The Bank of Japan (BOJ) announced a cap on 10-year bond yields and raised its inflation expectations beyond the 2% previously set at its September meeting in a move which surprised markets.
The central bank’s government bond buying programme will continue, but the bank will buy less long-term bonds, which will enable banks to earn profits by allowing the yield curve to steepen.
Interest rates were held at -0.1%, but the BOJ said further rate cuts could be an option for additional easing, which are all part of Governor Kuroda's on-going efforts to kick-start Japan's flagging growth.
Against this backdrop, Citywire Selector has collated the views of leading fixed income managers and Japan equity specialists on what lies ahead for the Japanese economy.
The Japanese equity market responded positively to the BOJ’s announcement. While some market participants were concerned about a potential policy surprise, the central bank’s efforts to communicate more carefully succeeded.
The BOJ’s decision to keep its short-term interest rate unchanged and steepen the yield curve is definitely positive for financial sectors, such as banks and insurance. Although the BOJ decided not to reduce short-term rates further, the Japanese yen depreciated. This reflects the improved communication between the central bank and the market, which is supportive of risk-on moves.
The FOMC rate announcement later today is an important event that will decide the direction of currency markets. Overall, I think that the Japanese yen is likely to remain range bound.
The head of portfolio management Japan at Pimco, Tomoya Masanao, said the announcement is a significant shift for the central bank as its quest to end deflation is taking longer than previously thought.
The decision is in part a reflection of the BOJ’s recognition that base money expansion itself has little easing effect and that Japan’s neutral yield curve, which is neither expansionary nor contractionary for the economy, is steeper than the bank would have thought.
The actual yield curve should not be too flat relative to the neutral curve otherwise the economy will be negatively affected through weakening of financial intermediation.
The decision is also an optimization of the BOJ’s toolkit for longevity of monetary easing - given that a war against deflation is likely to take longer than they thought - under the constraints of a practical limit on the JGB purchase amount and the effective lower bound of the yield curve.
The BOJ will stay in the game for many years but will no longer take the lead. The BOJ alone cannot win the deflation war, unless economic growth expectations increase.
Staying in the game
Nicholas Wall, who manages the Old Mutual Global Strategic Bond fund with Mark Nash, said the BOJ is trying to keep policy loose while mitigating the negative side effects of excessive asset purchases.
There are two elements to the new policy. Firstly, instead of the traditional central bank model of setting the short-term rate, the BOJ will now seek to set the rate on the longer-term 10-year part of the curve too, they will target a yield of around 0% at the front-end initially, close to current levels.
Secondly, the central bank has committed to keeping the policy in place until inflation has overshot the inflation target of 2%. It has abandoned the explicit target of expanding the monetary base by ¥80 trillion each year, but instead says it will adopt a flexible approach.
This is tapering but with asset purchases no longer the independent variable in the policy mix. The global pool of liquidity is unlikely to keep on increasing at the current pace so the ‘hunt for yield’ trade looks less attractive. The BOJ announcement that it will target the 10-year should suppress local yield curve volatility, but could lead to volatility in other markets and asset classes.
Daryl Liew, who is head of portfolio management at Reyl Singapore, said the BOJ’s attempt to end deflation have not proved effective enough and further fiscal stimulation will probably be needed.
The BOJ maintained its QQE policy, with a couple of minor tweaks – firstly targeting control over the yield curve; and secondly that it would allow inflation to exceed 2% before the BOJ will look to tighten.
The first adjustment helps to address the unintended consequences of negative interest rate policy, namely that financial institutions were squeezed due to the flattening of the yield curve.
The resulting steeper yield curve will help ease pressure on interest margins of the banks and possibly also lead to some repatriation of Japanese assets that moved offshore due to the negative interests all across the yield curve.
In summary, the BOJ appears committed to continuing with unorthodox monetary policy in its quest to put an end to deflation. However, I believe that easy monetary policies have proven ineffective in the current environment, and Japan probably requires further fiscal stimulus and for the third arrow of Abenomics to kick in.
Opens the door
Paul Brain, the head of fixed income at Newton IM, thinks that the actions taken by the BOJ are reminiscent of the past.
This is no bazooka from the BOJ but it’s an interesting approach nonetheless. Targeting long term rates as well as short rates reminds us of the period in the 1940s and 1950s when the US fixed 10-year government borrowing rates. It opens the door for more government spending finance at very low rates without further undermining the banking system.