Japan could be about to surprise the markets with its 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

Japan’s central bank is approaching an inflection point.

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

The Swiss National Bank was one of the last major central banks to intervene, surprising markets last month with its first interest rate hike in 15 years. The SNB jumped blocks with a 50 basis point increase and the shock move sent the Swiss franc to its highest level against the euro in almost two months.

Japan, however, sought to remain flexible and prioritize yield curve control. The world’s third-largest economy has been stuck for many years in a low-growth, low-inflation and sometimes deflationary environment, which means the Bank of Japan has maintained an accommodative policy in an effort to stimulate the country’s sluggish economy.

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

Headline CPI sits just above Japan’s 2% target, while core inflation sits at 0.8%, so the central bank doesn’t face the same inflationary pressure than many Western counterparts,

The BOJ reiterated its commitment to avoiding deflation, which remains the main political obstacle in Japan. The central bank expects consumer price inflation to slow over the medium term once the influence of energy prices on the headline figure begins to fade.

But if that assessment turns out to be wrong and the BOJ is forced to raise interest rates – either due to inflation or upward pressure from other monetary tightening measures around the world – it could have a knock-on effect on world markets.

According to Neil Shearing, group chief economist at Capital Economics, much depends on how “open” the country’s capital account (its balance of payments) is and how much flows are jolted by changes in interest rates. interest 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 – holding down JGB yields (Japanese government bonds) to 10 years within a 25 basis point band on either side of zero – has been tested by global investors,” Shearing said in a note on Monday.

Yield curve control tested

The Bank of Japan’s self-imposed bond yield cap is helping to contain borrowing costs across the economy, in principle supporting growth.

“The recent sell-off in global bond markets has pushed the 10-year JGB yield to the upper end of the BoJ’s range, forcing it to buy increasing amounts of government debt to maintain its target – by some measure. , if it continued buying at this month’s pace, it would own the entire market for exceptional JGBs within a year,” Shearing said.

The Bank of Japan continued to defend its yield target even as global momentum pushes for higher rates, and its divergence pushed the Japanese yen sharply lower.

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

Essentially, the Bank of Japan can support the anchoring of bond yields by buying unlimited amounts of bonds, sending the yen into a downward spiral, or it can protect the currency against a destabilizing depreciation, but it cannot manage the two simultaneously.

Capital Economics expects Japan to give ground in its control of the yield curve by widening the target range, which could then see investors test its resolve to hold the line at the new range. Against a backdrop of rising global rates, this could further weaken the yen.

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

“At some point, something gives way, either because balance sheets start to come under strain or because imported inflation becomes a problem.”

Since deflation typically leads 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 boost its productive capacity and rate of growth. growth.

“Violent adaptation”

The BOJ’s continued quantitative easing could also have a number of important consequences for domestic and global markets.

By capping the rise in long-term interest rates, the central bank risks pushing inflation beyond its original targets, according to Charles-Henry Monchau, chief investment officer at Syz Bank.

Monchau noted that the BOJ’s purchase of bonds implies that it would have to lend the equivalent amount, which would further aggravate the rise in prices. The divergence in yields from other developed countries, which are tightening their monetary policy, is weakening the yen. Meanwhile, the BOJ is keeping bond yields artificially low by buying so many JGBs to prevent it from raising interest rates, the primary method of containing higher inflation.

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

Maintaining a flexible policy at all costs could also create risks on the international scene.

“The weakening of the yen could lead to a currency war in Asia, which could, in turn, fuel higher inflation in neighboring countries, increase the cost of servicing their dollar-denominated debts, and so increase default risks from less creditworthy countries,” Monchau told CNBC on Tuesday.

“Another international consequence with even greater ramifications is the risk of a sudden unraveling of the carry trade.” A carry trade is a strategy in which investors borrow from a low-interest currency to finance the purchase of a higher-yielding currency, capturing the difference between rates.

Monchau argued that with the BOJ obligated to lend the equivalent of the bonds it buys, this market environment “of access to funding at very low rates in a constantly depreciating currency” favors the use of carry trades. .

“For example, a ‘long Brazilian real, short yen’ strategy has already generated gains of 35% this year. But the risk of this type of strategy is a sharp reversal of the trend in place,” explained Monchau.

“Indeed, if the yen strengthens and/or if the JGB yields increase (due to the abandonment of the YCC by the BOJ), there is a risk of an abrupt and massive unwinding of the carry trades, with a cascading liquidation of risky assets.”

This would facilitate panic selling of stocks, forced selling of the US dollar and a spike in US bond yields due to rising JGB yields, he suggested, the type of sudden “financial crash” that could worsen the pain of risky assets and increase the risk of recession.

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

“However, the current situation for JGBs, amid high market volatility, is perilous to say the least. And any market stress due to the end of QE in Japan could have another consequence for international financial markets: the loss confidence in the monetary policies of the major central banks.”

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