Last month, the Bank of Japan announced the first tightening of the price of money since the 1990s. Specifically, it decided to change its sovereign debt yield curve control regime by allowing bond interest to become more expensive. As a result, the return on Japanese 10-year debt can now reach a maximum of 0.5% without intervention by the monetary authority, up from 0.25% previously.
Fredrik Repton, portfolio manager at Neuberger Berman says that the Bank of Japan’s official explanation as to why they adjusted the mid-point for the yield curve control was that market functioning deteriorated. “Additionally, the Bank of Japan wanted to smooth out the shape of the yield curve and reduce arbitrage opportunities between spot and futures markets as well as elevated swap rates. In their opinion, this had a possibility of a negative impact on financing conditions as the 10-year point is a very important reference for bank lending, corporate bond issuance, and so forth”, points out Repton.
According to Neuberger Berman’s vision, the decision was also likely underpinned by an improving inflation outlook. “Throughout the year, Japanese inflation has been inching higher on all measures. Even core inflation is now above the Bank of Japan’s inflation target and at its highest level since the early 90s if one disregards the spike in 2014 that was due to VAT hikes. Indications from financial services firms would suggest that the large Shunto wage negotiation for March will show a large increase in wages by Japanese measures“, explains Repton.
In addition to this, Repton says that the weak yen, “boosted by wide interest differentials and the view from market participants that the Bank of Japan was not going to relent on yield curve control is likely to have played a role in the decision”.
In the short term, the outlook for inflation is not materially altered by the adjustment of the yield curve control, he details. However, in the medium term, the strength in the yen that has followed the decision is likely to reduce imported inflation and thus the overall level of prices. “Should the Bank of Japan adjust the yield curve control once again or even give up on it, we expect the trajectory of inflation to be more meaningfully altered“, points out.
How does it affect the Japanese economy? The expert comments that in the short term, the outlook for inflation is not materially altered by the adjustment of the yield curve control. Economic activity is continuing to improve in Japan, a lagged effect from a slow reopening compared to the rest of the developed world. China’s faster-than-expected reopening should also support the growth momentum. “In our view, the Bank of Japan would not have taken the decision to alter its policy on yield curve control if it thought that economic activity would slow down given it’s been very conservative and nurturing of the recovery thus far“, says Repton.
Finally, the expert highlights that the big question that emerges from the Bank of Japan’s move is how this will affect capital flows. “While it is still too early to tell with hard data, there are few signs that there has been a material change in behavior among investors. The most prominent change in financial markets is the strength of the yen, which is likely driven by foreign investors either unwinding short positions that accumulated over 2022 or adding to long positions they have held since the Ministry of Finance intervened in the USD JPY pair. In addition, Japanese investors have likely started to re-hedge some unhedged exposures of foreign bonds and equities” explains.
