Bank of Japan meetings have generally been rather sedate affairs in recent times as policymakers ticked off their uber-dovish bias and policy measures. But speculation has ramped up in recent weeks that more changes are afoot after the bank tweaked one of those long-held policies in December. This stunned markets and hastened more JPY buying as the BoJ appeared to be taking its first steps to policy normalisation. Rising interest rates and the end of the yield curve control (“YCC”) policy are mooted and would be a huge deal for markets.
The two-day BoJ meeting kicks off today with statements due out in the early hours of Wednesday. This is the penultimate gathering for the bank’s longest serving governor, Haruhiko Kuroda, who has been the architect of numerous dovish polices during his tenure. The YCC policy and negative rates were enacted to stimulate lending, growth and inflation. But the bank is now under pressure to eliminate this framework, which has been in place for seven years.
What is YCC?
After years of bond buying failed to fire up inflation, the BoJ cut short-term rates below zero in January 2016. However, yields got crushed so the yield curve control policy was started to stop interest rates from falling too low. The BoJ initially added a 0% target for 10-year Japanese government bond yields to its -0.1% short-term rate target. The idea was to control the shape of the yield curve to suppress short-term rates which affect corporate borrowers, without impacting longer-term yields too much. Depressed yields on long-term bonds would have reduced returns for pension funds and life insurers.
But with inflation remaining at very low levels, YCC was in place far longer than anticipated. This caused yields to trade in a very narrow range and trading volumes to dwindle. To address these side-effects, the BoJ has twice widened the band which the 10-year yield can move to try and spark life into the zombie Japanese government bond market.
Fast forward to December last year and the bank shocked markets by doubling that cap to 0.5% as markets bet on BoJ rate hikes due to the rest of world embarking on aggressive policy tightening. Bond buying was also ramped up to defend the ceiling, but markets have smelled blood and keep pushing yields beyond the 0.5% band. That means the BoJ has spent record amounts buying bonds to bring yields back under the cap, a situation which is unsustainable and led to a highly dysfunctional market.
What happens next?
In simple terms there are probably three options for the BoJ. Do nothing and assess the impact from December’s change. That would be a big disappointment for many and the yen would get sold aggressively. Otherwise, the BoJ can increase the band again or even abandon it all together. The yen would surge as the policy normalisation theme kick ins. Certainly, Japan is now suffering like other Western countries with high inflation and wage growth concerns.
Will Kuroda want to tarnish his legacy with a winding up of one of his most fabled policies? Or is it prudent to let his successor take on the mantle, who will be under immediate pressure to adjust YCC? It seems it’s all in the timing as Japan can’t run massively dovish monetary policy for much longer. But the window of opportunity isn’t large as Japan has never tightened policy when the US is easing. Money markets currently price in Fed cuts for later this year.