Not Davos, but Tokyo has the markets’ attention on Wednesday. The Bank of Japan earlier today defied market expectations by keeping its Yield Curve Control interest rate policy unchanged, at least for now. Markets question however how long the BoJ can sustain this now that global government bond yields are rising. Japan could be sitting on Pandora’s box.
The departure of outgoing BoJ governor Haruhiko Kuroda, the architect of the YCC programme, is scheduled for April. Following December’s BoJ signal that YCC could be phased out, markets had wondered if more statements on the end of YCC could be coming at this week’s meeting. Today, however, the BoJ did not flinch, a move that triggered a steep drop in Japanese bond yields and a jump of some 2 percent on Tokyo’s stock market.
‘Not the Japanese way’
“It’s not the Japanese way to go out and humiliate a long standing Governor just before he is about to depart,” said Tony Sycamore, market analyst at IG on Australian television as the BoJ news broke.
The BoJ’s control of Japan’s yield curve is aimed at keeping ten-year government bond yields near 0 per cent. A unique twist in policy caused the upper limit of the range to be raised from 0.25 per cent to 0.5 per cent on 20 December. The central bank has had to buy record amounts in the government bond market since its December meeting to counter further upward pressure on interest rates. Last Friday, the BoJ bought 4.5 trillion yen worth of Japanese government bonds.
Because much Japanese wealth is in assets issued by other countries, such as US and European government bonds, the risk of a careless exit from YCC is significant. Yet specialists say there is not yet a crisis situation like in the UK at the end of last year.
Unsustainable
Speaking before today’s BoJ decision, Alex Botte, strategist at Ostrum Asset Management, said US Treasuries could be most affected. Japan holds 17 per cent of all outstanding US government paper (over $1,200 billion). While many parties find US government bond yields attractive at the moment, the release of YCC could ensure that yields will not fall quickly in the US. Eurozone and Australian government bonds can also expect big moves, according to Botte.
Botte called the situation unsustainable. “Daily market intervention in a ‘one-way market’ makes no sense for the BoJ, which already holds an absurdly large share of the JGB market. An increase in the interest rate ceiling would therefore have to be accompanied by an outright sale of Japanese government bonds. The BoJ’s policy is therefore unsustainable.”
Jakob Vijverberg, multi asset portfolio manager at Aegon AM, acknowledges that a tightening policy by the BOJ, could have a boosting effect on interest rates in Europe, but this will only be limited. The relatively limited economic linkages between the Eurozone and Japan relative to the size of the economy will not allow interest rates to rise too far in Europe, he said.
However, equity markets in Japan will underperform with tightening monetary policy, Vijverberg said. On the other hand, European investors could benefit from a strengthening yen in that case.
Further range widening
The widening of the range for Japanese 10-year government bonds seems to be largely on Japan’s own account for now. The fall in bond prices started back in December, which undoubtedly affected Japanese institutions, above all the Japanese central bank.
“However, it did not have a big impact like we saw in the UK in September,” said Erik Schmal, senior investment strategist at Rabobank. A new shock effect, he said, will come only when YCC is completely unleashed. The market is currently pricing in an increase in the range to 0.75 per cent for buybacks of 10-year government bonds. Schmal expects a gradual exit from the central bank’s YCC
“A forward adjustment to 1 per cent will also not provide a shock that could have a major impact on financial markets,” Schmal said. “It would be different if the entire buyback programme was ended, but that is not expected to happen in the coming months.”
Carry trades under pressure
The main impact outside Japan, as far as Schmal is concerned, is that the yen will no longer be the default option for “leveraged trades”. It will become less easy to buy and “funnel” higher-yielding currencies out of Japanese yen.
“This is one of the main reasons why the yen has strengthened so much again in recent times. I suspect it was also the main reason for the reversal in interest rate policy,› says Schmal.
Hedging the yen also yielded interest for a long time, as euro interest rates were negative. This made it a beacon of stability in Rabobank’s bond portfolio last year, which suffered heavily outside Asia from the rise in interest rates, according to Schmal.