Breaking The Bank Of Japan? It Won’t Be Easy

“It’s not appropriate to tighten policy now.”

That quote, from Haruhiko Kuroda, summarizes Friday’s uneventful Bank of Japan meeting. Headed in, the gathering was dramatized such that you could’ve easily believed it was more consequential than the June Fed meeting. Although it didn’t live up to the billing, the hype was, in fact, warranted.

Speculation about the sustainability of the bank’s yield-curve control regime reached a fever pitch this week. Upward pressure on global bond yields has forced the bank to mount an aggressive defense of Kuroda’s 0.25% line in the sand on 10-year JGBs, and the more he defends it, the wider the effective policy divergence with the BoJ’s global peers — it’s an easing tool, after all.

The SNB’s surprise Thursday hike, along with the Fed’s 75bps move and the BoE’s fifth hike in a row, risked making the situation as untenable as it is laughable. Not only does defending the cap amount to easing in a world where developed market central banks are all tightening, it guarantees that absent a rally in US Treasurys, the dollar-yen yield differential can’t close. The wider it is, the more pressure on the yen, which this week weakened to the lowest since 1998 (figure below).

On Friday, in the lead up to the BoJ’s June meeting, the yield on 10-year JGBs hit 0.265%, the highest since January 2016.

Bets that Kuroda will ultimately be forced to relent are becoming more popular, even as shorting JGBs is the very definition of perilous. BlueBay, for example, has what CIO Mark Dowding called “a sizable short,” while speaking to Bloomberg earlier this week. This always sounds straightforward. “Yield-curve control is designed so that the more the Fed hikes, the more the BoJ is going to need to ease and grow its balance sheet,” Dowding said. “This is what makes it untenable.”

He’s correct. Sort of. But as objectively perilous as the BoJ’s policy bent surely is in the current environment, “untenable” is still something of a misnomer when it comes to central banks. That’s especially true of the BoJ, the ECB, the BoE and, of course, the Fed.

Market participants continue to point to the RBA’s short-lived experiment with yield-curve control, which the bank abandoned late last year, but I’d note two things. First, the RBA scrapped the cap on a three-year target bond not because it lacked the capacity to defend it, but rather because the benefits of doing so were seen as diminishing, especially relative to the annoyance of fighting the market, which, after smelling blood in October, was pushing the envelope pretty hard. Second, the BoJ isn’t the RBA. Forcing Kuroda to abandon Japan’s yield-curve control regime is a quixotic endeavor. That doesn’t mean betting on abandonment can’t work. It just means you’re betting on a policy choice, not on your own capacity to foist that choice on the bank.

Earlier this week, Bloomberg posited a hypothetical, noting that if Japan’s yield curve shifted up by 100bps, the BoJ would be left staring at a 29 trillion yen loss on its JGB holdings. But that’d be a paper loss. And it’d have to be netted against longer-term gains on the same bonds. More importantly, the BoJ can conjure yen at will. The concept of a “broke” developed market central bank, where “broke” refers to losses denominated in its own currency, is a contradiction in terms. It’d be a political hot potato, especially if the story were sensationalized in the media at a delicate time, but the real concern in a scenario where yields rose sharply over a compressed time frame isn’t some theoretical “loss” for Kuroda, but actual, real losses for other holders of JGBs who don’t have the luxury of printing money.

Additionally, any hawkish pivot from the BoJ could entail a sharp rally in the yen, which could easily spill over into Japanese equities to the detriment of anyone who owns them, including, by the way, the BoJ itself. Although paper losses on local equities are no more “real” to a central bank than paper losses on local bonds, the BoJ’s equity holdings are a bit of a quandary. There’s no natural exit plan. Stocks don’t “mature.”

So, one problem with abandoning yield-curve control (or otherwise tweaking policy), is that it would almost surely impose overnight losses on a lot of people. A second problem is that the shock associated with a decision even to adjust the band around 10-year yields would ripple across global bond markets at an extremely delicate juncture, when liquidity is severely impaired and nerves are frayed. Relatedly, the smaller the tweak, the more inclined the market would be to immediately test it. But the market will test it either way, and probably in very short order, so the larger the tweak, the more disruptive the fallout would be. If, for example, the BoJ were to tolerate 10-year yields rising another 25bps, JGB yields would invariably trade 25bps cheaper almost immediately. Worse, the very fact that the bank made a concession would encourage markets to push even harder, on the assumption that if Kuroda blinked once, he’ll blink again. It’s the Schwarzenegger logic from Predator: “If it bleeds, we can kill it.”

If, or maybe “when” is more apt now, the BoJ does decide to abandon yield-curve control, the least bad option will be to simply scrap it overnight with the caveat that disorderly price action won’t be tolerated. That way, the market would have to guess at what counts as “disorderly.” It’d be a painful experience, but tweaks like those the BoJ has tried in the past won’t work when the market is acting like a pressure cooker.

Until then, the BoJ will just have to hope US yields fall. “Dollar-yen still remains at the mercy of 10-year UST yields,” one Sydney-based strategist said Friday, when the yen fell nearly 2% in response to the BoJ’s obstinance (figure below).

The bank on Friday said it’s watching the impact of the currency on the economy and inflation, and pledged to keep buying 10-year JGBs at 0.25% every business day. No retreat, no surrender.

“At the end of the day, Kuroda is sticking with the YCC plan,” SPI Asset Management’s Stephen Innes wrote. “If there is a change in YCC, it will come on the BoJ’s terms, not as a knock-on effect of other central banks’ policies.”

There was no change to the bank’s commitment to its inflation target, and policymakers reiterated their willingness to ease more without hesitation. “The reference [to] currency in the statement may be a warning for FX markets,” JPMorgan’s Takafumi Yamawaki remarked.

Although the weaker currency and the read-through for inflation aren’t as pernicious for Japan as they are for other advanced economies given the country’s long battle with deflation, the flipside of that is a consumer who’s not accustomed to rising prices. Kuroda needs to break the disinflationary psychology, but this isn’t how the BoJ envisioned winning the fight — letting the currency careen lower in the face of epochal exogenous shocks while persisting in a policy bent that’s beginning to look less like persistence and more like recklessness isn’t ideal.

Earlier this month, after enduring a backlash on social media, Kuroda was compelled to apologize for suggesting Japanese households are learning to accept higher consumer prices. A recent Kyodo poll found 58.5% of participants believe Kuroda isn’t fit for his job. In the same poll, more than 77% of respondents said they believed his remark about families’ “increasing tolerance” for inflation was inappropriate.

“Sudden yen movements make it difficult for businesses to plan, which is negative for the economy,” Kuroda said Friday, during remarks to reporters following the policy meeting. He gave no ground on the yield corridor. “There’s been no change in thinking around the YCC program,” he told the press. Yield-curve control, he insisted, “is not reaching its limit.” The sustainability of the program isn’t in peril, and he doesn’t believe any review of the regime’s parameters is necessary right now.

The BoJ bought 70.1 billion yen of equity ETFs on Friday after the Topix dropped 2% in morning trading. It was the second time the bank bought stocks this month.