Japan’s central bank is nearing an inflection point.
It comes as policymakers around the world scramble to tighten monetary policy in an effort to rein in record-high inflation.
The Swiss National Bank was one of the latest major central banks to get in on the act, surprising markets last month by delivering its first interest rate hike in 15 years. The SNB leapt out of the blocks with a 50 basis-point increase and the shock move sent the Swiss franc soaring to its strongest level against the euro for almost two months.
Japan, however, has sought to remain loose and prioritize yield curve control. The world’s third-largest economy has been stuck in a low growth, low inflation — and at times deflationary — environment for many years, meaning the Bank of Japan has kept policy accommodative in a bid to stimulate the country’s sluggish economy.
The central bank was on track to purchase around 15 trillion Japanese yen ($110 billion) of government debt in June, rendering it the only major central bank still embarking on a significant asset purchase program.
Headline CPI is running just above the 2% target in Japan, while core inflation sits at 0.8%, so the central bank does not face the same inflationary pressure as many counterparts in the West,
The BOJ has reiterated its commitment to avoiding deflation, which remains the dominant policy hurdle in Japan. The central bank expects consumer price rises to decelerate in the medium-term once the influence of energy prices on the headline figure begins to wane.
But, should this assessment prove misguided, and the BOJ be forced to hike interest rates – either as a result of inflation or upward pressure from other monetary tightening moves around the world – this could send a ripple effect through global markets.
According to Neil Shearing, group chief economist at Capital Economics, much depends on the “openness” of the country’s capital account (its balance of payments), and the extent to which flows are buffeted by changes in interest rates elsewhere.
“Japan is open to global capital flows and so, as bond yields in other countries have moved up, the BoJ has found that its commitment to a policy of Yield Curve Control – keeping 10-year JGB (Japanese government bond) yields within a 25 basis point band either side of zero – has been tested by global investors,” Shearing said in a note Monday.
Yield curve control tested
The Bank of Japan’s self-imposed bond yield ceiling helps to hold down borrowing costs throughout the economy, in principle supporting growth.
“The recent sell-off in global bond markets has pushed the 10-year JGB yield right to the upper limit of the BoJ’s range, forcing it to purchase increasing amounts of government debt to maintain its target – by some measures, if it carried on buying at this month’s pace, it would own the entire market of outstanding JGBs within a year,” Shearing said.
The Bank of Japan has continued to defend its yield target even as the global momentum pushes toward higher rates, and its divergence has driven the Japanese yen sharply downward.
Shearing pointed out that while the People’s Bank of China imposes capital controls to retain influence over its currency and monetary policy, Japan’s relatively open capital account means it cannot control the yen while maintaining sovereignty over monetary policy.
In essence, the Bank of Japan can prop up the bond yield peg by buying boundless quantities of bonds, sending the yen into a downward spiral, or it can shield the currency against a destabilizing depreciation, but it cannot manage both simultaneously.
Capital Economics expects Japan to give some ground in its yield curve control by widening the target range, which could then see investors testing its resolve to hold the line at the new range. Against a backdrop of rising rates around the world, this could further weaken the yen.
“Of course, a markedly weaker currency might be a positive development for an economy struggling to emerge from three decades of deflation, but large and rapid currency moves can be destabilizing,” Shearing said.
“At some point something gives – either because balance sheets start to come under strain or because imported inflation becomes a problem.”
Since deflation generally leads companies and consumers to delay investments and purchases, the Bank of Japan has been working for years to return inflation to its 2% target to reignite its productive capacity and growth rate.
‘Violent adjustment’
The BOJ’s persistent quantitative easing could also have a number of significant consequences for both domestic and global markets.
By capping the increase in long duration interest rates, the central bank risks pushing up inflation beyond its initial targets, according to Charles-Henry Monchau, chief investment officer at Syz Bank.
Monchau noted that the BOJ buying bonds implies it would need to lend the equivalent amount, further exacerbating price rises. The divergence in yields compared to other developed countries, which are tightening monetary policy, weakens the yen. Meanwhile the BOJ keeping bond yields artificially low by purchasing so many JGBs prevents it from raising interest rates, the main method of containing higher inflation.
Cumulatively, he suggested that these dynamics could create conditions for inflation to “suddenly spiral out of control, implying an inexorable and violent adjustment in the bond market.”
The maintenance of loose policy at all costs could also create risks on the international stage.
“The weakening of the yen could lead to a currency war in Asia, which could, in turn, fuel rising inflation in neighbouring countries, increase the cost of servicing their dollar-denominated debts, and so increase the risks of default by less creditworthy countries,” Monchau told CNBC on Tuesday.
“Another international consequence with even greater ramifications is the risk of a sudden unwinding of the carry trade.” The carry trade is a strategy in which investors borrow from a low interest rate currency to finance the purchase of a higher yielding currency, capturing the difference between the rates.
Monchau argued that with the BOJ obliged to lend the equivalent amount of the bonds it buys, this market context of “access to very low-rate financing in a constantly depreciating currency” favors the use of carry trades.
“For example, a ‘long Brazilian real, short yen’ strategy has already generated gains of 35% this year. But the risk of this type of strategy is a sudden reversal of the trend in place,” Monchau explained.
“Indeed, if the yen strengthens and/or if JGB yields rise (due to the BOJ abandoning the YCC), there is a risk of a sudden and massive unwinding of carry trades, with a cascade liquidation of risky assets.”
This would facilitate the panic selling of stocks, forced selling of the U.S. dollar and a spike in U.S. bond yields due to the rise in JGB yields, he suggested, the type of sudden “financial accident” that could worsen the pain for risky assets and heighten the risk of recession.
“The bleak scenario described above is far from a certainty. First, the imbalances created by the Japanese authorities (over-indebtedness and manipulation of the bond market) have been pointed out for many years now without ever leading to a major accident,” Monchau noted.
“However, the current situation in JGBs, in a context of high market volatility, is perilous, to say the least. And any market stress due to the end of the QE in Japan may have another consequence for international financial markets: the loss of confidence in major central banks’ monetary policies.”
