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Japan does not appear to be preparing itself or broader financial markets for what most believe is an inevitable monetary policy shift in the coming months. The longer it sticks with yield curve control - in a world of rising interest rates, the worse the longer-term consequences and the harder it will be to engineer a ‘soft’ pivot. Failure to manage the exit smoothly could also have wide-ranging consequences for global financial markets. 

 

Surprise 

The Bank of Japan surprised markets in December when it widened the trading range for the 10yr Japanese government bond yield from 0.25% either side of zero to 0.5%. This wider envelope was quickly tested as the yield topped 0.5% and the BoJ threw more at the market, buying 5trillion in yen on Friday January 13th, and another 1.7 trillion the following Monday. 

 Traders bet that this tweak to YCC was the prelude to an off-ramp from years of ultra-loose monetary policy. However, BoJ governor Haruhiko Kuroda maintained that this was not an exit strategy but a way to ensure smooth functioning of financial markets.  The BoJ restated its commitment to YCC at its meeting on Jan 18th. The yen, which had rallied firmly against the dollar as traders front ran an expected exit, dropped sharply and yields pulled back from the 0.5 target ceiling. But this reprieve may prove to be short-lived. 

 

Timing 

At the heart of this is a question of timing. Governor Kuroda departs in April after ten years at the helm of the BoJ. A successor may have a freer hand to pivot policy. But it will still be painful. Exit from YCC will result in a significant repricing of Japanese debt and we can expect large losses in some corners, particularly among domestic holders of JGBs who have been assured of the BoJ ‘put’ for a decade. The BoJ could have chosen to go with the market wave over the last couple of weeks – it could still do so, but for now it’s holding fast to YCC.

There is a concern that a sharp repricing will result in fire sales of debt and other assets, resulting in contagion across other asset classes – Japanese equities and the yen would be among them. An interest rate shock – which abandoning YCC would cause – will expose undesirable levels of leverage on many a corporate balance sheet. It would undoubtedly send shockwaves through global interest rate markets. The effects could be worsened if it comes as US quantitative tightening really starts to put the squeeze on global liquidity. Just look at how much worry the blow up in the much smaller UK gilt market caused last year. And Japanese investors own a lot of foreign assets - about $3.2tn at the last look. If Japanese bonds start offering a decent yield, we should expect a fair amount of repatriation; i.e. selling of dollar or euro or whatever denominated assets. 

YCC cannot survive much longer. Japan is chucking billions of dollars to prop up the JGB market in an unsustainable fashion. It has also been burning FX reserves to stem the depreciation in the yen. And it can no longer hide behind soft inflation – the Tokyo core consumer price index rose 4% in December, up from 3.6% in the prior month and the highest level since 1982. Still though the message from the central bank is that they have no intention of abandoning YCC. This will only make it all the harder for Kuroda’s successor, if and when he eventually pulls the trigger. Before that we can expect the market to again test the resolve of the BoJ by pushing the envelope on the 10yr yield.  

 

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