Head of FX Strategy
Summary: The Bank of Japan has continually surprised dovish, but markets still expect some amount of normalization this year. In this article, we look at the BOJ toolkit, and assess the factors that could support or deter a policy pivot. We think that liquidity, fiscal and political risks remain too high to support the case for higher interest rates, which makes a tactical bearish case for the yen as long as US rates remain volatile.
The BOJ currently has a range of policy tools, mainly:
Policy rate, or the overnight rate – This is the short-term interest that is applied to the Policy-Rate Balances in current accounts held by financial institutions at the central bank and purchases of Japanese government bonds (JGBs). The BOJ has fixed the policy rate at -0.10% since January 2016, and hence this policy is also called the Negative Interest Rate Policy (NIRP).
Yield curve control (YCC) – This is the policy through which the BOJ controls short- and long-term interest rates through market operations to seek a decline in real interest rates. When the YCC is used to fix long term interest rates, it means that there is an implicit commitment from the central bank to acquire (or sell) securities in the amount necessary to keep rates in line with the target.
After short-term interest rates were cut to negative, yields across the curve plunged. So, BOJ introduced YCC to pull long-term rates back higher, and set a 0% target for 10-year bond yields. The idea was to control the shape of the yield curve to suppress short- to medium-term rates - which affect corporate borrowers - without depressing super-long yields too much and reducing returns for pension funds and life insurers.
The YCC mechanism has been tweaked three times in the last 12 months, and the ceiling for the ten-year bond rate has been raised from 0.25% to 0.5% to 1%, and subsequently, 1% became just a “reference,” and operation of the mechanism will be “nimbly conducted” around 1%. This greater tolerance for the fluctuation in the 10-year yield around the threshold reflected concerns that defending that limit too strictly could impact the ordinary functioning of the market.
Quantitative and qualitative monetary easing (QQE) – In addition to the above, the BOJ has also adopted measures such as fixed-rate purchase operations and the Funds-Supplying Operations against Pooled Collateral in order to achieve the smooth conduct of yield curve control.
After more than two decades of QE, there have been signs of a deflation exit in Japan. This prompted the BOJ to initiate a broad-perspective review of its QE programme at the first meeting under current Governor Ueda in April 2023, to be held over the next 1-1.5 years.
The desynchronization between the global central bank policies that went generally on a tightening path last year and that of Japan which continued its massive easing has been a huge driver of yen weakness. Higher US yields have also exerted upward pressure on JGB yields, which in turn has forced a gradual adjustment of the BOJ’s YCC policy. It can however be expected that this divergence in monetary policy stances is likely to narrow this year as the Fed and other global central banks start embark on a rate cut cycle, but with global rates unlikely to go back down to their earlier lows, some of the gap will have to still be covered by the Bank of Japan.
Headline inflation in Japan has returned to be above the 2% target since April 2022. While part of this is imported inflation due to supply chain imbalances and a weak yen, authorities are still trying to understand how much of the uptick in inflation is demand-led. Wage growth still looks to be depressed, and BOJ has the 2024 spring wage negotiations (Shunto) on watch to see if they bring enough of an increase to justify policy normalization.
Despite the yen and inflation focus, there are other considerations for the BOJ that necessitate that any steps towards normalization from years of massive easing are taken carefully. A rapid tightening of monetary policy could hinder economic growth, undermine financial stability, or even complicate the fiscal situation. The 7.6-magnitude earthquake in Japan on January 1 has shifted out BOJ tweak expectations from January to April.
However, there are other considerations that could make it tougher for the BOJ to normalize its monetary policy, such as:
While headline inflation stayed at or above 3% since August 2022, the November print was down to 2.8% YoY and December printed expected to cool further to 2.5% YoY. Governor Ueda has highlighted that even though inflation is running above 2%, he lacks sufficient certainty that the inflation target is being met in a “stable and sustainable” manner. In fact, inflation has exceeded nominal wage growth, leading to a fall in real wages. Growth has also surprised on the downside for the third quarter, with the Japanese economy entering a contraction. This weakens the conviction around whether inflation is really driven by a virtuous cycle of increased real income and spending.
Wage negotiation results also remain a key watch, so timing of any BOJ move, if one was to happen, will likely have to be after the results of shunto wage negotiations are announced. BOJ credibility could be at risk if it moved in January and the wage negotiations underwhelmed in March/April. Preliminary results of shunto are likely to be available on March 15, while the final results will be available in July.
As global central banks shift to neutral-to-dovish policies, any normalization move by the BOJ will still stand in contrast again. The Fed and the ECB are priced in to cut rates by about 150bps this year, while the Bank of England is priced in for 120bps of easing. Although any tightening move by the BOJ will likely remain modest, it will be in contrast to the global monetary cycle.
Steps towards policy normalization will expose the BOJ to SVB-type risks. The central bank has warned in its recent Financial Stability Report that regional banks and shinkin financial co-operatives were exposed to interest rate risk after piling into long-term loans and securities. Given that the prolonged phase of ultra-low interest rates has driven financial institutions to shift toward longer-term loans and bonds in pursuit of higher yields, the magnitude of the valuation losses brought about by the increase in interest rates is not expected to be trivial.
After the July tweak to YCC, Japan’s 97 regional banks reported unrealised losses on bonds and investment trusts totalling about 2.8 trillion yen at end-September, up 70% from the end of June, according to calculations by Nikkei. This would limit the banks’ capacity to make new investments to buy higher-yielding bonds when interest rates rise, posing a threat of stagnation.
Global financial stability risks would also be under consideration, given Japanese investors are the biggest foreign holders of US government bonds and own everything from Brazilian debt to European power stations. An increase in Japan’s borrowing costs threatens to amplify the swings in global bond markets. Flow reversal is already underway, with Japanese investors repatriating as local yields rose in anticipation of a BOJ pivot.
Raising the policy rate above zero could also impose a cash-flow burden for the central bank, as it increases its interest burden for the financial institutions' reserves parked at the central bank. The Fitch said that the BOJ will face significantly higher interest expense on bank reserves and potentially large losses on its bond holdings when it raises policy rates. Weaker income would cut transfers to the government, hitting the BOJ’s capital, similar to developed-market peers. This could in theory hurt its policy credibility and/or create a contingent liability for the sovereign.
The BOJ will also need to take fiscal sustainability risks into account if it was to embark on the path of policy normalization, especially given that the fiscal policy is likely to remain expansive as global economy faces recession threats with the increase in interest rates. Meanwhile, elections are due in Japan and PM Kishida’s approval ratings have been slipping.
Raising the interest rate will increase the burden of the government’s massive debt load. The BOJ owns more than 50% of the JGBs, and an increase in interest burden could use up the scarce fiscal space that may be needed this year. Risks of a failure to repay government debt could threaten the public confidence in government bonds and diminish the potency of the BOJ's monetary easing measures.
This long laundry list of considerations suggest that any BOJ normalization remains nuanced both in terms of timing and magnitude.
In terms of timing, it may be premature to expect a move before the wage negotiation results are out and the BOJ’s policy review will be complete. This means that a tweak, if one was to happen, is unlikely in January. Both April and July meetings could be live as they come with the updated outlook. If early results of shunto suggest over 3% wage hike, then expectations could build up for a July tweak. However, if the wage increases remain subtle, then expectations could be slashed or shift forward to July. However, markets will continue to price in some expectations of a pivot, causing significant volatility in the yen and the rates market over the course of the next few months.
In terms of the magnitude, there is a case for the BOJ to not raise its rates significantly. At most, the negative interest rate policy could be scrapped, but raising rates above zero seems to remain difficult especially given the government debt burden and lack of a JGB market. This is still an important move, but not substantial to reverse the yen’s carry advantage.
As I wrote in the Q1 Quarterly Outlook, Japanese yen is a BOJ problem with a Fed solution. Given that the Fed is likely to cut rates this year and yields will go down, there is room for the policy divergence between the Fed and the BOJ to narrow even if the BOJ continued its massive easing. In fact, several automated FX trading algorithms over the past many years have remained dependent only on US yields, with Japanese yields stuck at 0%. It may be safe to assume that yen reacts more to changes in Treasury yields.
However, recent price action has once again brought rates volatility in focus, and a fragile geopolitical landscape this year could continue to fuel volatility. USDJPY got close to testing the 140 support at the end of 2023, but has since rallied to 148+ levels as on 18 January. Dollar-yen risk reversals have also jumped to -0.98 from -1.48 at end-2023. This signals that implied volatility premium for USDJPY puts over calls is trending lower, or that the demand in the options market is decreasing for downside protection in USDJPY. This could mean a higher perceived risk of USDJPY gaining than falling in the options market.
Overall, this suggests a bearish tactical picture for the yen but USDJPY close to 150 could limit the upside from here. However, traders could continue to be compelled to go long if USDJPY trades below 145 and US yields remain volatile. However, a bullish structural picture is intact given the yield dependence and valuation, but the negative carry is a hinderance. Piling into long JPY positions could become attractive closer to April meeting if wage numbers are optimistic. EURJPY and AUDJPY could be particularly interesting as EUR is likely to remain under pressure amid growth challenges in the Eurozone and RBA rate curve seems to have room for a catchup as inflation and labor market data disappoints. Until April, carry will continue to make efforts to bid the yen futile and FX options may be an easier play.
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