Japan is about to surprise the markets with monetary policy

The national flag of Japan flies atop the Bank of Japan building on November 12, 2019 in Tokyo, Japan.

Tomohiro Ohsumi | Getty Images

The Bank of Japan is approaching an inflection point.

It comes as policymakers around the world are scrambling to tighten monetary policy in an effort to contain record high inflation.

The Swiss National Bank was one of the last major central banks to act, surprising markets last month by implementing its first rate hike in 15 years. The SNB jumped out of the blocs up 50 basis points and the shock sent the Swiss franc soaring to its highest level against the euro for nearly two months.

However, Japan has tried to stay loose and prioritize yield curve management. The world’s third-largest economy has been stuck in an environment of low growth, low inflation and sometimes deflation for years, meaning the Bank of Japan has kept policies accommodative in an effort to boost the country’s sluggish economy.

The central bank was on track to buy about 15 trillion Japanese yen ($110 billion) in government debt in June, making it the only major central bank yet to embark on a significant asset purchase program.

Overall CPI in Japan is just above the 2% target, while core inflation is at 0.8%, so the central bank is not facing the same inflationary pressures as many western counterparts,

The BOJ has reiterated its determination to avoid deflation, which remains the dominant policy hurdle in Japan. The central bank expects consumer price growth to slow in the medium term once the impact of energy prices on the overall figure begins to diminish.

But should this assessment prove wrong and the BOJ was forced to raise interest rates – either as a result of inflation or as a result of upward pressure from other monetary tightening moves around the world – it could set off a ripple effect in global markets. .

According to Neil Shearing, chief economist at Capital Economics, much depends on the “openness” of the country’s capital account (the balance of payments) and the extent to which flows are ravaged by changes in interest rates elsewhere.

“Japan is open to global capital flows and so, as bond yields in other countries have risen, the BoJ has found that its commitment to a policy of Yield Curve Control – keeping the 10-year JGB (Japanese government bond) yields within 25 basis point band on either side of zero — has been tested by global investors,” Shearing said in a note Monday.

Yield curve control tested

The Bank of Japan’s self-imposed bond yield ceiling helps keep borrowing costs low across the economy, essentially supporting growth.

“The recent sell-off in global bond markets has pushed 10-year JGB yields to the upper end of the BoJ’s range, forcing the BoJ to buy ever-greater amounts of government debt to maintain its target — through some measures, if it went through.” if it bought at this month’s pace, it would own the entire market of outstanding JGBs within a year,” Shearing said.

The Bank of Japan has continued to defend its yield target even as global momentum drives towards higher yields, and the divergence has driven the Japanese yen sharply lower.

Shearing pointed out that while the People’s Bank of China imposes capital controls to maintain leverage over its currency and monetary policy, Japan’s relatively open capital account means it cannot control the yen while retaining sovereignty over monetary policy.

Essentially, the Bank of Japan can support the bond yield link by buying boundless amounts of bonds, sending the yen into a tailspin, or it can protect the currency from a destabilizing depreciation, but it can’t manage both at once.

Capital Economics expects Japan to lose some ground in its yield curve containment by widening its target range, which could then see investors test its determination to hold the line at the new range. Against a background of rising rates around the world, this could weaken the yen further.

“Of course, a markedly weaker currency could be a positive development for an economy struggling to get out of three decades of deflation, but large and rapid currency movements could be destabilizing,” Shearing said.

“At some point, something gives – either because balance sheets come under pressure or because imported inflation becomes a problem.”

As deflation generally drives businesses and consumers to delay investment and purchases, the Bank of Japan has been working for years to bring inflation back to its 2% target to relaunch its manufacturing capacity and rate of growth.

‘Violent Adjustment’

The ongoing BOJ quantitative easing could also have some important implications for both domestic and global markets.

According to Charles-Henry Monchau, chief investment officer at Syz Bank, by limiting the rise in long-term interest rates, the central bank is risking inflation above its original targets.

Monchau noted that the BOJ buying bonds implies that it would have to borrow the equivalent amount, further exacerbating price increases. The divergence in yields compared to other developed countries, which are tightening monetary policy, is weakening the yen. Meanwhile, the BOJ is artificially keeping bond yields low by buying so many JGBs that it can’t raise interest rates, the primary method of containing higher inflation.

In summary, he suggested that these dynamics could create the conditions for inflation “suddenly spiraling out of control, implying an inexorable and violent adjustment in the bond market.”

Maintaining loose policies at all costs can also entail risks on the international stage.

“The weakening of the yen could lead to a currency war in Asia, which in turn could fuel rising inflation in neighboring countries, increase the cost of paying off their dollar-denominated debt, thus increasing the risk of default. by less creditworthy countries.” Monchau told CNBC on Tuesday.

“Another international consequence with even greater consequences is the risk of a sudden termination of the carry trade.” The carry trade is a strategy in which investors borrow from a currency with a low interest rate to finance the purchase of a higher yielding currency, absorbing the difference between the rates.

Monchau argued that since the BOJ is required to lend the equivalent amount of the bonds it buys, this market context of “access to financing at very low interest rates in a currency that is constantly depreciating” favors the use of carry trades. .

“For example, a long Brazilian real, short yen strategy has already yielded a 35% gain this year. But the risk of this type of strategy is a sudden reversal of the current trend,” explains Monchau.

“Indeed, if the yen strengthens and/or if the JGB rate rises (because the BOJ exits the YCC), there is a risk of a sudden and massive settlement of carry trades, with a cascade liquidation of risky assets.”

This would facilitate the panic sell of stocks, the forced sale of the US dollar and a spike in US bond yields due to the rise in JGB interest rates, the kind of sudden “financial accident” that could exacerbate the pain for risky assets and increase the risk of a recession.

“The bleak scenario described above is far from certain. First, the imbalances created by the Japanese authorities (over-indebtedness and bond market manipulation) have been pointed out for years without ever leading to a major accident,” said Monchau. noted.

“The current situation in JGBs, in a context of high market volatility, is dangerous to say the least. And any market stress resulting from the end of QE in Japan could have another impact on international financial markets: the loss of confidence in the monetary policy of the major central banks.”

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