Markets Ponder The Unthinkable After BoJ Shock

“Symbolically, this is an important step,” SocGen’s Kit Juckes wrote Tuesday.

He was referring to the Bank of Japan’s surprise policy shift.

Yield-curve control tweaks aren’t the stuff general interest headlines are made of, but make no mistake: The bank’s decision to allow 10-year government bond yields to rise to 0.5%, double the previous ceiling, was one of Tuesday’s bigger stories for serious market participants. (Admittedly, the definition of “serious” in the context of traders, pundits and economists is malleable.)

Read more: Surprise! Bank Of Japan Stuns Markets With Policy Tweak

Maintenance of the 0.25% cap on benchmark yields required ongoing purchases by the BoJ as pressure on global bonds tested the ceiling. Those bond purchases were tantamount to easing, and preventing Japanese yields from rising meant that on any day when JGB yields were near the cap and US Treasurys were selling off, rate differentials moved against the yen.

That was part and parcel of the currency’s inexorable slide to a three-decade low (figure below).

Official intervention to arrest the yen’s slide meant the Japanese government and the BoJ were working at cross purposes, even as an obstinate Haruhiko Kuroda insisted he wasn’t trying to engineer a weaker yen.

On Tuesday, Kuroda was adamant that “this isn’t a rate hike.” That seemed incongruous with his previous remarks on the signaling effect from a wider yield-curve control band. “Although today’s measures will widen the yield band, we believe the effects of monetary easing, starting with yield-curve control, will spread more smoothly through corporate finance and other means as a result,” he added.

As you can imagine, the yen surged (figure below).

“Looked at through the lens of relative 10-year yields, the move is small, an 8bps narrowing in the spread to the US that leaves it 170bps wider than it was at the start of the year, but arguing that the USDJPY reaction, which is much more a function of the US side of the relationship, is excessive, would be to ignore the context,” SocGen’s Juckes said. “This is a change of direction for the BOJ [and] the yen remains undervalued on almost any measure.” In real effective terms, Juckes went on to note, the yen had fallen to its lowest level in nearly 50 years.

Plainly, this is bullish for Japanese banks and bearish for domestic equities in general. The Nikkei slid 2.5%, while bank shares rose more than 7% at one juncture, before trimming gains.

“From a risk perspective, it’s best not to underestimate the lingering impact this could have on broader sentiment because tighter BoJ policy would remove one of the last low-interest rate safe harbors that have helped to keep borrowing costs at low levels,” SPI Asset Management’s Stephen Innes remarked. “Investors are trying to find central banks’ endgame… and the BoJ raising the last low-rate anchor isn’t helping to calm year-end stormy seas.”

Ironically for a central bank synonymous with perpetual accommodation, the BoJ does revel in surprises which are “a monetary policy tool for them,” as one money manager who spoke to Bloomberg last week put it.

It’s easy to argue that the huge jump in 10-year yields (figure above) is a testament to the surprise element, but really it’s a testament to the notion that, as discussed in these pages on too many occasions to count this year, the market will be inclined to test the BoJ’s resolve by immediately driving yields up to the new ceiling. The new cap is 50bps, and at the highs Tuesday, yields were nearly there.

That, in turn, underscores the risk. Although unthinkable just nine months ago, it’s no longer far-fetched to suggest the market could force the BoJ out of yield-curve control, just as the RBA was compelled to abandon a short-lived experiment in YCC in November of 2021 after yields on the target note rose to eight times the ceiling.

“The forward policy ramifications from the move are aptly skewed as hawkish — greater flexibility on the 0.0% target is widely viewed as a precursor to either retiring the target or even outright rate hikes,” BMO’s Ian Lyngen and Ben Jeffery said. “Suffice it to say, the pace of future changes in BoJ policy will be topical as 2023 begins with April no longer viewed as an important inflection point in Tokyo.”

Kuroda said there were no plans to widen the band further, but conceded the market may push the envelope. Any relief for global bonds in 2023 (amid softer inflation, for example) could serve as a pressure release valve for JGBs, but with that caveat, I’d suggest Tuesday’s decision signals that YCC’s days are numbered. Even the BoJ has its limits, apparently.