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The Bank of Japan (BoJ) has underpinned global liquidity for decades through monetary policy decisions aimed at generating inflation in a country seemingly unable to do so since the early 90s. Notably, in 2016, it started its ultra-accommodative policy of “yield curve control” (YCC), which commits it to defending a preset yield ceiling level. However, since late 2022, this policy has become increasingly challenged by rising domestic inflation and political pressure, with BoJ Governor Haruhiko Kuroda’s leadership finding it difficult to stem the pressure for higher rates.
The BoJ continues to defy market expectations. It stunned the market in December with its decision to widen the target yield band for the reference 10-year Japanese government bond (JGB) from +0.25% to +0.5%. And it surprised markets again when it maintained the current band at its January monetary policy meeting.
What this means is that the BoJ is prepared to let its balance sheet expand between now and its next meeting on March 10, and potentially beyond.
Why does this matter for global investors?
In effect, the contraction in global liquidity has stopped, and even reversed, as the BoJ’s bond purchases dwarf the US Federal Reserve’s (Fed’s) quantitative tightening (QT) measures. Because the BoJ has been forced to buy assets aggressively to defend the new 10-year YCC band, Global QE is rising at its fastest pace since mid-2021. This accelerating central bank liquidity partly explains the fall in bond yields and the bounce in risk assets we have seen so far this year.
Why do we think policy change is imminent?
The main characters are changing — Japan has a relatively new prime minister and the current BoJ governor is due to retire on April 8. Neither Prime Minister Fumio Kishida or the yet-to-be-nominated new governor will be tied to the “inflation at all costs” strategy set out by former PM Shinzo Abe and Governor Kuroda. Forward guidance has become irrelevant as markets are no longer confident in the BoJ’s reaction function.
Macroeconomic conditions suggest change is needed — The BoJ is defending a yield that looks increasingly inappropriate for the cyclical outlook and, hence, is unsustainable. Its unexpected shift at the December meeting implied unease at the BoJ about expanding its balance sheet while exiting ultra-loose policy. Meanwhile, the outcome of the January meeting suggests that the bank is still not fully convinced that inflation is now sustainable.
The cost of bond buying looks unsustainable — Core inflation is running at a 40-year high and 2023 may see the Japanese economy record its second-strongest year of nominal growth since 1991. This leaves the BoJ in the wrong place, defending an increasingly problematic yield peg at a spiralling cost. It has cited an unrealised loss potentially as high as JPY 28 trillion (equivalent to 5.2% of GDP) as a consequence of buying up bonds to curb the 1% parallel move in the JGB curve that occurred in early December 2022, while the amount spent trying to defend the 0.5% 10-year yield target peg may have exceeded JPY 17 trillion to date. Moreover, the BoJ currently owns 50% of outstanding JGBs and its holdings are likely to reach 60% by mid-year at the current pace of purchases.
What might happen next?
- We think there is a high likelihood that the BoJ will widen its band again (to 75 or 100 basis points), with a good chance of dropping YCC and a shift to committing to ongoing bond-buying support to ensure a smooth transition. Should our expectation of BoJ normalisation play out, with YCC coming to an end, a potential increase in 10-year JGB yields to around 1% would eliminate curve distortion and could trigger a rise in global rates as Japanese capital is attracted back to Japan. As the BoJ (and the European Central Bank [ECB]) start normalising policy, there will be less incentive for Japanese and euro-area investors to search for yield in the US and elsewhere, as there will be attractive yields in the domestic markets. Global liquidity would contract again, dominated by the pace of Fed and ECB quantitative tightening, while the liquidity headwind for risk assets would resume.
- Near term, the BoJ may well continue to fight the market pressure, citing factors like receding inflation pressures globally and/or the need to see sustainable wage gains before altering policy settings. This would initially drive yields lower and prolong the rally in risk assets. However, with growing consensus that we are on the path towards policy normalisation, I think expectations for an adjustment will build again in the run up to the BoJ’s March and April meetings, with wage growth and inflation remaining key indicators to monitor.
Final thoughts on the Bank of Japan’s monetary policy
The BoJ is trying to manage a tension that requires a gradual adjustment out of an inappropriate policy without risking financial instability. At times, it will be in the uncomfortable position of having to aggressively accelerate its balance-sheet expansion to smooth its exit and, hence, add more global liquidity. The stronger the cycle and the higher the level of inflation, the more the bank will be forced to expand its balance sheet to defend an inappropriate level of yields. As a result, the impact on global duration and the USDJPY exchange rate becomes more cross-directional and nuanced, and certainly not as linear as in 2022, because there will be periods of aggressive BoJ buying into the exit from ultra-accommodative policy.
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