Japan’s national flag flies atop the Bank of Japan building on November 12, 2019 in Tokyo, Japan.
Tomohiro Ohsumi | Getty Images
The Bank of Japan is nearing a turning point.
It comes as policymakers around the world scramble to tighten monetary policy to curb record-high inflation.
The Swiss National Bank was one of the last major central banks to join the action, surprising markets last month with its first rate hike in 15 years. The SNB jumped out of the blocks with a 50 basis point hike and the shock move sent the Swiss franc to its strongest level against the euro in almost two months.
However, Japan has tried to remain loose and prioritize yield curve control. The world’s third-biggest economy has been mired in an environment of low growth, low inflation — and at times deflationary — for many years, meaning the Bank of Japan has kept policies accommodative to boost the country’s sluggish economy.
The central bank was on track to buy about 15 trillion Japanese yen ($110 billion) of government bonds in June, making it the only major central bank yet to embark on a significant asset-buying program.
Japan’s headline CPI is just above the 2% target while core inflation is at 0.8%, leaving the central bank not facing the same inflationary pressures as many of its Western counterparts,
The BOJ has reiterated its commitment to avoiding deflation, which remains the dominant policy hurdle in Japan. The central bank expects consumer price inflation to slow down in the medium term as the impact of energy prices on the headline fades.
However, should that assessment prove wrong and the BOJ be forced to raise interest rates – either as a result of inflation or upward pressure from other tightening measures around the world – it could trigger a ripple effect through global markets.
According to Neil Shearing, group chief economist at Capital Economics, much depends on the “openness” of the country’s financial account (its balance of payments) and the extent to which flows are affected by changes in interest rates elsewhere.
“Japan is open to global capital flows and so, while bond yields have risen elsewhere, the BoJ has found that its commitment to yield curve control policies – to keep 10-year JGB (Japanese government bond) yields within the 25 basis point band on either side of zero – has been tested by global investors,” Shearing said in a statement Monday.
Yield curve control tested
The Bank of Japan’s self-imposed bond yield cap helps keep borrowing costs low across the economy, which in principle supports growth.
“The recent sell-off in global bond markets has pushed the 10-year JGB yield right to the top of the BoJ’s range, forcing them to buy more and more government bonds to maintain their target – through certain measures if they continue at a Buying at this month’s pace, it would own the entire market of outstanding JGBs within a year,” Shearing said.
The Bank of Japan has continued to defend its yield target despite global momentum pointing towards higher interest rates and its divergence has pushed the Japanese yen sharply lower.
Shearing pointed out that while the People’s Bank of China is imposing capital controls to maintain leverage over its currency and monetary policies, Japan’s relatively open capital account means it cannot control the yen while retaining sovereignty over monetary policy.
In essence, the Bank of Japan can prop up bond yields by buying unlimited amounts of bonds and sending the yen into a downward spiral, or it can protect the currency from destabilizing depreciation, but it cannot handle both at the same time.
Capital Economics believes that Japan will ease its yield curve control somewhat by widening the target range, which could then lead investors to test its resolve to hold the line in the new range. Against the backdrop of rising interest rates worldwide, 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 moves can be destabilizing,” Shearing said.
“Eventually something will give way – either because balance sheets come under pressure or because imported inflation becomes a problem.”
With deflation causing businesses and consumers in general to delay investment and purchases, the Bank of Japan has been working for years to bring inflation back to its 2% target in a bid to revive its productive capacity and growth rate.
The ongoing BOJ quantitative easing could also have a number of significant implications for both domestic and global markets.
By capping the rise in long-dated 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 implied that it would have to lend the equivalent amount, further exacerbating the price hike. The divergence in yields relative to other developed countries tightening monetary policy is weakening the yen. Meanwhile, the BOJ keeps bond yields artificially low by buying so many JGBs that it doesn’t raise interest rates, the primary way to curb higher inflation.
Overall, he suggested that these dynamics could create conditions where inflation “suddenly spirals out of control, implying an inexorable and violent bond market adjustment.”
Maintaining loose policies at all costs could also create risks internationally.
“The weakening of the yen could lead to a currency war in Asia, which in turn could fuel rising inflation in neighboring countries, raising the cost of servicing dollar debt and thus increasing the risk of default for less creditworthy countries,” Monchau told CNBC on Tuesday.
“Another international consequence with even greater implications is the risk of a sudden unwind of the carry trade.” The carry trade is a strategy where investors borrow in a low-interest-rate currency to fund the purchase of a higher-yielding currency and capture the difference in interest rates.
Monchau argued that given the BOJ’s obligation to lend equivalent to the bonds it buys, this market context of “access to very low-yielding financing in an ever-depreciating currency” favors the use of carry trades.
“For example, a ‘long Brazilian real, short yen’ strategy has already returned 35% this year. But the risk of this type of strategy is a sudden trend reversal,” explained Monchau.
“Indeed, if the yen strengthens and/or JGB yields rise (as the BOJ abandons the YCC), there is a risk of a sudden and massive unwinding of carry trades with a cascading liquidation of risky assets.”
This would facilitate panic selling of stocks, forced selling of the US dollar and a rise in US bond yields due to the surge in JGB yields, he suggested, the kind of sudden “financial crash” that could exacerbate the pain for risky assets and increase the risk of recession.
“The grim scenario described above is far from certain. First, the imbalances created by the Japanese authorities (over-indebtedness and bond market manipulation) have been pointed out for many years without a major accident ever occurring,” Monchau noted.
“However, against the backdrop of high market volatility, the current situation in JGBs is dangerous to say the least. And any market stress from the end of quantitative easing in Japan may have another consequence for international financial markets: a loss of confidence in the monetary policies of the major central banks.”