Yen-sanity

The yen was on track for its weakest close in more than 30 years on Tuesday, which left me compelled to weigh in on the Bank of Japan for the third time in as many days.

Headed into this week, consensus expected no change to the bank’s yield-curve control settings, but with the yen loitering near 150 (so, a very weak yen), there was some speculation that Kazuo Ueda might raise the ceiling. Again.

That speculation went into overdrive on Monday afternoon in the US after Nikkei suggested the BoJ was, in fact, prepared to unveil a higher YCC cap.

Instead, the BoJ offered a vague description of a new regime. It was all at once a game-changer and not. As at the July policy gathering, Ueda went for nuance and got confusion for his trouble.

The yen weakened markedly, careening through 151.

A little history is in order. The specter of a disorderly, RBA-style YCC “crash out” for the BoJ haunted markets in 2022, when a relentlessly strong dollar, surging commodity prices and a recalcitrant Haruhiko Kuroda put enormous pressure on the yen, eventually compelling the government to intervene on the currency’s behalf for the first time since 1998. Kuroda rode out the storm (which reached a crescendo around this time last year) only to blindside markets with a YCC tweak in December.

Fast forward seven months and Ueda, who succeeded Kuroda, unveiled what he called a “flexible” approach to YCC. Specifically, the bank kept the 0.5% range (on either side of 0%), but instead of a “rigid” (their word) corridor, it became a “reference” region. The hard cap was moved up to 1%. The relentless rise in US yields beginning just days after that July meeting was unwanted and arguably untenable by the time the October gathering rolled around.

As I never tire of reminding readers, defending the YCC cap is doubly bearish for the yen. The BoJ has to print money to defend the yield cap (e.g., bond-buying) and in capping yields, they ensure that on days when Treasury yields are rising and JGB yields are at or near the ceiling, yield differentials can only move in favor of the dollar. Official intervention on behalf of the yen adds an extra layer of absurdity: Japan sells dollars to shore up the yen, then turns around and prints more yen to defend YCC.

Everyone knows it’s ridiculous, and everyone knows it has to be jettisoned. It’s just a matter of how to go about abandoning a policy which distorted the JGB market beyond recognition. You can’t distort one market without second-order effects for other markets, and this is no exception. So, coming out and declaring “YCC is over!” isn’t generally seen as an attractive exit strategy. It could be chaotic — the market equivalent of the US exiting Afghanistan, complete with tragic explosions and heavily-armed, delirious fundamentalists reasserting dominion after decades spent fighting an insurgency from the surrounding hills.

In case it isn’t clear enough, the point is this: The BoJ can’t just pick up and leave. They have to gradually exit YCC and it appears their strategy will be defined by an obfuscatory approach to the cap and ad hoc purchase ops. Here’s the key passage from the BoJ’s October policy statement:

With extremely high uncertainties surrounding economies and financial markets at home and abroad, it is appropriate for the Bank to increase the flexibility in the conduct of yield-curve control, so that long-term interest rates will be formed smoothly in financial markets in response to future developments. In this regard, currently, the Bank considers that strictly capping long-term interest rates by fixed-rate purchase operations at 1% for consecutive days, which it has offered every business day in principle, will have strong positive effects, but could also entail large side effects. Given this, it decided to conduct yield-curve control mainly through large-scale JGB purchases and nimble market operations.

That was enough to drive more than a few market observers to frustrated tears. “That’s just… the market, surely? Where is the control?” exclaimed one Bloomberg blogger. “Does YCC even effectively exist anymore?”

Spoiler alert: You’re not supposed to be able to answer that question. The whole point is (or at least should be) to leave the market in the dark as to when and where the BoJ might step in. The problem with explicitly identifying the location of a hard yield-cap is that the market will immediately test it. Probing around in the dark to find it is more risky — you could overestimate where it is and get burned, for example.

That said, Tuesday probably did mark the end of YCC in Japan as we’ve known the policy. The BoJ plainly doesn’t want to be obligated to buy unlimited bonds at a specific yield cap, and now it isn’t.

In theory, that means the market can test whatever levels the market sees fit to test, with the caveat that pushing the envelope could be met with pushback.

The BoJ on Tuesday marked up its inflation projections. The bank now sees price growth running in excess of the 2% target for at least three straight years. That’s unusual, to put it mildly. Still, they won’t be in a hurry to tighten policy. As ever, officials aren’t convinced (or claim they aren’t) that more lively wage growth is sustainable, and they worry the deflationary mindset is so deeply embedded in Japanese psychology that exorcizing it may yet prove impossible.

So, why the yen weakness? Shouldn’t the currency be stronger in light of this long-awaited nod to the end of YCC? Not necessarily. Some argued that the absence of a more decisive message suggested the BoJ is still on the fence about how to proceed, which means the normalization process could take longer than expected and anyway isn’t likely to take the form of an overnight abandonment. Others suggested the Nikkei report set expectations such that anything less than an explicit commitment to countenance yields beyond 1% was considered dovish.

I don’t find either of those explanations especially satisfying, but the bottom line is that monetary policy in Japan remains an extreme outlier and nothing communicated by the bank on Tuesday suggested that’ll change anytime soon.