The Bank of Japan doubles down on dovish monetary policy

Last week I wrote about the happenings in Asia. The Chinese Yuan is getting hit. Chinese markets are dropping. Asian currencies are weakening. But one of the most important signals is coming from the Bank of Japan and what is happening to the Japanese Yen.

I highly suggest you read my previous article for the foundation as this one will be an update.

Yesterday the Bank of Japan had their monetary policy meeting before Golden Week kicks off. Japan will be offline for 6 trading days during this 11 day holiday. Since the last 50 something Bank of Japan meetings have been unchanged, nobody really expects anything from them. But yesterday’s meeting got a lot of attention given the weakness in the Japanese Yen.

Some traders and macro investors were, and still are, betting that one of the largest financial events in modern history would happen. That the Bank of Japan would give up on their yield curve control.

A quick refresher. Japan is doing yield curve control to keep bond yields from rising. They have marked the 10 year Japanese Government Bonds (JGBs) at 0.25%. Because of global rates rising, the 10 year JGB was also rising above the 0.25% level. In previous months, the Bank of Japan initiated fixed rate operations. What this means is the Bank of Japan announces that they will buy an unlimited amount of 10 year JGBs at any rate. Remember the inverse relationship between bond price and yields. When bond prices go up, yields go down and vice versa. The Bank of Japan is buying bonds to ensure yields remain below 0.25%.

All western and western allied central banks are hawkish and raising interest rates. Japan is the exception. This is where the breaking of the Bank of Japan trade comes in. Many traders think that interest rates will have to rise in Japan in order for the Yen to strengthen. The question now becomes how low can the Bank of Japan stomach a weaker Yen?

Let’s get to that press conference and then put things together from there. Here are some points from the statement:

• The short-term policy interest rate: The Bank will apply a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.
• The long-term interest rate: The Bank will purchase a necessary amount of Japanese government bonds (JGBs) without setting an upper limit so that 10-year JGB yields will remain at around zero
  percent.
• In order to implement the above guideline for market operations, the Bank will offer to purchase 10-year JGBs at 0.25 percent every business day through fixed-rate purchase operations, unless it is highly likely that no bids will be submitted.

I highlighted the last point because it is a change. Essentially fixed rate operations have become permanent. If 10 year JGBs approach 0.25%, the Bank of Japan will print Yen to buy bonds to bring yields down. No more announcements needed.

The Bank of Japan is basically telling traders betting against them to give it their best shot. The Bank of Japan will not budge.

Above is the Bank of Japan effect. Yields did drop from 0.25%… for now. I don’t really like that large daily wick on the candle now, but we will observe. If we continue to see the JGB yield rise above 0.25% even with the Bank of Japan buying bonds to keep yields down, we are in some trouble. The Bank of Japan breaks and would have to accept that rates will need to rise.

The USDJPY is at levels not seen since 2002. Or the Japanese Yen is at its weakest level for 20 years. With other western central banks raising rates, the Yen will weaken on interest rate differentials. Many traders think 130 is the line in the sand for the Bank of Japan. We are already at 131. The next Bank of Japan meeting will definitely be interesting.

By the way, the Bank of Japan is already worried about the weakening Yen. It came out last week that they asked the US for currency intervention to help weaken the US Dollar against the Japanese Yen. It was declined. This means the Bank of Japan will have to act on their own…which will be a huge financial event for western markets.

As I explained in my previous article, if the Bank of Japan goes hawkish and begins to raise interest rates like all other western central banks, interest rates in those western countries will rise very quickly…and the stock market and perhaps even real estate, would go through the floor. The Bank of Japan has been keeping this house of cards afloat, and they are saying they will continue to bear the weight.

Since interest rates are low in Japan, Japanese money has been flowing overseas. Mainly into US treasuries, hence why Japan is the largest foreign owner of US debt. Because of Japanese money buying US treasuries, Japan in a way is doing indirect yield curve control for the Fed. Japanese money buys US treasuries which means yields drop and will stay subdued. This is great because it means the US government can keep spending like crazy and not worry about the deficit because Japan will buy the debt.

If Japanese interest rates rise, that Japanese money will be looking at the domestic market. They would not need to go overseas to hunt for yield. This would mean a lot less Japanese money buying US treasuries and other bonds, and yields in said nations would spike without indirect Japanese yield curve control. The argument against this is that’s fine because other buyers would step in to buy US treasuries now, especially at these interest rates. Perhaps…but remember technically a US investor is still losing money by buying bonds. With inflation still at elevated levels, bonds are yielding negative in real terms. For the Japanese investor with inflation below 2% in Japan, US treasuries provide a return on money.

Keep your eyes on the Bank of Japan and the Yen. Lot of things are happening over in Asia.