What to watch in 2023: Bank of Japan under pressure

The Bank of Japan is the mother of monetary accommodation. Monetary-policy innovation and creativity have kept interest rates in Japan close to zero for years now. Today, this stands in starker contrast than ever to the macroeconomic fundamentals and to monetary policy in the rest of the world. Japan’s central bank is under enormous pressure and is likely to be compelled by the market to end its monetary-policy experiment sooner rather than later.


Innovative monetary policy…

A big monetary-policy experiment has been underway in Japan for years (or, more accurately, for decades). An entire generation there practically knows nothing other than zero interest rates and deflation (risks). The architect, implementer and mouthpiece of this monetary policy is Haruhiko Kuroda, who has headed the Bank of Japan (BoJ) for the last decade. He took office in 2013 with a pledge to reach an inflation rate of 2% “at the earliest date possible” – a promise he was never able to keep, though not for want of ideas about how to do that. After incessant securities-buying made the BoJ in 2016 the owner of already more than half of all Japanese bonds outstanding, Kuroda invented the concept of “controlling the yield curve.” Instead of purchasing a certain amount of government bonds every month, the BoJ pledged to keep market interest rates within a certain range. The cardinal interest rate in this endeavor was the 10-year government bond yield, which initially was maintained in range of +/– 0.1%, which was later widened to +/– 0.25%.

Past the expiration date | The market is betting against the BoJ

Yield on 10-year government bonds and 10-year swap rate

Sources: Bloomberg, Kaiser Partner Privatbank


…with side effects

At a time of zero and negative interest rates around the globe in recent years, the BoJ seemed to have found the ideal tool for constructing a permanent artificial world of ultralow interest rates. But with the onset twelve months ago of extremely rapid rate-hiking by every (other) central bank around the world, the BoJ became an outlier. Moreover, its monetary policy in the meantime has also become increasingly askew in relation to Japan’s own macroeconomic conditions because inflation has arrived in Japan as well by now. Japan’s core inflation rate (excluding energy) climbed to a 30-year high of 3% in December and thus has exceeded the 2% inflation target for nine consecutive months already. Furthermore, Kuroda’s going it alone on monetary policy is not without risks and side effects, which have included a massive depreciation of the Japanese yen (until October of last year) and a resulting surge in import costs, huge currency interventions (last autumn), and regularly recurring stress episodes on the Japanese bond market (including almost completely dried-up liquidity) to this day. In December, the BoJ finally saw itself compelled to release some steam from the kettle and to double the width of the trading range for 10-year Japanese government bonds to +/– 0.50%. But since then, the financial market has begun speculating in earnest on an end to yield curve controls. In the four weeks alone after this monetary policy “easing measure,” the BoJ had to buy up well over JPY 30 trillion worth of bonds (equal to 6% of Japan’s annual economic output) to keep yields within the tolerance range.


Still undervalued | The yen could appreciate further

USD/JPY exchange rate

Source: Bloomberg, Kaiser Partner Privatbank


Inevitable change of course?

In the runup the central bank’s policy meeting on January 18, there was thus mounting speculation that BoJ Governor Kuroda might declare an end to yield curve controls. However, Kuroda stuck to his mantra that the BoJ’s current monetary policy is appropriate, sustainable, and necessary to buttress economic activity. In its updated forecasts, the BoJ expects core inflation to drop back below 2% for the next two fiscal years and thus does not see any inflation problem. The financial market, though, does not believe these reassurances (any longer). In fact, more and more market participants are betting on an inevitable and potentially turbulent end to Japan’s monetary-policy experiment sooner or later. Some hedge funds consider a bet against Japanese government bonds a rare instance of a truly asymmetric trade, one with (almost) no downside potential but with a high possible return. The speculative action has also been stoked lately by rumors that the BoJ is getting set to make its inflation targeting more flexible. Prime Minister Fumio Kishida could arrange a flexible inflation target with the future BoJ governor once Kuroda steps down in April. It would arguably mark the preparation for a long-overdue U-turn in monetary policy. Such a turnaround would have to be well orchestrated by Japan’s central bankers because it isn’t entirely without risk. The Japanese yen, which is still massively undervalued despite the correction in recent weeks, would likely further appreciate. The Nikkei initially would probably perform poorly in response to that. It would become less attractive for those Japanese investors who heretofore have invested most of their money outside Japan to continue doing so. They could pull their money out of Western markets. It would also become less attractive for carry traders who heretofore have borrowed cheaply in yen to invest and earn higher returns elsewhere. A big interest-rate shock could ripple through Japan’s economy. Economic actors who heretofore have operated with high leverage thanks to the cheap money could particularly come under pressure in such a scenario. Financial institutions, however, would likely profit from a potential return of interest-rate conditions to normal.


Conclusion: An end to Japan’s big monetary-policy experiment appears to be only a matter of time, but BoJ Governor Kuroda will probably leave the job of unwinding it to his successor. Returning to “more normal” interest-rate levels will be a balancing act and will require a masterly feat of communication. An overly abrupt change of course could spark turmoil on the financial markets. Further widening the interest-rate corridor could be a first step. One key indicator worth watching in the weeks ahead is the upcoming rounds of wage negotiations in Japan. Are large corporations dropping the deflationary mindset? If they are, that could seal the end of yield curve controls.


Oliver Hackel, CFA Senior Investment Strategist

Investment News


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