Should You Still Bet Against the Bank of Japan?

One of the most fascinating developments in financial markets over the past year has been the Bank of Japan (BOJ) and its policy of yield curve control (YCC). It has been of special focus for financial market participants amid speculation that the policy would be dropped on various occasions. Last week (mid-January), investors were positioned for the BOJ to tweak or at least abandon its YCC policy. Yet, the BOJ surprised markets, and made no change. It was not the first time the BOJ has blindsided investors over the past year on YCC.

Hang on, just what is yield curve control (YCC) again?

To recap, the BOJ’s yield curve control is a policy which involves holding a target on the 10-year government bond yield, currently at zero, but has been allowed to fluctuate around a band.

Given inflation and short-term interest rates have risen significantly around the world over the past year or so, bond yields (outside of Japan) have also lifted. Subsequently, Japanese bonds have traded towards the upper part of the band.

The BOJ vs The Free Market

Even though the BOJ has a target on the 10-year bond yield, there are still buyers and sellers which influence supply and demand, which depend on economic conditions.

Since early 2022, the BOJ has widened the band twice, and most recently in December last year. The announcement surprised financial markets by increasing its band, and effectively increasing the cap on yields from 0.25% to 0.50%.

BOJ Governor Kuroda expressed that widening the band at that December meeting did not equate to a tightening of monetary policy. Nonetheless, increasing the band does highlight pressure from financial markets on bonds.

For my Australian friends, the BOJ’s policy may sound like déjà vu given that the Reserve Bank (RBA) who adopted a similar policy during the pandemic, abandoned yield curve control in 2021. The end of the RBA’s yield target resulted in a surge government bond yields, and was somewhat disruptive for financial markets. The RBA itself has admitted that the exit from the policy was “disorderly” and in retrospect, viewed that the policy could have been ended earlier. An earlier exit would have resulted in less market disruption, as the market-determined yields would have been closer to the actual yield target.

Sentiments from BOJ Governor Kuroda in regard to the BOJ’s yield curve control however, stand in stark contrast, who claims that the policy is “sustainable”.

Nonetheless, here are two key reasons why YCC is not sustainable, as the RBA found in Australia.

For Japan, the first reason is technical. YCC is not sustainable because it is limiting the ideal functioning of the bond market.

The BOJs actions should speak louder than words. And the actions from the BOJ would suggest that there some recognition that a transition away from yield curve control is going to be necessary at some point.

The widening of the allowable trading band for the 10-year yield in December implies a need for improved market function. It also allowed for speculation that the BOJ was looking for some kind of exit strategy from the yield target. The BOJ also tweaked a funding program at its meeting last week, even though it left its yield curve control policy unchanged. While the funding program was aimed at bringing down interest rates across the curve to improve market function, it highlights how unsustainable that the yield curve control policy has become in the BOJ’s monetary policy toolkit.

The BOJ owns around half of the whole Japanese bond market, and more than 100% on some issues of 10-year bonds. How does the BOJ own more than 100%? According to Bloomberg, it is because the BOJ has lent out bonds and then bought them back, thus double counted ownership of these bonds.

Needless to say, a lack of liquidity could be an issue when the BOJ owns pretty much most of the 10-year government bond market, if not all.

To sum up, Japan’s bond market is not functioning as it should.

The second reason why YCC is not sustainable, is that economic conditions continue to suggest higher yields than the BOJ’s target.

Ultimately, it is economic factors which has led to markets pressuring yields to rise. On top of the lift in global bond yields, inflation in Japan is at a 41-year high at 4%. Core inflation, which strips out food and energy, sits at 3%. Clearly not an environment which supports bond yields close to zero, nor official interest rate settings that are still negative.

The BOJ claims that inflation will fall towards their target and hopes to see more sustainable wage growth before looking to normalise monetary policy. I’ll admit that there is some merit to the BOJ’s argument of falling inflation. Headline rates of inflation globally should fall given oil prices are down over 30% from their peak, and the global capacity pressures that were witnessed last year have eased. In all likelihood, we will see easing inflation globally and in Japan, at least in the near term.

But wages growth has picked up. Moreover, there remains a risk for more persistent global inflation later this year. Even if we do see inflation rates dip, we may not see a significant shift in the hardline stance on inflation from the US Federal Reserve or other central banks, at least for the remainder of the year.

That would suggest that there will remain market pressure within global financial markets for yields to remain well above where the BOJ is targeting right now.

Implications

Investors and traders might have been caught out on a few occasions in the past year.

However, the economic conditions suggest that there is a strong case that rates in Japan do not need to be at zero. Along with inflation now running above target the BOJ’s 2% target, wage growth has also picked up from a year ago and has been close to 3% for much of last year. Indeed, potential successors to Governor Kuroda, have hinted at tweaks to monetary policy away from non-conventional monetary policy tools, which may include dropping YCC and its negative interest rate policy. BOJ Kuroda will be stepping down from his post in April.

Even if Japan wants to maintain a relatively easy monetary policy stance, there is an increasing cost to Japan’s yield target, particularly if the BOJ wants a functioning bond market. Odds remain high that it will be dropped at some point, and speculation is likely to mount again that policy will be tweaked.

So, despite the fact that the BOJ defied expectations once again by keeping monetary policy unchanged last week, the trades betting on the BOJ dropping YCC or normalising policy are most certainly not dead.