The Bank of Japan for decades has had one of the biggest market footprints of any central bank, from powerful currency market interventions to buying huge amounts of bonds in a “quantitative easing” blueprint that most others would eventually follow.
At the vanguard of global policymaking, the market-savvy institution’s record is mixed. But the benign reaction across markets to the BOJ’s latest “yield curve control” tweak suggests BOJ Governor Kazuo Ueda may have timed this one just right.
Reversing ultra-loose monetary policy and reducing its over-bearing presence in the Japanese Government Bond (JGB) market was always going to be difficult for the BOJ, never mind convincing itself that the generational battle against deflation has been won.
Doing that in the midst of the greatest global bond market selloff in 40 years would turn a formidable challenge into an almost impossible one. Timing, sequencing and signaling were always going to be crucial.
Symbolism too. It is surely no coincidence that the BOJ’s move to effectively double the 10-year JGB yield cap to 1.0% came after official data showed that annual Japanese consumer price inflation is now higher than U.S. inflation for the first time in eight years.
Since catching markets by surprise with its first YCC tweak in December, the BOJ had until last Friday resisted market, public and political pressure to go further. In those eight months global inflation has topped out and is now clearly falling, and major central banks are closer to “peak rates.”
This is important because when the BOJ starts to unwind its JGB holdings, domestic investors will be more willing to buy and smooth the transition - all else equal, the huge yield premium offered by foreign bonds over JGBs will have shrunk, and on a hedged exchange rate basis, perhaps evaporated completely.
“Although the semantics of the change can be debated, the path is clear,” and YCC is on track to be removed early next year, according to analysts at HSBC.
Barclays analysts reckon the BOJ will scrap YCC in October, which would be “sufficiently justified” by Japan’s strengthening inflation dynamics.
BOJ GETS MARKET BUY-IN
Whenever the BOJ decides to start offloading its JGBs, there will be plenty of pent-up demand.
Japan is the world’s largest creditor with a net investment position of $3.2 trillion, according to the International Monetary Fund. Japanese investors hold $4.3 trillion in various overseas debt instruments, including $2.1 trillion in portfolio investments.
Current rates market pricing suggests the U.S. Federal Reserve will have ended its tightening cycle by October this year and be gearing up for more than 100 basis points of rate cuts next year.
Meanwhile, the European Central Bank is indicating it could soon pause its rate hiking cycle and markets are pricing in 50 bps of cuts next year. The Reserve Bank of Australia has refrained from raising rates at its last two meetings.
This is probably a less risky environment for the BOJ to be stepping up its policy “normalization.” And investors know it - Friday’s move did not trigger a huge shock in any market.
The yen has weakened - perhaps surprisingly - but with that has come a sharp decline in volatility. Three-month dollar/yen implied volatility on Friday had its biggest fall in more than a year, and implied volatility in JGB futures fell too.
Three-month dollar/yen cross currency basis rates - a measure of demand for dollar funding often seen as a proxy for wider market stress - have tightened to almost zero, reflecting the least amount of dollar funding stress since March 2022.
The response to the BOJ’s initial - and highly surprising - move on Dec. 20, 2022 to effectively double the 10-year yield cap to 0.5% was less benign.
The dollar fell to a seven-month low near 127 yen by mid-January from 137 yen, implied dollar/yen volatility had its biggest one-day jump since the coronavirus pandemic, and the dollar/yen cross currency basis widened.
There will undoubtedly be setbacks and obstacles along the way. But the early signs suggest investors believe the BOJ has timed it right and can, to coin a phrase, achieve its own “soft landing.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.