Surprise! Bank Of Japan Stuns Markets With Policy Tweak

The Bank of Japan finally blinked.

At its last meeting of the year, the lone dovish holdout in a world full of policy hawks announced a widening of the yield-curve control band for 10-year Japanese government bonds. Yields will now be allowed to rise as high as 0.5%.

Haruhiko Kuroda’s insistence on defending the 0.25% ceiling on JGB yields this year contributed to a harrowing and prolonged bout of depreciation for the yen, prompting official intervention to arrest the slide.

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Kuroda’s bond-buying and refusal even to consider deviating from ultra-accommodative policy settings stood in stark contrast to the Fed’s aggressive tightening campaign.

That juxtaposition torpedoed the yen, putting the Japanese currency on track for one of its worst years in decades, although it recently found its footing amid a meaningful pullback in the dollar.

USDJPY peaked at 151.95 in October (figure above). The yen surged Tuesday as news of the wider JGB yield band rippled across markets.

Rumors about a possible pivot from the BoJ after Kuroda’s term ends early next year are a mainstay of the financial news cycle. Last week, Kyodo indicated Fumio Kishida may be open to revising the government’s agreement with the central bank and allowing for flexibility around the timeline on achieving 2% inflation. The government denied the report.

The Fed’s hawkish dot plot, released last week in conjunction with fresh economic projections showing officials see core inflation in the US remaining far above target through 2023, as well as very aggressive language from Christine Lagarde following the ECB’s December meeting the next day, served to underscore the BoJ’s outlier status. That might’ve raised the stakes for this week’s meeting.

Core inflation in Japan is the highest in decades (figure above). It’s obviously well below the peaks seen across other developed markets, but remember: The Japanese public isn’t used to this. 3.6% price growth likely seems very hot to a public accustomed to little or no inflation and, at times, outright deflation.

The implications of the BoJ’s shift could be profound even as the tweak doubtlessly seemed trivial to the uninitiated. Although a policy review was widely expected next year, the bank’s decision to adjust the band with Kuroda still at the helm was a surprise. Not a single economist predicted Tuesday’s decision. Aussie yields surged and Treasury yields moved higher as well.

I’ve long warned that widening the band carried considerable risks, even as I’ve insisted it was necessary. On September 10, in “Breaking The Bank,” I wrote that,

If the BoJ does pivot (perhaps under pressure from the finance ministry or the prime minister), the key consideration will be what that pivot looks like. The preferred option is probably a widening of the band which allows 10-year yields to rise beyond 0.25%, but with a commitment to cap them at some higher level. The problem with that approach is that markets, smelling blood, would immediately drive yields up to that level, forcing Kuroda to defend it. Worse, there’s some risk that the upward pressure on JGB yields would spill over — that bunds and gilts and Treasurys would inherit the selloff. With JGB yields still capped, just at a higher threshold, widening the band could boomerang back to Kuroda if JGB-inspired rate rise in other locales ends up perversely increasing the rate differential between Japan and other developed markets.

10-year JGB yields nearly doubled on Tuesday after the decision. The BoJ indicated it’ll increase bond purchases during the January to March period. They already own around half the market.

The bank unironically cited deteriorating market functioning in government bonds in the December statement, which contained a reiteration of the commitment to quantitative and qualitative easing as well as yield-curve control for “as long as it is necessary.”