Bank of Japan Unexpected Policy Turn – Signs of End of Yield Curve Control?

Bank of Japan surprised markets with changes to its yield curve control policy, possibly in preparation for a final departure from this policy in 2023. Although this decision was allegedly influenced by financial markets, there is a clear risk of a spike in inflation. This most likely prompted Chairman Kuroda to declare victory and ensure a smoother transition to the new policy of the next chairman in April. Short positions in Japanese Treasuries or long positions in the yen may have more leeway as yen trades carry are likely to be reversed.

What did the Bank of Japan do?

In a surprising communiqué at its December 19-20 meeting, the Japanese central bank changed its long-standing policy of controlling the yield curve. The bank extended the range of acceptable changes in the interest rate on 0,25-year Japanese treasury bonds from the current -/+ 0,5% to -/+ 0%. Other monetary policy levers remained unchanged, including the XNUMX-year target kept at XNUMX%.

Why did the Bank of Japan change its policy?

President Kuroda stressed that this decision was dictated by motives related to the financial market, not economic considerations, potentially trying to limit expectations regarding further changes. However, behind this announcement there is a significant upward revision of the projected core inflation to ~3,5% compared to ~3% reported in the October report.

This is a moment of victory for Kuroda as he can claim to have brought back inflation in Japan while highlighting the success of the yield curve control policy.

The move will also ensure a smoother transition of power to the new CEO, and further policy changes in 2023 should not be ruled out.

Let's highlight two reasons why we believe this announcement was released earlier than expected, aside from the fact that the Bank of Japan loves to surprise the markets (read: The Bank of Japan is poor at communication).

First, with the Fed slowing down its recent rate hikes and the 4,2-year yield dropping from 3,5% to, at one point, even below XNUMX%, the pressure on the yen has eased. The Bank of Japan does not want to be perceived as yielding to market pressures and it seems that now is a slightly better time to change policy than later when yields go up again.

Secondly, Kuroda he wanted to be able to take credit for initiating changes in policy, rather than leaving it to his successor when his term ended in April. Expectations for a review of Japan's central bank's policy rose after reports over the weekend that the Kishida government is considering revising a 2013 agreement between the government and the Bank of Japan in which the central bank pledged to achieve 2% inflation as soon as possible.

Will there be a final end to the current policy?

The effectiveness of the yield curve control policy remains debatable, and it is especially difficult to maintain it in the context of this year's global wave of monetary policy tightening without incurring enormous collateral damage. This year, the damage was seen in currency markets as the Japanese yen fell to a 32-year low. The limits of the yield curve control policy have also been tested in the bond markets.

With the continuing risk of a greater than expected Fed tightening in 2023, there is still a risk that markets will again test the limits of Japanese central bank policy. Long-term Japanese government bond yields are likely to test the new upper limit of 0,5% again after rising more than 15bps following the announcement. We may see the Japanese yen strengthen as expectations emerge for an eventual departure from the yield curve control policy. Regardless of how Kuroda puts it, he seems to be setting the stage for a final end to the current policy, and markets will increasingly position themselves in this regard.

Investment implications

The rise in Japanese bond yields is likely to cause further volatility in global equity and bond markets, especially given that it comes at a time of low liquidity and lack of other impulses.

As the market starts to put pressure on the Bank of Japan again to move towards the eventual end of its policy, short Japanese bonds or long yen could potentially gain more room for maneuver. This view is also supported by the probable reversal of yen trades carry, as Japanese investors are rewarded for keeping cash at home during a period of global economic downturn and high macroeconomic uncertainty. This is not only positive for the yen, but also negative for foreign assets, particularly US Treasuries, which accounted for the majority of assets held by Japanese investors. In the case of equities, this could mean favoring Japanese financials at the expense of exporters and tech companies.

About the Author

Charu Chanana, market strategist in the Singapore branch Saxo Bank. She has over 10 years of experience in financial markets, most recently as Lead Asia Economist in Continuum Economics, where she dealt with macroeconomic analysis of Asian emerging countries, with a focus on India and Southeast Asia. She is adept at analyzing and monitoring the impact of domestic and external macroeconomic shocks on the region. She is cited frequently in newspaper articles and appears regularly on CNBC, Bloomberg TV, Channel News Asia, and Singapore's business radio channels.