By Toru Fujioka and Ruth Carson
(Bloomberg) — Even a modest tweak to the Bank of Japan’s entrenched monetary policy could set a wrecking ball in motion through worldwide markets, if traders project the last heavyweight anchor stopping global yields from rocketing further is finally shifting.
Most economists expect Governor Haruhiko Kuroda to stick with yield-curve control, until he steps down in April, even as the yen slides. But there’s no denying his policy framework has been under more pressure this year than it ever has since its formation in 2016.
___STEADY_PAYWALL___If the Bank of Japan decides to shock investors and finally tighten policy, they face the turmoil inflicted on global markets by the UK’s recently-abandoned economic plan — just on a larger scale.
“An abrupt abandonment could cause havoc potentially both domestically and globally given the obvious reasons: the scale of the program and its history, the low level of JGB yields and yen weakness,” said Jim O’Neill, former Goldman Sachs Group Inc. economist and chairman of investment company Northern Gritstone. “If poorly handled, it could have much bigger global consequences than the recent UK mess.”
Speculation that the BOJ will suddenly have to release its iron grip on benchmark bonds has been simmering ever since the debt selloff buckled Australia’s yield curve control framework last year. That collapse tarnished the reputation of the Reserve Bank of Australia, while inflating the confidence of bond vigilantes looking for more targets.
The BOJ currently keeps a 0.25% ceiling on 10-year yields in a bid to boost Japan’s stuttering economy and secure stable price and wage growth. The bank holds its next meeting between Oct. 27-28. Most economists’ base case is for no change to policy.
Scrapping YCC
In the most dramatic scenario for markets, the BOJ would jettison its framework without warning, causing shockwaves in markets throughout the world. The bank would allow the yield on 10-year government debt to move freely while limiting policy to its control of short-term interest rates.
That would lead to a roughly 50-basis point jump in the benchmark yields, with the most significant macroeconomic impact being a repricing of the global term premium — the extra compensation investors demand to hold longer-dated bonds — according to Arjun Vij, portfolio manager at JPMorgan Asset Management.
“In short, we think that other developed market government bond yields, such as in the US or in Europe, will rise,” Vij said. Persistent Japanese demand for foreign bonds has been an important driver for low developed-market yields and “a reversal of the policy therefore could lead to some unwinding of those positions.”
Analysts at UBS predicted this month that bonds in the US, Australia and France would be most at risk and a YCC abandonment would send Japan’s stocks into a bear market and may lop 10% off US and European shares.
Their rationale was that a shock move could turbocharge a yen rebound, give an extra impetus to the selloff in global bond markets and trigger a wave of money flowing back toward Japan out of foreign holdings like Treasuries.
Volatility Risk
Still, a jarring regime change like this runs counter to the BOJ’s efforts to build sustainability into its easing framework and to keep markets stable. Some kind of event-based trigger would likely be needed to force the central bank to opt for this extreme course of action.
“Outright abandonment would create significant volatility in global rates and destabilize the Japanese markets, of which pensions are a massive player,” said Calvin Yeoh, Singapore-based portfolio manager at Blue Edge Advisors Pte. “I would actually expect similar dynamics to what just happened in the UK,” if they did that.
And while conventional thinking would suggest the yen would immediately rocket higher from its now 32-year low, easing the pressure on Japan’s government to intervene to support it, the impact there is harder to predict, said JPMorgan’s Vij.
“It will depend upon the prevailing circumstances in the market at the time of the change,” he said.
The problem is, a tweak within the framework of YCC also risks sparking a storm, such as the central bank raising its yield target or widening the movement range around it. Either move would effectively serve as a rate hike and for economists at JPMorgan Chase & Co. that could mean wilder swings in the yen and a repatriation of Japanese funds.
If “domestic yields are permitted to trade in a wider/higher range, so too will the potential for yen volatility to rise as the currency follows potentially more erratic yield spreads,” a team including Ayako Fujita wrote this month. “Higher onshore yields could dent Japan’s demand in overseas fixed income markets, particularly if higher yields lead to substitution from currency-hedged Treasuries back to JGBs.”
Review Pressure
Another BOJ strategy might be to call for a review that keeps investors guessing and is then used to justify policy change such as reducing the maturity of the yield it targets.
Kuroda first used that tactic long before the pandemic to come up with the YCC framework he now has. Its very existence points to the central problem of the BOJ’s inflation drive. Despite the best intentions to rid Japan of decades of falling prices, Kuroda’s initial splurge into asset buying failed to generate the stable inflation he sought in two years.
The governor resorted to a policy review to justify the patching together of a new approach for sustaining stimulus that didn’t involve buying up every single Japanese government bond and ETF out there.
The most recent review before tweaks made in March 2021 lasted three months, a period that now seems implausibly long given the likely market pressure that it would generate.
“This isn’t the time to be announcing a policy review,” said Shigeto Nagai, a former head of BOJ’s international department and head of Japan research at Oxford Economics. “Any move like that would trigger a fierce reaction in markets and heighten expectations for adjustments in YCC no matter how the BOJ announces it.”
Still, change to policy could have at least one silver lining: an improvement in Japan’s dysfunctional debt market, where earlier this month the 10-year benchmark failed to trade for four straight days.
“Bonds will be sold, with the artificially-capped 10-year zone seeing the heaviest selling to move it in line with super-long yields,” said Masahiro Ichikawa, chief market strategist at Sumitomo Mitsui DS Asset Management. “But the side effects of YCC will disappear and will help JGB market functioning to recover. That’s one positive impact.”
–With assistance from Sumio Ito and Chikako Mogi.
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