Bank of Japan tinkers at the edges of yield curve control

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When the Bank of Japan (BoJ) surprised markets by tweaking the yield curve control (YCC) framework at its meeting on 30-31 July, it appeared to have pulled off a neat move.

The BoJ did not change the yield target, but created scope for more flexibility by doubling the symmetric range around zero for 10-year Japanese government bond (JGB) yields from +/- 10bp to +/- 20bp. The range was in practice not symmetric, so the bank’s move can be seen as a stealth rate increase.

The prospect of a rise in 10-year JBG yields offered relief to domestic banks, whose profitability has suffered as the BoJ has strived to keep the yield curve artificially flat, without triggering a ‘tantrum’ in financial markets.

So far, the market doesn’t seem to buy it completely…

JGB yields have risen in August (see Exhibit 1 below).

Exhibit 1: Ten-year JGB yields have risen in the wake of the BoJ’s tweaking of yield curve control

Source: Bloomberg, BNP Paribas Asset Management, as at 27/08/2018

But, so far, it would appear that the BoJ’s tweak has not completely convinced financial markets that the prospects for Japan’s domestic banks have materially changed. The broad-based TOPIX index of Japanese stocks, which has a much heavier weighting in domestic banks, has continued to underperform the much narrower Nikkei 225 Average of Japanese stocks (see Exhibit 2 below).

This underperformance is all the more surprising as a shift in the balance of the BoJ’s JPY 6 trillion exchange traded fund (ETF) buying programme away from the Nikkei 225 in favour of the TOPIX index was also among the measures announced by the central bank on 31 July.

Exhibit 2: The TOPIX index (relatively large allocation to Japanese banks) has continued to underperform the Nikkei 225 average (relatively small allocation to Japanese banking sector)

 

Note: the graph shows changes in the NT ratio – the Nikkei divided by the TOPIX – during the period from February 2017 through 27/08/2018. Source: Bloomberg, BNP Paribas Asset Management, as at 27/08/2018

With Japan a global exporter of capital, there was scope for a tantrum

The prospect of a policy shift by the BoJ was seen as a risk for global bond markets as higher JGB yields might weaken the appetite among Japanese investors for foreign assets.

Net purchases of overseas equities and bonds are reckoned to have been positive since early 2014. With US investors scaling back their foreign exposures significantly as the Federal Reserve has moved to normalise monetary policy, an upward shift in Japanese yields has the potential to prompt Japan’s investors into repatriating funds. There has been no evidence of this happening so far, suggesting the BoJ’s recent measures were not sufficient to restrain the search among Japanese investors for overseas yield.

Not as dovish as first meets the eye, but rather a stealth rate rise

The BoJ pulled off a furtive tightening tweak by leaving the headline indicators of its policy stance unchanged. The policy rate remains negative. The yield target is unchanged. The target for ETF purchases remains the same. Moreover, there is now forward guidance that interest rates are set to remain low for an extended period, so one could be forgiven for thinking that the announcement was dovish. Not so.

The major adjustment was to yield curve control itself

The Bank of Japan will now allow more volatility in the 10-year JBG yield with the tolerance band having been doubled to +/- 20bp. In theory, this greater tolerance applies in both directions, but let’s not fool ourselves: this is about how high the BoJ will let yields go. It is likely that yields will settle in the upper quadrant of that range.

So, it would appear that yield curve control now applies around 0.2% rather than 0.1% – that is, the point at which the BoJ will intervene and stabilise yields with fixed-rate operations – so we have indeed had a stealth rate rise.

Looking ahead, the BoJ may have discovered an exit door from yield curve control

We know that the bank wants to find a way to allow volatility back into the market and gradually let go of the curve – but without causing a ‘tantrum’ in the market. Maintaining the guidance that rates will stay around zero, while gradually increasing the supposedly symmetric tolerance band could prove to be an effective route to the exit.

If (and this is a big ‘if’) data on inflation in Japan were to improve over the next 12 months, we could see an extension of the band to +/- 30bp, which would of course be a(nother) stealth rate increase.


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