Bank of Japan policy shift ushers in a new era for investors

Author: Tomoya Masanao, co-head of Asia-Pacific portfolio management and co-head of PIMCO Japan.

The Bank of Japan (BOJ) has said goodbye to its negative interest rate policy (NIRP), yield curve control (YCC) and quantitative and qualitative easing (QQE), marking the end of an era of extraordinary monetary easing. This paves the way for a more normalised Japanese bond market, offering new opportunities for investors who have been wary of this space over the past decade.

It is time to move away from the NIRP, YCC and QQE

The BOJ's shift from a complex and overly accommodative stance (combining NIRP, YCC and QQE) to a positive 0%-0.1% policy rate and a simpler approach came as no surprise. Fundamentals were supportive and the changes were well telegraphed prior to the BOJ meeting.

Inflation expectations in Japan have largely re-anchored to more positive levels. The combination of COVID-19 induced global inflation and yen weakness, exacerbated by diverging central bank policy, served as the catalyst Japan needed to break free from entrenched deflationary expectations and offered the BOJ the opportunity to withdraw some of its more inflexible policy tools.

The BOJ's pre-meeting statements underlined its expectation that it would maintain an accommodative policy stance, including the continuation of government bond purchases. This cautious rate hike is strategically aimed at managing the potential spike in bond yields without causing market disruptions.

A new inflationary outlook for Japan

The Bank of Japan's policy changes two days ago, 19 March, while largely expected, should have minimal immediate market impact. However, the medium to longer-term implications could be significant, as the potential scale of the BOJ's policy changes may be larger than financial markets currently anticipate.

A key question is where Japan's trend inflation rates will stabilise after the pandemic. While Japanese inflation has shown signs of moderation, and further moderation is quite possible, we believe that the country appears to have settled on an inflation rate of "one and a bit" percent, if not 2%. This is a significant departure from the near zero per cent trend of the last three decades.

This new baseline represents a structural change in the labour market and in corporate price behaviour. The Abenomics era (2012-2020) saw a temporary easing in labour force decline due to a rise in participation rates, but further improvements are now limited. The global inflationary impact of the pandemic, coupled with the depreciation of the yen, has been an important catalyst for significant changes in inflation expectations and in firms' price and wage-setting behaviour. While the BOJ's 2 per cent inflation target remains elusive, given the country's still inflexible labour system and low productivity, a reversion to zero per cent inflation seems equally unlikely.

The BoJ's policy in the new inflationary context

Although the BOJ reiterated its commitment to the 2% inflation target, it is unlikely, in our view, to maintain its accommodative monetary policy indefinitely in order to solidly achieve its 2% target. A more realistic approach would be to tacitly accept a 1%-2% inflation range as a practical target for a nation with low economic growth potential. The expansion of the Bank of Japan's balance sheet to almost 120% of GDP has produced only modest inflation at best and has led to various economic and market distortions. Adjusting the inflation target (perhaps informally), while politically sensitive, is not insurmountable given the current political landscape.

The future policy stance of the Bank of Japan depends on the estimated neutral real interest rate, i.e. the level at which policy becomes neither stimulative nor restrictive. Assuming a fairly conservative estimate of -0.5%, the BOJ could gradually raise its policy rate to close to 1%, slightly above current market expectations, to achieve a neutral stance in line with a tight inflation target range of 1%-2%.

The BOJ's medium-term policy adjustments are likely to involve both balance sheet reduction and interest rate hikes. Despite potential headwinds from a global economic slowdown and rate cuts by other major central banks, the BOJ is set to reduce its extraordinarily large balance sheet slowly but surely.

Investors' outlook

For investors, Japanese bond markets should begin to offer a higher risk premium and modestly higher yields in response to the Bank of Japan's continued policy adjustments and the transition of government bonds back to market forces. As the market digests the new and changing policy stance, there will be tactical opportunities for active managers to capitalise on inefficiencies in the Japanese bond and interest rate swap markets during this period of heightened volatility.

Structurally, however, Japanese investors are generally underweight in Japanese bonds and should consider increasing their allocations over time given higher yield levels. While we expect a modest rebound in bond yields, the trajectory is expected to be gradual and nuanced across the yield curve. Japanese bond yields are correlated with their global counterparts, and with major central banks poised to initiate rate cuts this year, any sharp fluctuations in Japanese yields could prompt intervention by the Bank of Japan. The positive carry of Japanese bonds, supported by a steep yield curve, should over time provide a cushion for bondholders against rising yields. We do not expect Japanese investors to significantly influence global market dynamics. Domestic flows into Japanese bond markets will increase, but we do not expect these investors to be forced to dump foreign bonds in favour of Japanese duration. Japanese investors have ample yen liquidity to deploy domestically and there is a discernible demand for US duration to hedge against potential recession risks.

To sum up, the Bank of Japan's policy developments should mark the beginning of a period of normalisation for Japanese bond markets, finally attracting investors to higher yields who have been reluctant to invest over the last decade.