The surprise might only have been in the timing, but yesterday the BoJ effectively signalled the end of Yield Curve Control and the start of ‘normalisation’ of interest rates in Japan. As a major supplier of international risk capital, the rest of the world needs to watch carefully as Japan steadily unwinds decades worth of interest rate policy.
Japan is edging ever closer to ending Yield Curve Control
While the headlines were, once again, on the Fed - who, perhaps not wishing to be seen to be simply following the headline CPI, pushed up another notch this week, or the ECB which merely followed along - much more important for markets we think is that the Japanese moved much closer, albeit not quite fully admitting, to ending yield curve control. The implications of this are likely to be wide ranging, there are choppy waters ahead for Japan and global liquidity in general and we would be wise to keep our eye on ‘the last man standing’.
The BoJ has some dangerous waters to travel
In a move yesterday that was largely unexpected - in its timing at least - the BoJ effectively moved its upper target for the 10 year JGB from 50bps to 1%. Kind of. It didn’t explicitly say that there was a new band, or that 1% would be explicitly defended, nor did it say that it was going to change its long-held policy of targeting 2% inflation by having negative real interest rates - even though core CPI is currently double this target. This policy, we should remember was the same one followed by all western central banks until zero Covid policies brought in the inflation we are now seeing. However, unlike Japan they have been reacting to by rapidly reversing policy, leaving the BoJ as the last man standing. Until now.
It looks like the Bond yield will be managed like the Yen used to be
However, in classic BoJ style, things remain ‘fuzzy’. Instead of giving clear guidance, Kazuo Ueda, the new BoJ governor, gave a characteristically opaque set of ‘guidelines’ akin to the old days of talk around managing the exchange rate. Indeed, we would regard this as the best template for now.
Needless to say, the market reacted by pushing the JGB yield through 50bps to the highest level seen since 2014 and the hedge funds who had been short Japanese Bonds pulled off a ‘reverse ‘ widowmaker’ trade. Meanwhile, the FX market moved the Yen first ‘one big figure’ weaker, (a move of the second decimal place is a big deal in FX, hence the name) then it reversed and moved two big figures stronger, before it ultimately ended up where it started the day, proving that nobody had much of a position beforehand - or seemingly much of a clue afterwards.
Unwinding decades of ‘bad policy’ is a delicate operation
Ueda San, who took over in April, had always implied that an end to Yield Curve Control was coming, but it is fair to say the consensus of Japan watchers hadn’t thought it would be this month, but more likely September. As to the timing, arguably we might see this as a view from the Japanese that ‘everyone else’ has finished tightening and it was now ‘their turn’, but we would hesitate to extend this analogy too far. Rather than the high and fast approach of the last 12 months, we would look to an analogue of the early days of the Powell Fed. Thus, in the same way that Jerome Powell has had to unwind the policies of the Bernanke and Yellen Feds (as well as the Yellen Treasury) with an eye on not only keeping markets calm, but also looking out for hidden land mines, so Ueda is giving himself as much flexibility as possible to unwind the policies of his predecessors.
A key issue for Ueda and the BoJ is that, while a sell-off in JGBs is good for the Hedge Funds and arguably is a positive step towards ‘normal’ rates, they obviously need to try and manage this re-pricing of bonds without triggering balance sheet issues -particularly with the Japanese life companies. As such, the reality is that the uncertainty they talk of in the press release is less about the inflation outlook, as it is about overall financial stability. As such, we would expect the process to be slow and careful, just as the Powell Chairmanship of the Fed was in the pre-Covid period.
Some see this as a reason to buy Yen, others to buy $
As far as we can see, with the US, and the rest of the Central Banks that follow them, seemingly in the end-game on raising rates, the Japanese have now finally begun to tighten and we suspect that most of the initial drama, such that it is, will be played out through the FX cross rates. In simplistic terms, while the higher yields in the US should ‘support’ the currency, the reality, and the complexity, is such that capital can flow to countries seen as being in a ‘growth phase’ and thus have the inverse effect. Indeed, this was played out in microcosm yesterday as exchange rates gyrated. Medium term, we would side with the Japan relative growth trade, but in the near term acknowledge that other factors can dominate. Consider last year, when the big Japanese life companies found themselves ‘over-hedged’ as US Treasuries sold off heavily. They were short $1bn of cash for every $1bn of Treasuries such that with those Treasuries marked down 20% at one point, they needed to buy back $200m of US$ cash for every $1bn of bonds. As we noted at the time, this was a catalyst for a large sell off in Yen from 110 to almost 150. Nothing really to do with fundamentals, all to do with market mechanics.
Hedging costs remain key to Japanese savings flows
Even without sharp moves in capital markets having effects such as this, further confusion arises in that because lower yielding currencies like the Yen are periodically used for ‘carry’ trades, both for in-country and cross currency leveraged trades, this can have myriad impacts that don’t always match either the rate differential or the relative growth theory. For example, the above mentioned carry trade from Yen cash to US Treasuries only makes sense to the big life companies if the cost of the FX hedge is sensible. With higher US short rates and an inverted yield curve, as well as higher volatility in the swap markets actually used for hedging, this is largely no longer the case and thus re-patriation of fixed income trades is a likely phenomenon that will not only impact bond markets but also FX.
Japanese Equities may now see a currency neutral carry trade from abroad.
Meanwhile in the Japanese Equity market, the need for real returns is starting to focus domestic investors, while the strong balance sheets and high dividend yields available are starting to attract more international attention. As discussed on previous occasions, the so-called Buffet Trade, borrowing in Yen and buying the Japanese Trading companies, which all yield 3.5% or more, offers both carry and upside to global/Asian growth. Not surprising it continues to ‘work’. Equally, with short rates going higher, the same logic of buying European Banks that we have discussed could be applied to Japanese banks as well. The key is that higher inflation shifts relative pricing power and profits are always made at the margin.
All part of the great unwind
The key takeaway remains that QE is ending and that means Assets are returning to their proper role - Fixed Income for income, Equities for compound growth and real return and cash for risk management
This is all part of the great unwind of the 15 years of QE in the west, but almost 3 decades worth of the equivalent in Japan. While we remain unconvinced that any of the Central Banks have acknowledged the errors of QE and inflation targeting, the real world is now effectively forcing their hands. Dis-inflation has largely gone and the new range for inflation is now 200bp higher than it was. Interest rates have to adjust accordingly. The west is basically there, while Japan is now starting its journey, but as Japan is one of the biggest providers of liquidity to global markets, we have to recognise that in Hokusai’s picture of the wave, we are all in that boat too…..
Please note that the usual disclaimers apply. None of this should be considered investment advice, it is for information and hopefully entertainment purposes only and you should do your own research and or contact your investment advisor.
