Earlier this year, the Bank of Japan announced a new course of monetary policy that shocked the markets. In this article, Bilal Hafeez looks at the potential implications of the BoJ's decision.
The BOJ saw the first test of its policy to control the yield curve when, following the recent Trump victory, the majority of yield curves jumped. Given the scale of moves in Treasuries and Bunds, it is all the more remarkable that the JGB market appeared to be immune to the global bond sell-off. In theory, it should be easy for the BOJ to stop a bond yield rise as it can buy JGBs. In the opposite direction, stopping a JGB yield decline through selling JGBs would appear like tapering and so conflict with BOJ goals. So assuming the BOJ can and will maintain its yield curve control policy, Japan should not see a tightening in financial conditions that other countries will face.
The BOJ surprised investors when, at the end of September, it announced it would ensure the 10y JGB yield will remain around 0%, achieved through varying its JGB purchases and offering fixed rate JGB purchases when needed. At the time, the 10y yield was below 0% and the BOJ didn’t lower policy rates, leading to an increase in yields on the day. Undoubtedly, there are risks of it negatively affecting the functioning of the bond market. But what helps the BOJ is that much of the JGB market is held by domestic investors, which means that it is less internationalised and so easier to manage. We also have the precedents from the US. In the 1940s, the Fed capped 10y yields at 2.5% in part to ensure the government could easily issue debt and finance its war efforts. It lasted from 1941 to 1951. Then in the 1960s, the Fed successfully flattened the yield curve through Operation Twist. Again, it was able to maintain this from 1961 to 1965 until inflation rose.
Perhaps more importantly, with the central bank essentially setting yields, the announcement dramatically altered the economics of engaging in yen carry trades – borrowing in yen and investing in high-interest currencies and assets. We know from studies that FX carry trades that target the short-end of the curve have tended to be profitable over time. Part of the reason is that the volatility of that part of curve is controlled by the central bank. However, the longer the tenor of the FX carry trade, the less profitable the strategy. Indeed, studies have shown the so-called uncovered interest parity condition, that is, the theory that spot should converge to the FX forward rate and so prevent profits from being made on FX carry trades, tends to be more closely met at the long-end of the curve. That is, holding a 5y AUD/JPY carry trade to maturity tends not to be profitable, whereas holding a 3m carry AUD/JPY trade does tend to be profitable, see chart below.
What's next for Japanese policy? Explore further on our themes and trades page.Read more