Financial markets have been unstable throughout December for fear of weaker corporate earnings and ‘higher for longer’ interest rates. The Bank of Japan (BoJ) has just added to the nervousness amongst global investors with a surprise change in policy.
Yesterday, the BoJ announced that it would follow other major western central banks in tightening monetary policy to bring down inflation. Not by changing interest rates but by altering its quantitative easing program to allow long-term borrowing costs to climb.
The BoJ announced an increase in the range that will allow the 10-year Japanese Government Bond (JGB) to trade in, from +/- 0.25% to +/-0.5%. This is known as its Yield Curve Control policy (YCC). The BoJ monetary policy change is small, but the symbolism is immense. The last primary source of cheap money in the global economy is fading.
Many economists thought the change was overdue. The BoJ has continued with a super-stimulative monetary policy long after other major central banks have raised interest rates and begun winding down asset purchase programs. The BoJ persisted because it wants to ensure no sliding back into the deflationary conditions in which the country has been stuck for almost three decades.
The BoJ has been hoping wage growth will be stimulated by rising prices (+3.6% y/y in October), which will generate a wage/prices loop. (This is precisely what western central banks are trying to avoid!).
However, savers and pensioners exert a powerful political voice and object strongly to rising inflation. The industry was complaining of soaring import costs, as the yen fell sharply this year in response to rate hikes elsewhere and the increasingly negative real returns available on Japanese bonds, as the government persisted with large bond purchases.
The explanation for the policy change said nothing of the need to appease savers and pensioners. Instead, it pointed to ‘market disfunction’ in the JGB market. The 10yr JGB has been consistently hitting the top of the +/-0.25% range since January, making a mockery of the idea of a range in which it should trade.
This reflected fear of inflation in Japan, spurred in part by a weak yen resulting from the BoJ holding down interest rates while other central banks raised theirs.
Many economists had come to believe the policy was unsustainable and had to end sooner or later.
A yen play?
The yen rose 4% against the dollar yesterday on the news, while the Topix index fell 1.5%. Global stock and bond markets weakened on the news.
Investors are concerned that higher Japanese borrowing rates will trigger selling by Japanese investors of overseas assets, pushing up the yen. This would, in turn, encourage more sales of overseas investments and a still stronger yen.
Global investors who hold Japanese equities and bonds may hope that an appreciating yen will outweigh any stock or bond price falls over the coming months.
However, investing in currency moves is high risk. While the yen does look undervalued against the dollar – particularly if U.S. Treasury yields resume their recent fall- this is an altogether different approach to investing than holding Japanese equities and bonds for their underlying value.
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