At its policy decision on Tuesday morning, the Bank of Japan surprised markets by raising the cap on 10-year bond yields to 0.5%, in what's interpreted as a tweak to its yield curve control (YCC) policy. That doubled the rate the BOJ was tolerating up until that point, up from 0.25%. The move surprised the markets as economists polled ahead of the meeting expected no change to policy. It was seen as setting the stage for policy normalisation by a new governor, with some analysts seeing it as a prelude to increasing interest rates in the course of next year.
The yen soared in response to Tuesday’s move, pushing the USD/JPY down 3.5% to just above the 132.28 handle. The Nikkei (Japan 225), on the other hand, fell as much as 3% through the remainder of the Japanese trading session. The 10-year yield also surged 21bps in the aftermath of the BOJ's decision, rising through most of the 25bps increase in range, though it later faded some of the gains. The move was so dramatic that Japanese bond futures trading was suspended after the bond market hit a circuit breaker.
The End of a 6-year Long Policy
The move represents a change in a monetary policy established back in 2016 when the BOJ introduced a strategy of controlling short and long-term interest rates, known as the "yield curve control". This policy is at the core of the central bank's framework. (Source: Bank of Japan)
Recently, Governor Kuroda had been adamant about sticking to the dovish stance and even ruling out that the BOJ would take measures to halt the slide in the yen. He argued that the easing needed to be maintained until there was more robust wage growth. Meanwhile, markets were focused on reports that Prime Minister Fumio Kishida is planning on revising the 2% inflation goal, allowing more flexibility for the BOJ to tackle inflation. That kept analysts' attention away from the possibility of a change to YCC.
The BOJ introduced YCC after its extraordinary quantitative easing drive was questioned for potentially unsustainable. The idea was that by buying just enough bonds to keep the yields at the specified target, the bank could reduce the amount of purchasing it did.
Yield curve control was initially put into action as part of a series of measures developed under former PM Abe Shinzo, and implemented by his hand-picked BOJ chief, Haruhiko Kuroda, which his term ends in April. The Governor explained that the objective of raising the band for the yield curve was to increase liquidity in a dormant bond market. The yield curve control target remained the same at 0%; it's just that the BOJ would allow the yield to fluctuate in a wider band.
The BOJ's policy had been coming under increased public criticism, as it was seen as draining market liquidity and supporting the significant drop in the value of the yen earlier this year. The weakness in the yen was also seen as contributing to inflation, which is anticipated to stay above the 2% inflation target in 2023.
Possible Implications for Global Markets
The move by the BOJ was seen as a signal that the conditions pushing the yen's recent weakness were about to turn around. Japan is the world's largest creditor, and the policy change could incentivise a return of capital, which could drive up borrowing costs across the globe, with investors potentially selling bonds in the US, Australia and France. This could also support the yen.
Other analysts said the initial reaction in the markets might have gone too far, arguing that the policy technically isn't tightening because the target remains the same and the BOJ might step up bond purchases. There were already rumours that the BOJ might change its policy towards reducing monetary support. Regardless of the explanation given by Kuroda, the consensus among economists appears to be a general perception that the move is an indication that further change might be expected under a new governor.
The bottom line is that the BOJ's move could have implications across markets as it allows for higher borrowing costs. Many economists are considering that it could be laying the groundwork for Japan to exit its decade-long extraordinary easing policy and raise rates in 2023. More clarity on the BOJs plans forward might be revealed in the minutes on December 22 and Kuroda’s speech on December 26. Otherwise, we’ll wait to strap on until the next meeting on January 18 of 2023.