The financial markets got an early Christmas present courtesy of Haruhiko Kuroda, the Governor of the Bank of Japan. I have covered the Bank of Japan extensively this year. I told readers that the Bank of Japan (BoJ) is the most important central bank to be watching. I laid out the case in that article and this video:
The reason is quite simple, but requires a complex deep dive.
The simple part is that the BoJ is not raising interest rates while most of the western world are. This has impacted the Japanese Yen big time. The Yen has weakened due to interest rate differentials and what you call the carry trade. In the currency/forex world, you get paid the difference in interest rates between the currencies. So say you are long USDJPY (buying USD and short JPY), you would get quite the substantial overnight swap since US interest rates are much higher than Japanese rates. This applies to pretty much every Japanese Yen currency pair.
A weak Yen is great for Japanese exports. However, the Yen weakening against the US dollar to levels not seen since 1990 isn’t really what Japan wants. Especially since Japan is also experiencing inflation due to supply chain disruptions.
What makes things more dramatic is the fact that Japan is an importer for commodities. Commodities which are traded in US dollars. US dollars which are getting more expensive. Many analysts have gone contrarian mode saying the Bank of Japan will have to act.
And they have.
Nobody really paid attention to the BoJ because interest rates have been low for decades and the BoJ rarely changes policy. However, in my articles, I told readers that this is about to change and the Bank of Japan is super important.
In reality, bond yields around the world are down due to easy monetary policy from the Bank of Japan. If it wasn’t for this, real estate and stock markets would be falling due to higher interest rates.
While interest rates were rising globally, Japan did not budge. They kept the 10 year pegged at 0.25%. There were some traders betting on the peg to break as the Yen fell. Bank of Japan’s response? Buy unlimited 10 year bonds at any price to keep yields from rising.
Here’s a reminder of the doubling down of dovish policy the BoJ announced:
- 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.
And now to the shocker.
In an unexpected move, the Bank of Japan has tweaked its yield curve control policy to allow Japanese 10 year bond yields to move 50 basis points either side of the 0% target. The 0.25% peg has been moved higher.
The Bank of Japan said it is intended to “improve market functioning and encourage a smoother formation of the entire yield curve, while maintaining accommodative financial conditions“. This move sparked a sell-off in bonds and stock markets around the world.
The Japanese 10 year yield spiked to adjust to the new yield curve control policy.
The Japanese Yen strengthened against the dollar and other currencies. Remember, when USDJPY drops, it means the Yen is strengthening and the dollar is weakening.
So why does this all matter?
First off, this was a surprise. Governor Kuroda is to step down as BoJ head in April 2023, and many analysts thought that there would be no policy change until the new Governor takes up the position.
Secondly, the BoJ may be taking steps to strengthen the Yen. This means they could be flipping hawkish.
I think this changed recently. If other central banks pivoted as the markets thought, the BoJ would do nothing. Instead, we got Powell saying interest rates are heading higher for longer. That got the Bank of Japan to act, and even though they have not raised rates, this announcement was huge for global markets.
“The decision is being read as a sign of testing the water, for a potential withdrawal of the stimulus which has been pumped into the economy to try and prod demand and wake up prices,” said Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.
“But the Bank is still staying firmly plugged into its bond purchase program, claiming this is just fine tuning, not the start of a reversal of policy.”
Recall that Japan is the number 1 buyer of US debt. It is not China. Since interest rates have been low in Japan for decades, Japanese wealth has been looking overseas for yield. They have been buying up safe US and European debt. In a way, Japanese money has inadvertently done yield curve control for the US and Europe, keeping rates low.
But with the BoJ adjusting the yield on the 10 year JGB, Japanese money may sell off US and European debt and return home. But interest rates aren’t high yet? Well inflation has been low in Japan for decades, and current inflation is from supply chain disruptions. We are not even seeing wages increase which would add inflationary pressures. The domestic Japanese investor may take this yield and the safety of having money in the country rather than overseas.
Oh and the major one: with the Yen being weak, it might make more sense buying Yen denominated assets than having to fork over more for US and European debt. Japanese savers could be bringing a big chunk of their savings back home and sell US and European debt. This will cause yields in the US and Europe to spike.
A spike in yields is troublesome. Stock markets would take a hit, and if yields rise too fast, central banks may need to intervene. Let’s watch out for this. Remember, intervention would occur during a time when central banks are supposed to be lessening the balance sheet. If yields go crazy, central banks would sell this intervention as a ‘temporary’ policy tweak.
As I said earlier this year, it is important to watch the Bank of Japan. Yesterday’s price action in global stock and bond markets prove that the Bank of Japan is one of the most important central banks to be keeping tabs on.