The BoJ And An ‘Enormous’ Risk From A ‘Very Out-Of-Consensus’ View

Overnight, the Bank of Japan tacitly persisted in the fantasy that Haruhiko Kuroda’s extraordinary (and at this point, it kinda feels like “extraordinary” is an inadequate adjective) easing measures are “very powerful”, when it comes to stoking inflation.

Every, single one of these meetings is defined by the ironic juxtaposition between, on one hand, no material changes to policy (July’s tweaks notwithstanding), and, on the other, begrudging admissions that these purportedly “powerful” measures are not in fact leading to inflation. Here’s a visual summary of the downgrades to the inflation outlook in the quarterly reports:

(Barclays)

As you can see, the bank no longer expects to be anywhere near their inflation target before 2021, which by extension means that these policies will have to be extended or “strengthened”, even as the side effects continue to pile up.

The BoJ attempted to mitigate some of those side effects in July by expanding the allowable range for 10Y yields and at the post-meeting presser on Wednesday, Kuroda tried to say that’s making a difference. Specifically, he flagged more active trading in both JGB cash and futures markets. He also mentioned that the relationship between 10Y JGBs and U.S. yields has been restored. Ever the optimist, Kuroda said he doesn’t expect to see any further deterioration in market functioning and as such, sees no reason to widen the range in which 10Y yields will be allowed to fluctuate.

There was also a nod to the effect the policies are having on bank profits (and that’s a long-running concern), but for now, the BoJ generally views that as “not significant.”

Anyway, the point is that they are going to keep doing what they’re doing because they’re pot-committed and have no other options considering their commitment to achieving their inflation target.

But increasingly belabored attempts to claim that the side effects aren’t mounting aside, the BoJ knows they simply cannot persist with this in perpetuity without causing more problems for market functionality, especially in JGBs. That’s why part and parcel of YCC is a so-called “stealth taper” (i.e., an ongoing fade in the amount of JGBs purchased). The problem, as ever, is that any tapering of bond purchases on top of what would be going on anyway has the potential to trigger outsized moves. This is complicated immeasurably by the yen’s safe haven status. If, for instance, a reduction of JGB purchases (“hawkish”) were to coincide with a bout of risk-off sentiment (JPY +), then you could get unwanted yen appreciation and that undermines the already fruitless inflation targeting effort.

As the BoJ learned on multiple occasions this year, the mere suggestion that policy tweaks are in the cards is enough to create turmoil, with the two most prominent examples coming in January and July, with the latter episode forcing the central bank to step in with three fixed-rate purchase ops in the short space of a week to cap yield rise ahead of the July policy meeting.

That’s the context for the November rinban purchase plan, which was also released on Wednesday. Sure enough, the BoJ made some changes. Specifically, they’re going to stop buying the day after debt auctions, with the exception of the 5-10Y bucket. In other words, they’re going to let the secondary market actually trade without them – at least for a day.

“The moves are aimed at improving market functionality in line with the BOJ’s policy directive,” Mitsubishi UFJ Morgan Stanley Securities’ Naomi Muguruma said of the tweaks, adding that “the BOJ wants markets to make their own judgement and manage profit and loss and trade accordingly”.

That’s nice of them, but I’m not sure it’s going to make much difference. The 5-10Y bucket is exempted (obviously to ensure they can keep control of 10Y yields) and the only thing that’s going to breathe life back into the market is if the band is widened for 10Y yields. Look how quickly the JGB VIX died back down after the July mini-tantrum:

(Bloomberg) 

Yields have risen and JGBs did indeed participate in the late-September/early-October bond rout, but as long as the BoJ is committed to that 10Y band, this market is going to remain characteristically moribund, even if they do manage to engineer some steepening courtesy of rising super-long yields.

(Bloomberg)

Complicating all of this further is of course the prospect that trade frictions could dent global growth or otherwise contribute to the kind of generalized risk-off sentiment that would lead to yen strength. As alluded to above, this is a perpetual problem for the BoJ. Any tweaks to the bond buying are JPY+ and the yen is obviously a safe haven. Worse, tweaks to the bond buying could themselves become a risk-off catalyst, which means that in addition to being JPY+ in their own right, reduced JGB purchases have the potential to freak everybody out, thus piling a flight-to-safety bid on top of whatever yen appreciation would be going on anyway.

Underscoring this on Wednesday is Nomura’s Charlie McElligott, who notes that the tweaks to the November rinban plan “are on the margin hawkish and allow for the continued evolution/expansion of stealth tapering.” But here’s the critical line from Charlie on JGBs:

Looking forward with regard to the potential for further BoJ policy adjustments and the ENORMOUS impact it could have on global Rates, Japan Macro Strategist Matsuzawa-san is reiterating his core (and VERY out-of-consensus) view that the BoJ will widen its 10Y YCC range once again in Japan, from 20bps to 40bps–this would have MASSIVE cross-asset implications, from cross-asset volatility (via Rates / term premium) to U.S. Equities “Value vs Growth,” as the curve would powerfully bear-steepen.

McElligott is right to effectively say that the English language isn’t a sufficient tool when it comes to expressing how dramatic the cross-asset implications would be from a sudden bear steepening episode/explosion higher in 10Y JGB yields.

Do keep that in mind, because as I gently told a commenter earlier this week, there will likely come a day when U.S. traders wake up to either a JGB tantrum or a German bund tantrum, and given lackluster liquidity in those markets, any such event would probably be far more acute than similar episodes which unfolded in the past.