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Today's edition of the Saxo Morning Call features the SaxoStrats team discussing the continuing weakness of the US dollar as commodity prices recover ground and in the wake of key US equity indices hitting all-time highs Thursday.
Article / 20 December 2016 at 23:42 GMT

BoJ plays dangerous game with yield curve control policy

Managing Director / Technical Research Limited
New Zealand
  • No change to bond yield target in BoJ's latest monetary policy review
  • BoJ attempting to control both price and quantity in the bond market
  • Strong correlation in place between USDJPY and yield spread

By Max McKegg
 
There were no surprises from the Bank of Japan in its latest Monetary Policy Statement. Despite a sharp selloff in the US bond market, Governor Haruhiko Kuroda and his colleagues seem more determined than ever to hold the line on “yield curve control”, with no consideration to be given to quantitative easing tapering until 2% inflation is staring them in the face.
 
As as result, the gap between US and Japanese government bond yields is blowing out, taking USDJPY with it.
 
So far everything is happening in an orderly fashion but the BoJ is playing a dangerous game.

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 Dangerous act? The markets may soon test the BoJ’s resolve over its yield curve control policy and a Swiss National Bank-style capitulation is possible. Photo: iStock
 
Having set the overnight deposit rate at minus 0.10% earlier in the year, it is now trying to control the shape of the yield curve a decade out. A target of “around zero percent” has been set on the 10-year government bond while longer maturities have been allowed to adjust somewhat to the US market selloff.


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Source: the Daily Shot
 
In yesterday’s statement, the BoJ reaffirmed the yield target, to be achieved, if necessary, by unlimited bond purchases. But at the same time it is hoping to restrict expansion of the monetary base to “more or less” 80 trillion yen annually (approx. $700 billion). 

The bank’s holdings of JGBs have already reached 38% of the amount on issue and its balance sheet as a percentage of GDP is approaching 100%, not far off that of the Swiss National Bank and well ahead of the European Central Bank and the US Federal Reserve.

jkj
Source: Bloomberg
 
And talking of the Swiss National Bank, questions are being asked about how long the BoJ will be able to maintain its “peg” on the 10-year bond rate if global rates continue to rise, especially as it appears to have set itself a limit on the amount of purchases. 

It’s a basic rule of economics that you can’t control both the price and quantity of a commodity at the same time: something’s gotta give.
 
That something is likely to be the quantity restriction. The statement made it clear the intention is to “continue expanding the monetary base until the year-on-year rate of increase in the observed CPI exceeds 2 percent and stays above target in a stable manner”. 

The key word here is “observed”. Monetary policy works with a delay, and according to the text books, today’s policy should be set with tomorrow’s inflation rate in mind. But the BoJ has given an “inflation-overshooting commitment” and intends to continue QE until the actual (“observed”) inflation rate has moved above 2%. 

Contrast this with the Fed, which is tightening policy, not because its inflation objective has been “observed”, but in anticipation that it will be.
 
The reason the Fed is moving ahead of time is because inflation expectations are “anchored” around its 2% target. In contrast, inflation expectations in Japan are backward-looking, that is, business and consumers assume today’s inflation situation will apply into the future. It’s this “deflationary mindset" that the BoJ is determined to overcome.
 
It remains to be seen whether the dual targets of a 0% yield on the 10-year JGB and ¥80 trillion of bond purchases annually are compatible.
 
Yesterday’s policy update made no mention of the exchange rate and Kuroda seemed unconcerned with the recent sharp decline in his follow-up press conference. USDJPY has rallied 10% over the last few weeks, but on a trade-weighted basis the yen’s fall has been less dramatic, as illustrated in the chart below. 

To everyone’s surprise, the negative interest rate policy (NIRP) introduced in January had the opposite effect of that intended: JPY rallied. Rather than doubling-down and cutting the deposit rate further, yield curve control (YCC) was introduced, and this has turned things around. But there’s still a long way to go to get back to the level where Kuroda gave a “warning” last June that the exchange rate was slipping into undervalued territory.
 
A strong correlation is in place between USDJPY and the US versus Japan 10-year yield spread. So it seems Kuroda has at last got some control over the exchange rate. Standing aside and letting the spread widen further will weaken the yen. In turn that will help raise the inflation rate.

lll
Source: CitiFX
 
The BoJ has thrown away the text book in its desperation to achieve 2% inflation. Committing itself to continue QE until the target is “observed” rather than anticipated risks letting the genie out of the bottle. 

At some stage – sooner rather than later if US bonds continue to sell off – the markets will test the BoJ’s resolve over the yield curve control policy and a Swiss National Bank-style capitulation is possible. Financial market turmoil would follow. Let’s hope Kuroda knows what he’s doing. 

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform. 
2y
Patto Patto
An astute reading of the situation Max..........
2y
Max McKegg Max McKegg
Thanks
2y
bvlaerhoven bvlaerhoven
well said Max and absolutely something we should keep in mind. Big moves in USDJPY coming rather sooner than later i think.

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