BOJ policy changes and their impact on capital flows

Policy changes at the Bank of Japan are likely to reverse capital flows, shift global yields higher, contribute to a stronger yen, and increase the value of Japanese stocks. With all this attention focused on the US Federal Reserve, it may be easy for US investors to They forget the influence of other monetary authorities. For more than a decade, the Bank of Japan’s policy has enabled Japan to be an important source of investment financing

Negative interest rates allowed investors to borrow cheaply in yen and then buy investments in other countries that offered a higher return. This may be coming to an end and lead to a reversal in capital flows and an increase in volatility across markets. The policy changes at the Bank of Japan noted last week have the potential to have significant impacts on global financial flows and markets next year.

The Bank of Japan is the only major central bank yet to raise interest rates during the current session – but the central bank last week took steps in preparation for the policy change. Like other central banks, the Bank of Japan sought to implement quantitative easing, or quantitative easing, eventually purchasing more than 50% of all Japanese government bonds. But it didn’t stop there. The Bank of Japan has also purchased corporate bonds, commercial paper, exchange-traded funds, and Japanese real estate investment trusts (J-REITs). No other central bank has been more dedicated to pursuing quantitative easing and negative interest rates. Then, last week, the Bank of Japan officially ended its commitment to buy an unlimited amount of Japanese government bonds in an effort to cap the 10-year yield at 1%, a policy referred to as yield curve control, signaling a potential shift. Towards ending quantitative easing and raising interest rates in 2024.

Control range for Japanese yield curve, the yen and the 10-year yield

Japan’s inflation rate has exceeded the Bank of Japan’s 2% target over the past 18 months. This is the longest period in decades and the only period longer than a few months that was not driven by a local tax increase or a sudden currency depreciation. The Bank of Japan’s significant upward revisions to inflation forecasts last week for this year and next show that the central bank currently expects three consecutive years of inflation exceeding its 2% inflation target.

In support of this view, the October release of the Tokyo Consumer Price Index, Japan’s leading indicator of overall inflation, was hotter than expected, rising from 2.8% in September from a year ago to 3.8% in October. . Core inflation (inflation excluding fresh food and energy) is at a 42-year high at 4.2% and shows no signs of abating. It seems that the time for change has come in Japan after decades of falling prices rather than rising prices.

Japan appears to be pursuing contradictory goals: the Bank of Japan buys bonds in an attempt to contain bond yields, which makes the yen less attractive, while the Ministry of Finance sometimes buys the yen to prevent the currency from weakening too quickly. These conflicting policies appear costly and unsustainable. We believe that at some point next year the Bank of Japan may need to allow bond yields to rise and raise interest rates.

In response to the market’s response to the Bank of Japan’s announcement that it was raising its commitment to keeping bond yields below 1%, the 10-year Japanese government bond yield rose to 0.94% from 0.89% on that day. But in an apparent counter-move, the yen briefly fell by 2% against the US dollar, with the yen-dollar exchange rate rising to 151.7 from 149.1.

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US real yields rise

If US real yields rise faster than Japanese yields in the near term, as they have recently, we might expect the yen to remain weak. But the possibility of higher Japanese real yields and lower US real yields after 2023 could be positive for the Japanese currency. We expect the Bank of Japan’s policy to unfold with a gradual and controlled rise in interest rates in Japan, which is unlikely to lead to destabilizing capital flows or a significant appreciation of the yen.

As we saw in the initial reaction to last week’s announcement. However, if economic data prompts the Bank of Japan to tighten policy significantly next year, moves across markets could be significant. Looking back a year ago, we saw big moves when the Bank of Japan just changed the YCC target range for the 10-year yield from 0.25% to 0.50% in late 2022. The yen rose sharply (by 15%) as the yen exchange rate appreciated. against the dollar. The price moved from 150 to 127.

If changes in Bank of Japan policy lead to higher real yields and a stronger yen, net capital outflows could turn into large inflows. For decades, Japanese institutional and retail investors have been borrowing at low interest rates in Japan to invest at higher interest rates elsewhere, in so-called yen carry trades.

In addition, Japanese investors are the largest non-U.S. investors in U.S. Treasury securities and are among the top five in ownership of non-Japanese stocks. Decades have accumulated current account surpluses, giving Japan the world’s largest net international investment position (even more than China) with $3.3 trillion in investments held abroad according to the International Monetary Fund.

Net international investment position by country

Although the United States has the greatest economic influence in the world, Japan may have the greatest influence in asset markets because of these account surpluses. If the Bank of Japan begins to tighten monetary policy significantly, the potential for a reversal of decades of capital outflow could be felt by investors around the world.

The impact on investment markets has been weak so far because the spread between Japanese yields and the rest of the world remains large. US yields rose more quickly than those of Japan in 2023. Since Japanese yields were not yet high enough to attract investors, Japanese investors continued to buy non-Japanese assets. This trend may change with monetary policy tightening by the Bank of Japan, especially if it comes at the same time that the Federal Reserve and other central banks begin cutting interest rates, which would narrow the yield spread, strengthen the yen, and attract Japanese investors. to local assets.

Japanese Yen – The market may expect a rate hike by the Bank of Japan next year, while the US Federal Reserve is expected to cut interest rates, narrowing the spread in short-term interest rates which may favor the yen. Reversing hedging costs in US dollars, euros, Australian dollars and other currencies could lead to a sharp reversal in exchange rates with the Japanese yen.

Bonds Japan holds more than $1.1 trillion in US Treasury bonds, in addition to US corporate debt and large amounts of European, UK and Australian government and corporate debt. Any tightening of Bank of Japan policy could put upward pressure on global bond yields to balance other influences.

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