Threading the Needle: BoJ’s Possible Policy Pivot
The BoJ’s reluctance to tighten its monetary policy may be attributed to Japan’s ongoing recovery and its export-driven inflation levels. However, the cost of maintaining a dovish stance amid a globally tightening environment is very high, and the BoJ might just adjust its forward guidance regarding its medium-term yield curve control policy in its upcoming meetings.
Japan’s weak growth prospects and dovish monetary stance amid a global tightening cycle sent the yen crashing, with USD/JPY breaching 139 on 14 July to touch a level not seen since September 1998. In part, this reflected softening growth expectations, with 2022 consensus growth forecasts for Japan sliding from almost 3.0% in January to just 1.7% now. Concomitantly, inflation expectations for 2022 also nearly tripled to 2.0%, with actual inflation touching 2.5% in May, above the Bank of Japan’s (BoJ) target level.
Given these circumstances, to support the economy, the central bank’s current aim is to keep the 10-year Japanese government bond (JGB) yield below 0.25% by committing to buy unlimited amounts of the asset class, which is popularly known as yield curve control (YCC). This means, while government bond yields in other countries are moving up, they are stuck below 0.25% in Japan. This divergence triggered the currency crash, with the yen trading very close to the psychologically important level of 140 against the US dollar in July.
Caught Between a Rock and a Hard Place
Japan almost always experiences a recession when the yen breaches similar levels and inflation climbs above 2% (Figure 1). This means, the BoJ is at an inflection point where it has to choose between maintaining its easing stance and preventing the yen from sliding further. Caught between a rock and a hard place, we suspect the BoJ may have to choose the latter as there is a high chance of additional yen depreciation given that the US Fed has further room for aggressive tightening, especially so after the US consumer price index (CPI) rose to a 41-year high of 9.1% in June. Political stability could also add wind to the sails of this policy pivot as the ruling dispensation scored a major victory in the 10 July house of councilors election held two days after former prime minister Shinzo Abe’s assassination.
Figure 1: Current Levels of USD/JPY Portend a Recession in Japan
The costs of BoJ maintaining its ultra-easy monetary policy have ballooned to unprecedented levels. The central bank had to purchase a whopping ¥16.15 trillion worth of JGBs (US$120 bn) in June – the highest ever monthly purchase, executed to control the yield curve and keep the 10-year JGB yields under 0.25% (Figure 2). This took the total worth of JGBs held by the BoJ to a staggering 50% outstanding. If the BoJ were to continue making these outsized purchases, it will likely hold 60% of JGBs outstanding in the near future, which we believe is an unsustainable level.
Figure 2: BoJ Assets for 2022 Estimated Based on June Purchase Level
Although a markedly weaker currency should in theory support an economy by boosting its exports, Japan imports over half of its food and almost all of its fuel – both of which are the biggest contributors to inflation globally this cycle. Indeed, Japan’s current account balance data for May show that the value of its imports rose by 51.3%. With this latest rise, Japan has witnessed its import value going up relentlessly for 16 months to touch the highest level on record, making its imports exorbitantly expensive.
What to Expect Next
An immediate worsening of macro conditions, including the yen weakening further and inflation continuing to runup, could still force BoJ’s hands to stay put in the short term. That being said, we expect soft signaling around a policy pivot to emerge in H2 2022. The BoJ should either increase its upper limit on the 10-year JGB yield to 0.5% from the current 0.25% or start targeting the 5-year JGB. We favor the former adjustment as the central bank has been targeting the 10-year JGB from the inception of its YCC program, which should make the adjustment more palatable to market sentiments.
To be sure, markets may have already begun pricing in the possibility of a YCC adjustment in H2 as 3M forward JGB yield rates have been slopping up recently. For instance, the 3M10Y forward rate has been trading above the 0.25% level since March and is currently trading at the 0.28% level (Figure 3).
Figure 3: 3M Forward Yields of JGBs of Varying Tenors
Market Implications
These market expectations are likely to intensify as we move toward the July 20-21 BoJ meeting where the central bank should unveil its new forecasts for GDP and inflation; possibly comment on the currency weakness; and give indications of a potential policy pivot. Thereafter, the central bank’s messaging could mature by the September meeting when two new members will join the policy board, including the reflationist economist Asahi Noguchi.
On the whole, headwinds are getting stronger for the Japanese economy and a BoJ policy shift is beginning to be priced in. There is a growing inflationary impulse and we expect guidance to emerge on likely YCC amendments. Once the amendments are put into effect and the messaging is mature, we expect the yen to gather some strength and move toward the 125 level against the US dollar.