Macro Insights: BOJ’s surprise policy tweak – signs of an eventual end of yield curve control?

What did the BOJ do?

The Bank of Japan tweaked its long-held Yield Curve Control (YCC) policy in a surprise announcement at the December 19-20 meeting. The bank widened the band in which it would allow rates for 10-year Japan government bonds to move to -/+ 0.5% from -/+ 0.25% previously. Rest of the monetary policy levers were left unchanged, including the 10-year target still being held at 0%.

Why did the BOJ tweak policy?

Governor Kuroda stressed that the move is for financial market motives, not for economic reasons, potentially trying to limit expectations of further tweaks. However, hidden beneath this message was a significant adjustment higher in core CPI forecasts to ~3.5% from ~3% in the October report.

This is a victory moment for Kuroda, as he can claim that he brought back inflation in Japan, while highlighting the success of the YCC policy.

The move also acts as a smoother transition to the new governor, and further tweaks cannot be ruled out in 2023.

I would highlight two reasons why we think this announcement was made earlier-than-expected, besides the fact that the BOJ loves to surprise markets (read: BOJ is poor at communication).

• One, with the Fed having slowed down its pace of rate hikes recently, and the drop in 10-year yields from 4.2% to sub-3.5% at one point, the pressure on the yen has come off. The BOJ doesn’t want to be seen as yielding to market pressure, and now seems to be a better time to tweak policy before yields rise again.
• Two, Kuroda wanted to take the credit of starting the policy tweaks, rather than leaving it all to his successor after his term ends in April. The expectations around BOJ’s policy review had picked up after weekend reports that the Kishida government is looking into reviewing a 2013 accord between the government and the BOJ, under which the central bank commits itself to achieving 2% inflation as soon as possible.

An eventual exit?

The effectiveness of a Yield Curve Control policy remains debatable, and it is especially hard to maintain this policy amid the global tightening wave that we have seen this year without a ton of collateral damage. The damage this year came in FX markets, as the Japanese yen plummeted to 32-year lows. The limits of the YCC policy were also tested in the bond markets.

With the risk of Fed tightening more than expected in 2023 still intact, there is still a risk that markets will again test the limits of BOJ’s policy stance. Long-end JGB yields will likely test again the new upper limit of 0.5% after being up over 15bps following the announcement. We would potentially see bouts of strength in the Japanese yen now as expectations of an eventual exit from the YCC policy emerge. However Kuroda puts it, he seems to be setting the stage for an eventual exit and the markets will increasingly position for that.

Investment implications

The run higher in Japanese yields is likely to create further volatility in global equity and bond markets, especially because it comes at a time of thin liquidity and lack of other catalysts.

As the market once again pressures the BOJ to move towards an eventual exit, the short JGB or long yen trades could potentially have more room to run. This is also supported by the likely reversal of yen carry trades as Japanese investors are getting positively rewarded to keep their cash at home during a global economic slowdown and periods of high macro uncertainty. This is not just yen positive, but also negative for foreign assets especially US Treasuries that have been the bulk of the assets held by Japanese investors. In terms of equities, this could mean a favourable stance towards Japanese financials vs. exporters and technology companies.