Japan may be surprising the markets with monetary policy

Japan’s national flag flies on top of the Bank of Japan building on November 12, 2019 in Tokyo, Japan.

Tomohiro Ohsumi | Getty Images

The Bank of Japan is approaching a turning point.

It happens while policy makers around the world are struggling to tighten monetary policy in an attempt to curb record high inflation.

The Swiss National Bank was one of the most recent major central banks to come on the scene and surprise the markets last month by delivering its first rate hike in 15 years. The SNB jumped out of the blocs with an increase of 50 basis points, and the shock movement caused the Swiss franc to rise to its strongest level against the euro in almost two months.

However, Japan has tried to remain loose and prioritize the management of the yield curve. The world’s third largest economy has been stuck in an environment of low growth, low inflation – and at times deflationary – environment for many years, which means that the Bank of Japan has kept the policy accommodating in an attempt to stimulate the country’s sluggish economy.

The central bank was on track to buy about 15 trillion Japanese yen ($ 110 billion) in government debt in June, making it the only major central bank still embarking on a significant buyback program.

Overall CPI is just above the 2% target in Japan, while core inflation is 0.8%, so the central bank is not facing the same inflationary pressures as many counterparties in the West,

The BOJ has reiterated its commitment to avoiding deflation, which remains the dominant political obstacle in Japan. The central bank expects consumer price increases to subside in the medium term as the impact of energy prices on the overall figure begins to decline.

However, should this assessment prove to be wrong and the BOJ be forced to raise interest rates – either as a result of inflation or upward pressure from other monetary tightening around the world – this could send a ripple effect through global markets.

According to Neil Shearing, chief economist at Capital Economics, much of the “openness” of the country’s capital account (its balance of payments) depends on the extent to which flows are affected by changes in interest rates elsewhere.

“Japan is open to global capital flows, and so as bond yields in other countries have risen, the BoJ has found that its commitment to a policy of managing yields – to keep 10-year JGB (Japanese government bond) yields within 25 baseband bands on both sides of zero – have been tested by global investors, “Shearing said in a note Monday.

Yield curve control tested

The Bank of Japan’s self – imposed bond yield ceiling helps keep borrowing costs down throughout the economy, which in principle supports growth.

“The recent divestment of the global bond markets has pushed the 10-year JGB rate all the way to the upper limit of the BoJ’s range, forcing it to buy rising amounts of government debt to maintain its target – by some measures, if it continued. By buying at this month’s pace, it would own the entire market of excellent JGBs within a year, “Shearing said.

The Bank of Japan continues to defend its interest rate target, although global momentum is pushing towards higher interest rates, and its divergence has driven the Japanese yen sharply down.

Shearing pointed out that while the People’s Bank of China imposes capital controls to maintain influence over its monetary and monetary policy, Japan’s relatively open capital account means it cannot control the yen while maintaining monetary sovereignty over monetary policy.

Basically, the Bank of Japan can support bond yields by buying limitless amounts of bonds, sending the yen into a downward spiral, or it can protect the currency from a destabilizing depreciation, but it cannot cope with both at the same time.

Capital Economics expects Japan to provide some ground in its yield curve control by expanding the target range, which can then see investors test their willingness to keep the line at the new range. Given rising interest rates around the world, this could weaken the yen further.

“Obviously, a markedly weaker currency could be a positive development for an economy struggling to get out of three decades of deflation, but large and rapid currency movements can be destabilizing,” Shearing said.

“At some point, it pays off – either because balances are starting to come under pressure, or because imported inflation is becoming a problem.”

As deflation generally causes companies and consumers to postpone investment and purchases, the Bank of Japan has been working for years to bring inflation back to its 2% target to restore its production capacity and growth rate.

‘Violent adaptation’

The BOJ’s sustained quantitative easing could also have a number of significant consequences for both domestic and global markets.

By limiting the rise in long-term interest rates, the central bank risks pushing inflation beyond its original targets, according to Charles-Henry Monchau, chief investment officer at Syz Bank.

Monchau noted that the BOJ’s purchase of bonds implies that it would be necessary to lend the corresponding amount, which further exacerbated price increases. The deviation in interest rates relative to other developed countries, which tightens monetary policy, weakens the yen. Meanwhile, the BOJ keeps bond yields artificially low by buying so many JGBs, preventing it from raising interest rates, the main method of limiting higher inflation.

Cumulatively, he suggested that this dynamic could create conditions for inflation to “suddenly get out of control, implying a relentless and violent adjustment in the bond market.”

Maintaining loose policies at all costs can also create risks on the international stage.

“The weakening of the yen could lead to a currency war in Asia, which in turn could fuel rising inflation in neighboring countries, increase the cost of servicing their dollar-denominated debt and thus increase the risk of default by less creditworthy countries,” Monchau said. CNBC Tuesday.

“Another international consequence with even greater consequences is the risk of a sudden closure of the transport trade.” Carry trade is a strategy where investors borrow from a low interest rate currency to finance the purchase of a higher rate of return that captures the difference between the rates.

Monchau argued that with the BOJ obliged to lend the corresponding amount of the bonds it buys, this market context favors “access to very low interest rate financing in a constantly depreciating currency” the use of carry trades.

“For example, a ‘long Brazilian real, short yen’ strategy has already generated gains of 35% this year. But the risk of this type of strategy is a sudden reversal of the current trend,” Monchau explained.

“If the yen strengthens and / or if JGB interest rates rise (due to the BOJ’s abandonment of the YCC), there is a risk of a sudden and massive liquidation of carry trades with a cascade of risky assets.”

This would ease panic selling of stocks, forced selling of the US dollar and a rise in US bond yields due to the rise in JGB yields, he suggested, the type of sudden “economic accidents” that could exacerbate the pain of risky assets and increase the risk of recession .

“The grim scenario described above is far from a certainty. First, the imbalances created by the Japanese authorities (over-indebtedness and manipulation of the bond market) have been pointed out for many years now without ever leading to a major accident,” Monchau noted.

“But the current situation in JGBs, in a context of high market volatility, is dangerous to say the least. And any market stress resulting from the end of QE in Japan could have a different consequence for international financial markets: the loss of confidence in major central banks. monetary policy. “

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