Obsessing over the Federal Reserve is understandable, but the Bank of Japan’s decision this past week to relinquish control over government bond yields is a reminder that investors ignore other central banks at their peril.
The BOJ took a small but meaningful step toward normalizing monetary policy in the world’s third-largest economy, paving the way for its first interest-rate hike since 2007. It may soon throw its weight around in a way that may surprise Wall Street, with important implications for Treasuries and the dollar if it pushes some of the biggest global investors to rotate out of the U.S. and back to Japan.
Deflation has weighed on Japan since a real estate bubble burst in the early 1990s. The BOJ pioneered “quantitative easing”—stimulating growth through bond-buying—in 2001 and pushed interest rates into negative territory in 2016, when it began a policy of controlling the yield curve for government bonds.
The BOJ is now beginning to reverse course. At its October meeting, the central bank held rates at minus 0.1% but de facto ended its yield-curve control policy. Having previously defined a rigid yield cap of 1% on the 10-year government bond, it said that level will now be a “reference.”
The language tweak might seem minor, but the implications are potentially seismic for markets. BOJ Gov. Kazuo Ueda said the central bank would allow for long-term yields to rise if driven by fundamentals, but that it would respond to speculative moves with intervention.
While the BOJ reaffirmed that it will “patiently continue with monetary easing,” there is a Tokyo policy drift at play against the backdrop of a dramatically weakening currency and more-sustainable inflation. The rate differential between Japan and the U.S. has pushed the yen to its lowest level against the dollar since 1990, and Ueda cited the risk of exchange-rate volatility as one reason that yield-curve control was tweaked.
Inflation is also more reliably around, or even above, the BOJ’s 2% annual target, which could push the central bank to begin tightening the ultraloose screws. Its policy board lifted its inflation expectations on Tuesday, seeing inflation holding above 2.8% in the 2024 fiscal year, up from estimates of 1.9% in July.
“The current monetary setting…is clearly inconsistent with economic fundamentals,” said Iain Stealey, international chief investment officer for fixed income at J.P. Morgan Asset Management. “We expect the BOJ to take a more active approach from here.”
Marcel Thieliant, head of Asia Pacific at research group Capital Economics, expects an end to Japan’s negative interest rates as soon as January. Stealey sees the BOJ ditching yield-curve control as early as the spring, after annual wage talks between unions and employers.
Japan’s ultralow rates have pushed domestic capital abroad and popularized a carry trade of borrowing yen to buy U.S. Treasuries, pressuring the yen and buoying the dollar. Japanese investors are by far the largest foreign owners of Treasuries, holding $1.1 trillion as of August, almost 40% more than Chinese investors.
If the central bank signals that it will normalize policy and might hike rates, Japanese investors like banks and life insurers could start dumping Treasuries to buy more-attractive domestic bonds. Along with any winding down of the carry trade, this would send Treasury yields higher and weigh on the dollar.
“If the BOJ hikes, that’s going to be a big moment that I think many market participants these days haven’t seen,” said Yusuke Miyairi, a foreign-exchange strategist at Nomura.
The BOJ decision is an early warning that forces beyond the U.S. are worth monitoring.
Write to Jack Denton at [email protected]
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