Bank of Japan Widens Yield Band, Yen Soars

Anyone expecting a nice quiet run into Christmas had a nasty shock overnight. The Bank of Japan actually DID something! After years of ‘no change’ to policy, the central bank widened the yield curve control band and the yen strengthened in response.

That big red daily USDJPY candle on the right is the yen strengthening 3% against the dollar. So what did the Bank of Japan actually do?

On the face of it, the decision is a bit of a head scratcher. The BoJ widened the band around the yield cap, but made no change to the policy rate. This Reuters graphic is an excellent visual:

So, the BoJ widens the band, allowing the 10 year yield to trade as high as 0.5%. Why does this matter?

Firstly, it narrows the differential between Japan and other nations. Yield differentials are a key driver of exchange rates, which is likely why we’ve seen the yen strengthen against other currencies. It’s only a 0.25% change, but everything is relative.

More importantly, the market is prone to running with these changes and pushing policymakers to find the pain points. Where’s the real constraint?

As much as the Bank of Japan claims that this isn’t policy tightening, and is merely a move to improve market functioning, it’s unlikely that participants will unquestioningly accept that explanation.

ING analysts laid out their thinking around an entirely reasonable question… Why now? Their conclusion is that the BoJ is moving to normalise monetary policy:

Despite the denials, we think Governor Kuroda is trying to pave the way for policy normalisation before stepping down (in April). A policy shift immediately after the leadership change is difficult and could miss the opportune time to end the decades-long ultra-low policy. He may be right that monetary policy should remain accommodative until a stable 2% inflation target is met and that the policy review is not needed in the short term. But, with today's tweak, his successor will have more flexibility to deploy monetary policy in the future.

We also expect that the BoJ will maintain its policy balance rate at -0.1% for a while and that the BoJ will take a wait-and-see approach until the next annual wage negotiation season (Shunto) in April/May. However, market participants will likely bet on further tightening, which will likely create market noise that the BoJ did not intend.

Which is significant across global markets. If (and it’s still a big IF) the BoJ joins the ranks of central banks raising interest rates, the low rate era is truly over.

Away from FX, savers would increasingly be rewarded for investing in government bonds and credit instruments such as corporate debt. The relative appeal of stocks could diminish, due to this increase in the global ‘risk-free’ rate.

Much will depend on Japanese wages. The BoJ has repeatedly said that without proportionate wage increases, the economy cannot grow sufficiently to handle higher rates. The central bank is still engaged in large-scale bond-buying.

If the global economy takes a turn for the worse in the coming months and inflationary pressures continue to fall, any BoJ enthusiasm for higher rates would likely lose impetus. Ironically, this could also see the Japanese yen strengthen further as global bond yields would likely decline in the flight to safety, and ‘catch down’ to Japanese bonds.