Keep an eye on Bank of Japan's policy meeting on Tuesday
- The Bank of Japan will present its updated economic projections on Tuesday
- BoJ is trying to control the price and quantity of Japanese government bonds
- It has been able to avoid conflict between its price and quantity goals lately
- The European Central Bank could take a leaf of of BOJ’s book
By Max McKegg
This week there is plenty of “event risk”, with President Trump at the forefront, announcing his pick for Federal Reserve chair and giving details of the tax reform bill he will put before Congress. The US economic data calendar is packed as well, starting with an update on a key inflation benchmark later today and the October employment report at week’s end. In between the Federal Open Market Committee will review monetary policy settings and issue a post-meeting statement. We will also get inflation numbers from the Eurozone (on Tuesday) and the Bank of England policy rate announcement (Thursday).
Flying under the radar will be the Bank of Japan’s monetary policy statement on Tuesday. This follows last Friday’s inflation report that showed the core rate in Japan rising at an anaemic 0.2% year on year. Updated economic projections will be presented at this meeting, providing the central bank with an opportunity to either make policy changes or, more likely, alter forward guidance.
The BoJ’s policy making board has lulled markets into complacency this year, issuing the same bland statement after every review meeting, namely, that the bank will control the yield curve, keeping the policy rate at –0.10% and purchasing government bonds (JGBs) so that the 10-year yield will remain around zero percent. At the same time as controlling the price of JGBs, they intend to control the quantity as well, increasing their holdings at an annual pace of 80 trillion yen (about $700 billion).
It’s a basic rule of economics that you can’t control both the price and quantity of a item at the same time. But so far so good for the Bank of Japan. As the following chart shows (click to enlarge), the 10-year JGB has traded in a tight range since the yield curve control policy was introduced. On the couple of occasions when traders have tried to push the yield above 0.10% (in response to moves in US Treasuries) the BoJ has stepped in, offering to buy an unlimited amount to hold the line.
Japanese government bonds chart
Source: Bank of Japan, Metastock. Create your own charts with SaxoTrader; click here to learn more.
Central banks around the world are grappling with the issue of the natural (or neutral) rate of interest, that is, the appropriate policy rate to aim for that would keep the economy on an even keel once it has returned to a state of full employment and 2% inflation. Not content with that, the BoJ is intent on trying to figure out what the natural yield curve is. This is an ambitions undertaking in what is the world’s second largest bond market.
Such has been the success of the BoJ’s yield curve control policy so far, FX traders have virtually ignored the JPY side of the USDJPY cross and taken their cue from movements in the US bond market. As the following chart shows (please click to enlarge), the correlation is strong.
In a recent speech, BoJ deputy governor Hiroshi Nakaso addressed the issue of trying to control both the price and quantity of JGBs. “The most appropriate shape of the yield curve cannot be be formed by fixing the amount of JGB purchases as an operating target” he said. Yield curve control enables the bank to purchase “just the right quantity” of JGBs to achieve the around-zero percent yield target on the 10-year maturity.”Consequently the amount of JGB purchases is determined endogenously”.
In other words, the BoJ’s priority is the shape of the yield curve, not expanding the monetary base, even though both are stated as explicit policy targets. But controlling the yield curve may involve purchasing JGBs at a rate a lot higher or lower than the nominal target of ¥80 trillion annually. As the following chart shows, the bank has been reducing the rate of purchases over the last couple of months while holding the 10-year JGB yield under 0.10%.
BoJ bond buying chart
Source: Goldman Sachs
The deputy governor may have come out in favour of price versus quantity but a complicating factor is the BoJ’s inflation-overshooting commitment whereby “the monetary base will be expanded until the year-on-year rate of increase in the observed CPI exceeds 2% and stays above that level in a stable manner”. This would suggest bond purchases will continue until inflation hits 2%, regardless of the impact on yields.
The BoJ has been able to avoid conflict between its price and quantity goals of late because the US Treasury bond market has been going sideways. But with the break above 2.40% on the 10-year maturity, there will be upward pressure on the JGB equivalent, testing the resolve of the BoJ. As such, and following on from the deputy governor’s comments, traders should be alert to any change in the wording of the statement that follows Tuesday’s board meeting.
Follow the leader
The European Central Bank was late to the party with QE and has had the benefit of being able to observe the tactics of the Federal Reserve and Bank of Japan. Would the ECB consider making yield curve control its primary policy target?
The obvious hindrance is that there isn’t a single Eurozone government bond market to target, rather there are 19 of them, and picking Germany out of the pack would have political implications. On the other hand, Italy would be an ideal candidate. Like Japan it has a large government debt problem and, with Italian bond yields higher than the country’s economic growth rate, the situation is worsening. Through yield curve control, Japan now has growth higher than interest rates, thus starting to eat away at its debt burden.
By taking a leaf out of the Bank of Japan’s book, the ECB could overcome some of the problems caused by its one-size-fits-all monetary policy.
The Bank of Japan’s monetary policy meeting on Tuesday is flying under the radar. But with updated economic forecasts to be presented and rising US yields putting the spotlight on the bank’s attempt to control both the price and quantity of JGBs, traders should be on the alert for any changes to forward guidance in the post-meeting statement.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. If you would like to receive his Daily FX trading forecasts, then see his contact details here. Post your comment below to engage with Saxo Bank's social trading platform.