Japan, Sarasin & Partners, 24.02.2023
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