Latest inflation numbers offer Bank of Japan a glimmer of hope
- Inflation numbers have ticked slightly higher in Japan
- Exchange rate depreciation will gather steam as the rate differential widens
- Bond futures suggest BoJ will give way on yield curve control
- The BoJ governor is deluded if he thinks he can hold back global market forces
By Max McKegg
On Friday morning the latest inflation numbers for Japan were released. The Bank of Japan’s benchmark (the Consumer Price Index less fresh food) declined 0.4% over the year ending October 31, a slight improvement on the previous month’s –0.5%. The core reading, excluding both fresh food and energy, came in at 0.2% up from zero.
On their own, these numbers weren’t good enough to push USDJPY any higher but, when seen in the context of the recent sharp decline in Japan’s exchange rate, the central bank might just about be able to see some light at the end of the tunnel.
Japan’s inflation problem is best illustrated in the chart shown below. The BoJ’s benchmark is the CPI (all items less fresh food), which is the black line on the chart. The graph splits the inflation rate into two components, the first being “Items other than energy” (as known as core) which has been slipping, in part due to the appreciation of the exchange rate, but remains positive. The second is “energy”, and with oil prices still below where they were this time last year, the negative contribution from this component has been sufficient to drag the total CPI number under zero.
But oil prices bottomed in January and have been on a steady rise since, meaning that the red bars will soon move back up to the zero line at least. At the same time the recent sharp reversal in USDJPY will start to have a positive impact on the core component as import prices rises feed through. All up, there is a good chance the benchmark index will crawl back into positive territory early next year.
Source: Bank of Japan
But Bank of Japan Governor Haruhiko Kuroda and his colleagues won’t count their chickens until they’re hatched, having made that mistake on too many occasions in the past.
That means current monetary policy centred on “yield curve control” will remain in place for some time yet, especially as it seems to have been very effective in weakening the exchange rate. The FX market is now taking its cue from medium term yield spreads rather than those at the short end of the curve, and with the BoJ holding the 10-year JGB rate close to 0% while global markets sell off, the yen is declining as rate differentials widen, especially in relation to the US.
But since 1996, the correlation between US and Japanese 10 year bond yields has been 0.85, so the governor is as deluded as King Canute if he thinks he can hold back the tide of global market forces (as Swiss National Bank President Thomas Jordan found out with his EURCHF peg). Kuroda should know that you can control the price of an item or the quantity, but not both at the same time. Yet the central bank’s stated policy is to set the 10-year yield at zero percent while maintaining the previous rate of bond purchases.
In reality, if yields continue to rise in the US, the BoJ will have to choose whether to remove the limit on purchases or raise the yield target. The former option will be pursued in the short term, even though the bank’s balance sheet is already the equivalent of more than of 80% of GDP and is giving the Swiss National Bank a run for its money (the Federal Reserve’s balance sheet topped out at 25% of GDP).
That won’t stop Kuroda. He will let the balance sheet go to 100% of GDP - or more - if that’s what needed to “drastically convert the deflationary mindset”, even at the risk of letting the inflation-genie out of the bottle. Indeed, frustrated by years of failure, he has already issued an “inflation over-shooting commitment”.
We saw evidence of the BoJ’s determination last week when they offered to buy unlimited quantities of 2-5 year maturity bonds at a set price. Sellers were scared off and the market stabilised without the bank actually having to write out any cheques.
In the meantime, the US versus Japan medium term yield spread has expanded to a five year high and the the FX market has taken USDJPY along for the ride. This is unexpected good news for the BoJ. Like everyone else they were surprised when the cross declined after negative rates were introduced to the short end of the yield curve last January. It seems a rise in the medium term interest rate differential is what the market was waiting for (as in the case of EURUSD).
However it would be mistake to bet the BoJ will continue to stand in the market if the US bond market selloff gathers momentum. Indeed the the JGB futures chart shown below (please lick to enlarge) suggests traders expect them to raise the yield target instead.
A clear head and shoulders pattern has formed with a decisive neckline break. The current price is equivalent to a yield a touch over zero. If achieved, the head and shoulders target would see the price/yield back to January levels, just before negative rates were introduced.
JGB futures chart
This latest inflation update isn’t going to change that perception in a hurry but, combine it with a further extension of the USDJPY rally, and the situation would look more promising.
Analysis of USDJPY rally
USD/JPY has rallied nicely these past couple of weeks. Please see my latest analysis below.
Daily USDJPY chart
Weekly USDJPY chart (click to expand)
Source: ThomsonReuters. Create your own charts with SaxoTrader; click here to learn more.
– Edited by Robert Ryan
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Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.