- Bank of Japan (BoJ) surprised the market this morning by raising the upper band on its yield curve control (YCC) policy from 0.25% to 0.50%.
- Bond yields in Japan rose on the news with spillover to global bond markets and the Danish callable bond market. USD/JPY dropped to 132 on the move.
- We expect a policy rate hike to 0% in Q2 followed by a 25bp increase in the yield target to 0.25% and an increase in the fluctuation band from -0.25% to 0.75%.
In a surprise move, BoJ adjusted its yield curve control this morning. BoJ widened the band around its 10-year 0% yield target to +/-50bp from +/-25. The official explanation is that it will allow for a smoother formation of the yield curve. The move comes with a pledge to sharply increase bond buying, in order to stress that this is a fine-tuning move and not tightening. At the press conference, governor Kuroda also did his best to communicate that it is not a tightening move.
Inflation has picked up in Japan, but it remains an imported phenomenon. Service inflation, for instance, is on the rise, but still stands at just 0.8%. An increase in wage pressure is key for BoJ to achieve its goal of reflating the economy permanently. It remains our base case that a global recession will obstruct a significant increase in wage pressure. However, we see a risk that a new governor will differentiate less between domestically created inflation and imported inflation and will use this opportunity to modify BoJ’s extreme position among global central banks – it is the only major central bank left with an easing stance.
Spring will be crunch time in Japan with the annual wage negotiations and a scheduled replacement of all three governors in BoJ. Based on today’s move, we think the probability of further moves next year has increased and we expect a move away from negative interest rates after a new governor has been appointed, followed by a further loosening of the yield curve control. Specifically, we expect a policy rate hike to 0% in Q2 followed by a 25bp increase in the yield target to 0.25% and an increase in the fluctuation band from -0.25% to 0.75%.
After the announcement today the market has started to position for a possible rate hike from BoJ. The market now discounts a full 10bp interest rate increase by April, which would take short-term Japanese interest rates back to zero and a full 25bp interest rate increase by August. Yesterday, the market did not expect a full 25bp increase until November, i.e. the market expects a possible rate hike in Japan to be a theme for H1 next year.
Fixed income markets
The unexpected change to the YCC target will have a negative impact on the long end of the French government bond yield curve, as the market speculates about a further repatriation from French government bonds to Japanese government bonds, as we saw in e.g. US treasury bonds and Australian government bond markets in Asian trade this morning. 10Y US treasuries have risen some 8bp, while 10Y Aussie government bonds have risen 19bp. However, Japanese investors already sold significant amounts of foreign bonds in 2022. They reduced their holdings of US treasuries by around USD150bn in 2022 according to the numbers from the Japanese Ministry of Finance. See our monthly overview of the Japanese holdings in various foreign bond markets.
There is also likely to be some negative spillover effect on the Danish callable mortgage bond market, as the market expects Japanese investors to sell in the 30Y callable bonds. Here they also reduced their holdings in 2022 according to the monthly statistics, but much less compared to other foreign markets. Furthermore, when we look at foreign holdings of Danish callable bonds, there has only been a modest reduction in 2022. Foreigners have reduced their holdings of callable bonds from 35% to 33% according to the ownership statistics from the Danish central bank; see Danish Mortgage Bonds, 28 November 2022. 30Y callable mortgage bonds provide a solid yield pick-up relative to 10Y and 20Y JGBs when hedged back into JPY, while e.g. US treasuries give a negative yield.
The higher 10Y yield in Japan could increase the appetite for returning to Japanese government bonds as mentioned, but on the other hand, a stronger JPY is a positive factor when extending FX hedges. However, we would expect Japanese investors to continue to reduce Danish callable bonds to the same or partly higher extent as seen this year. Buybacks in lower coupon callable mortgage bonds should dampen the effects of the continued selloff due to Japanese investors holding up to 75% of their exposure in 30Y lower coupon callable bonds. We see this as a negative event for callable mortgage bonds overall – and especially the lower coupons.
FX market
USD/JPY dropped five big figures to around 132. A stronger JPY is in line with our expectations, but it comes earlier than expected. We continue to see headwind for JPY in the short run from the global inflation pressure and the pressure on the Fed to hike rates further, but we see a substantially stronger JPY on a 6-month horizon. We will adjust our JPY forecast in January.
As the decision marks the end of YCC in Japan, it poses a duration shock to global markets including FX. While JPY is the big winner, the underperformers should be found in the cluster of cyclically sensitive currencies that suffer from higher global real rates like SEK and NOK. In addition, AUD and NZD look vulnerable in a global duration shock in which Asian growth prospects take a hit. On balance, the shock is positive for USD and negative for EUR/USD, although we do not want to overstate the impact at this stage. We are short USD/JPY; see our FX Top Trades 2023, 2 December 2022.
