The Federal Reserve often captures the attention of investors, but the recent decision by the Bank of Japan (BOJ) to relinquish control over government bond yields serves as a reminder that other central banks should not be ignored.
In a small yet significant move, the BOJ is taking steps to normalize monetary policy in Japan, the world’s third-largest economy. This move could potentially lead to the first interest-rate hike since 2007. If the BOJ continues along this path, it may surprise Wall Street and have important implications for Treasuries and the dollar, as some of the largest global investors may rotate their investments back to Japan.
Japan has struggled with deflation since the bursting of a real estate bubble in the early 1990s. In response, the BOJ pioneered “quantitative easing” in 2001, stimulating growth through bond-buying. In 2016, it went even further and implemented negative interest rates while also implementing a policy to control the yield curve for government bonds.
Now, however, the BOJ is starting to reverse its course. During its October meeting, the central bank decided to keep rates at minus 0.1%, effectively ending its yield-curve control policy. While the BOJ had previously set a strict yield cap of 1% on the 10-year government bond, it has now redefined that level as a mere “reference.”
Although this language tweak may seem minor, the implications for markets could be substantial. BOJ Governor Kazuo Ueda stated that the central bank would be open to allowing long-term yields to rise if driven by fundamentals, but it would intervene in response to speculative movements.
Despite this shift, the BOJ stated its commitment to continuing with monetary easing, but there is a noticeable policy drift in Tokyo. This shift comes amid a significant weakening of the currency and a more sustainable inflation rate. The difference in interest rates between Japan and the United States has led to the yen reaching its lowest level against the dollar since 1990. Ueda also highlighted the risk of exchange-rate volatility as one of the reasons behind the adjustment made to yield-curve control policy.
The Impact of Japan’s Inflation Target on Monetary Policy
Inflation in Japan is steadily inching closer to the Bank of Japan’s (BOJ) annual target of 2%. This development may prompt the central bank to consider tightening its ultra-loose monetary policy. Recently, the BOJ’s policy board revised its inflation projections, anticipating a rate of over 2.8% for the 2024 fiscal year, up from the previous estimate of 1.9% in July.
Financial experts, such as Iain Stealey, Chief Investment Officer for fixed income at J.P. Morgan Asset Management, agree that the current monetary policy is in conflict with economic fundamentals. Stealey expects the BOJ to adopt a more proactive stance moving forward.
Marcel Thieliant, head of Asia Pacific at research group Capital Economics, predicts that Japan’s negative interest rates will be discontinued as early as January. Likewise, Stealey believes that the BOJ will abandon yield-curve control in the spring, following annual wage negotiations between unions and employers.
The persistent ultra-low interest rates in Japan have led to an outflow of domestic capital and fostered a carry trade strategy wherein investors borrow yen to purchase U.S. Treasuries. This practice exerts downward pressure on the yen while boosting the value of the dollar. Remarkably, Japanese investors currently hold $1.1 trillion of Treasuries, surpassing Chinese investors by almost 40%.
If the BOJ indicates its intention to normalize policy by possibly raising interest rates, Japanese investors, including banks and life insurers, may opt to sell their Treasuries in favor of more attractive domestic bonds. Consequently, the winding down of the carry trade could result in higher Treasury yields and weigh down on the dollar.
Yusuke Miyairi, a foreign-exchange strategist at Nomura, emphasises that a potential BOJ rate hike would be a significant event for the market, catching many participants off guard. This decision acts as an early warning that global factors, beyond those in the United States, necessitate careful observation.