Thursday December 07, 2023

What the end of Japan’s yield curve control experiment means for markets

By News Desk
November 05, 2023
Pedestrians walk in front of the Bank of Japan head office building in Tokyo on April 27, 2022. — AFP
Pedestrians walk in front of the Bank of Japan head office building in Tokyo on April 27, 2022. — AFP 

Ever since the Bank of Japan embarked on a huge bond market experiment in 2016, one of the biggest questions among investors has been how it would end.

Central banks around the world have used bond-buying programmes known as quantitative easing to support economies for more than a decade. But seven years ago the BoJ went further, setting a hard limit on 10-year Japanese government bond (JGB) yields.

This week, the BoJ took the biggest step yet towards unwinding the policy, announcing for the first time that the 1 per cent cap on 10-year yields would now be understood as a reference rate.

The muted investor reaction to its decision has been a relief to the central bank, which has to loosen its grip on bonds gradually to avoid causing ructions in an international market worth trillions of dollars.

But there is still a long way to go before the BoJ gets out of another policy that is now considered an anomaly: negative interest rates, which make it the last big central bank still clinging to one of the tenets of its ultra-loose monetary policy.

Is the yield curve control dead?

Investors say the latest decision to remove a hard ceiling on 10-year JGB yields in effect means the death of the YCC.

“The formal end of the YCC will be more of a ceremony,” said Daiwa strategist Kazuya Sato, adding that the exit could come as early as December. “I think the BoJ has managed to begin a gradual path towards normalisation without creating too much market impact.”

Still, the latest change in the YCC did not mean an end to the BoJ’s quantitative easing measures since it will continue to conduct “fixed amount” bond purchases, although not at a fixed rate of 1 per cent, said Chris Jeffrey, head of rates and inflation strategy at Legal & General Investment Management.

When will Japan end its negative interest rate policy?

Now that the BoJ has in effect scrapped its policy of placing a hard cap on bond yields, investors are focused on when the central bank will raise its policy rate, which stands at minus 0.1 per cent. UBS expects the BoJ to lift negative interest rates in April while Goldman Sachs forecasts the change to occur in October. According to a simulation by Daiwa, the yield on 10-year JGBs is expected to reach about 1.15 per cent when the BoJ lifts the YCC and ends negative interest rates — suggesting the yield may not rise too dramatically even if the cap is entirely removed.

“Over the past three months, the market has now priced for not only the exit of negative interest rates but for a full interest rate hike next year,” said Steve Donzé, deputy head of investment and products at Pictet Asset Management, forecasting the first rise in short-term interest rates in January.

However, while the bank will remove the official cap, it is still expected to conduct bond purchasing operations if it feels it is losing control. That is a “red rag to a bull” for bond vigilantes who will now test where the BOJ’s thresholds are, said one Tokyo-based trader.

Will Japanese investors shift their bond holdings?

Japanese investors are at present the biggest foreign owners of US Treasuries and hold a high proportion of Australian and French debt too. Investors expect that, as policy in Japan starts to normalise, Japanese institutions will become increasingly motivated to invest at home, a trend expected to accelerate when interest rates start to rise.

Big Japanese investors that hedge their currency exposure, such as insurers, have already slowed down overseas bond ownership as the cost of hedging has become prohibitively expensive, cancelling out the growing yield gap between Japan and other economies and making Japan’s low-yielding bond market appear relatively attractive.

“The Bank of Japan is creating a really conducive environment for domestic investors to repatriate capital and deploy capital at home,” said Ella Hoxha, head of fixed income at Newton Investment Management. “If you are a Japanese investor you can’t invest in US Treasuries unless you take the currency risk — in terms of fixed income the only attractive market is their domestic one.”

The impact is also likely to be felt in the market for euro and dollar bonds although Japanese investors have not made significant shifts for now.

“If long term yields go up in Japan while hedging costs stay high . . . the negative impact on demand for euro and dollar bonds could be significant, as we could witness a strong repatriation of investments to Japan,” said Vincent Mortier, chief investment officer at Amundi. Economists said the BoJ’s ultimate goal was to shift some of the massive JGB holdings on its balance sheet over to the private sector, in particular regional banks. The big question over the coming weeks and months is whether the current level of 10-year JGB yields is high enough to be attractive for dozens of regional Japanese banks to start buying.

What is the impact on the yen?

So far, the reaction has been moderate. In earlier phases of the BOJ’s gradual exit from YCC, the currency market made a relatively straightforward place for funds to place large bets on the impact of the BOJ’s policies.

They could, at what they saw as relatively low risk, bet that the interest rate differential between the tightening Federal Reserve and permanently ultra-loose BoJ would create constant downward pressure on the yen. Traders now say that bet is viewed as both crowded and slightly riskier than before: the Fed looks close to the end of the tightening cycle and the possibility of currency intervention by Japan is on the table.

Market players had previously thought that financial authorities had drawn a line in the sand at about ¥150 against the dollar, but recent trading has shown that the Japanese government appears willing to let the yen slide below that level. Some currency analysts believe that if the yen’s fall is not too fast and too disorderly, the government may let it drop as far as ¥153.

Morgan Stanley strategists said the dollar’s upside should be limited by intervention risk, forecasting that the yen will remain about ¥150 against the dollar unless there was a major change in US economic data.