The Japanese yen dropped to its weakest point in 33 years against the US dollar (USDJPY) following the Bank of Japan's (BOJ) decision to adjust its yield-control policy during its recent meeting on Tuesday, October 31. The central bank redefined its 1% upper bound for 10-year Japanese Government Bond (JGB) yields, now seeing it as a reference limit rather than a hard ceiling, signalling the end of yield curve control (YCC).
Some market participants expected the bank to defend its 1% bound after it revised its core inflation target for fiscal year 2024 to 2.8% compared with 1.9% prior but earned a surprise instead. It seems that the US Treasury Yield, which is also causing severe issues with the US government budget, is one of the factors that has influenced the BOJ's decision.
Despite the bank essentially abandoning its pledge to defend the ceiling with unlimited bond purchases as seen in the past, it ramped up government bond buying only a day later, on Wednesday, in the aftermath of its decision that resulted in a spike in JGB yields to 0.97%.
What Is the YCC and Why Did BOJ Adopt It?
Yield Curve Control (YCC) is not a new tool. It was used during and after World War II by the Federal Reserve (Fed) to set yield caps. Moreover, several countries are implementing yield curve control policies currently, as this approach is different from quantitative easing (QE) as it aims to be more balance-sheet efficient.
The BOJ adopted its yield curve control policy in September 2016 to strengthen its ultra-loose monetary policy, aiming to control short- and long-term interest rates to realise its inflation target of 2%. However, inflation remained below target, and the BOJ strengthened its commitment to ultra-loose policy with yield curve control as a result.
Controlling the curve ascertained the BOJ's commitment to raise inflation. Despite its efforts, the recent rise in yields signalled the limitations of YCC and suggested the beginning of a shift away from ultra-loose measures. The bank now has to face the challenge of balancing policy normalisation while remaining committed to its 2% inflation target.
Is BOJ Abandoning Yield Curve Control?
The BOJ has widened its yield target band on the 10-year JGB by 50 basis points to 1% on either side of the band with a clear 8-1 vote. BOJ board member Toyoaki Nakamura dissented, saying the increase in the band should be enabled based on equity earnings power, which are currently ongoing.
BOJ's governor, Kazuo Ueda, maintained a dovish tone and emphasised the need for sustainable achievement of the 2% price target during the bank's policy meeting. However, the recent declines in the Japanese yen put the “BOJ in a bind” as it pushes up the cost of imported goods, delaying the achievement of a 2% target inflation.
The adjustments are seen as a step towards the BOJ eventually exiting from a negative interest rates policy (NIRP), possibly around the beginning of 2024, considering the YCC as "simplified but effectively dead" after the changes. However, the YCC may be replaced with a minimum bond purchase target to manage the BOJ's balance sheet and counter yield spikes.
Possible Implications of the BOJ’s Policy Shift
Allowing higher JGB yields could reduce the need for the BOJ to purchase vast amounts of bonds. More importantly, it could eventually support the yen and reduce the need for government intervention to prevent further currency depreciation as the bank fights to maintain a balance between controlling 10-year JGB yields and limiting the yen's depreciation.
In addition, Japanese stocks may face challenges as the BOJ signalled to abandon its super-loose monetary policy. However, the impact may be limited as a currently weakening yen has made stocks more attractive to foreign buyers. Market analysts also suggest that the BOJ's decision may have surprised the markets, but it has provided a boost to the Nikkei (Japan 225) on Tuesday against speculations that the BOJ would abandon YCC altogether - as it didn't.
Furthermore, rallies in USDJPY could continue BOJ interventions as prices close in on the 152 level, which is close to the threshold that prompted previous intervention. This leaves a question about how much of this rally is in the past and how domestic borrowing costs will impact the market.
Overall, the tweak may reduce the need for the BOJ to increase bond buying but may also solidify market expectations of a near-term end to yield curve control and negative interest rates, hence raising questions about whether a more substantial change is on the horizon for the central bank's dovish stance. (Source: Reuters)
The BOJ’s decision to end daily bond purchases is seen as a major step as it means that the BOJ will no longer fix the bond but will let the market decide.
It’s important to remember that while the BOJ may be moving closer to ending its ultra-loose monetary policy, other major global central banks are nearing the end of rate increases to combat inflation.
The focus now shifts to the United States, with the Federal Reserve (Fed) expected to keep rates unchanged, but investors will closely watch Jerome Powell's comments for clues on future rate hikes as higher interest rates may impact the Federal budget and Japanese bond yields.