BOJ's Yield Curve Control Tweak: Navigating Global Impacts

In the latest monetary policy address, the Bank of Japan (BOJ) unveiled a tweak to its yield curve control policy that could signal the start of a monetary tightening with far-reaching implications. The -/+ 0.5% deviation to the 10-year Japanese government bond yield, once a sacred threshold, will now be treated as a "reference rate" rather than a strict upper limit. The BOJ will cease to conduct unlimited bond purchases whenever the 10-year yield exceeds 0.5%, and instead, they will allow the 10-year yield to shift upwards in a gradual and stable manner.

Several factors combined to precipitate this shift in policy. First, the BOJ has finally reached its inflation target. The decade-long easing campaign has finally borne fruit, with both the headline and core CPI in Japan overshooting and staying above 2%. Positive inflation momentum is underscored by promising shifts in sentiments among domestic firms and households. Escalating wage pressures also lend credence to BOJ’s accomplishment, with firms acknowledging the need for wage hikes to attract and retain skilled workers in the latest employment report. Second, BOJ is rethinking yield curve control due to the weakness of the yen. Maintaining a prolonged stance of easing at a time where other central banks carried out unprecedented tightening campaigns had led to drastic interest rate differentials, triggering considerable depreciation of the yen. While initially welcomed for its benefits to exporters and inflation, the currency's weakness started to cause concerns. As the dollar-yen breached 140, Japan’s economy saw escalating price pressures and deteriorating terms of trade, while anticipated benefits for exporters were offset by companies’ offshore supply chains.

Lastly, the global fiscal policy landscape and JGBs market dysfunction warrant BOJ’s policy tweak. The pandemic normalized large fiscal stimulus for governments around the world, and the Japanese government to was able to endorse substantial fiscal outlays. Stimulus since the pandemic surpassed 100 trillion yen and amounted to 18% of GDP, bolstering the prospects of sustaining inflation above the 2% mark. As previous covered in our article, “Bank of Japan, the owner of last resort”, BOJ's sizeable purchases of Japanese government bonds have raised issues of illiquidity in the Japanese Government Bond market. This has led pertinent questions about the efficacy of continuing the yield curve control policy.

Global Implications of BOJ policy tightening

The tweak of yield curve control, while an insignificant policy pivot in itself, has the market speculating on whether it is the beginning of BOJ’s policy tightening. Over the past decade of quantitative easing, the BOJ injected substantial liquidity into the market. Diminishing Japanese bond yields and lacklustre stock returns incentivized many institutions and pension funds to chase overseas assets. Additionally, carry trades became a norm with the low rates, and funds commonly borrowed yen to buy asset overseas. As a result, substantial amounts of Japanese capital ended up in the U.S. Treasury markets. Japan is now the largest foreign holder of US treasuries (15% of all treasuries held by foreign investors as of Jan 2023). The fear is that monetary tightening in Japan may incentivize institutions to repatriate their investments, potentially triggering sell-offs in both the U.S. and European markets. Amidst elevated FX hedging costs, Japanese investors already became net sellers of global bonds in 2022. The trend is expected to continue as fully hedged overseas bonds now yield less than Japanese government bonds. In their latest financial stability report, the ECB sounded a cautionary note, citing vulnerability in the Euro Area Bond Market if Japanese investors withdraw abruptly in case of rapid monetary tightening in Japan.

The BOJ’s latest tweak in yield curve control policy has not tiggered any substantial market reaction so far, primarily due to the ongoing interest rate differential. The cross-currency basis, a gauge of carry trade sentiment, has stayed flat thus far. The immediate impact of a BOJ tightening should be felt first in the currency markets. Should negative interest rates and yield curve control be phased out, a yen rally could begin. Moving forward, market focus will centre on Japan's inflation and wage growth dynamics. Even though the BOJ is cautiously optimistic on Japan's economic trajectory, acknowledging the potential for a modest recovery driven by pent-up demand, they will want to completely dispel the deflation mindset that has long haunted the Japanese economy, and any future monetary tightening is likely to be gradually carried out methodically.