BoJ preview: reversal rates and natural yield curves

BY DEB SHAW | 

  • As one of the world's most dovish central banks, expectations for the BoJ remain limited
  • Recent commentary from Governor Kuroda suggests a subtle change of stance
  • While no immediate changes are expected, future monetary policy will be supportive for Japanese banks

As the Bank of Japan is one of the world’s most dovish central banks, market expectations for this week’s upcoming event are very limited. Governor Haruhiko Kuroda, who has overseen a $4T quantitative easing program and negative interest rates over his 5-year term at the Bank, is an unlikely candidate to bring about hawkish monetary policies. This is especially the case as domestic inflation remains stubbornly below the BoJ’s 2% target rate. CPI in the third quarter registered at 0.6%, while October CPI came in at just 0.2%.

Looking at the Japanese yen, USD/JPY has strengthened since the beginning of the year. While the pair was trading above 117 at the time, USD/JPY is currently above 112.50 today. As Japan remains reliant on global exports, a stronger yen worsens both GDP growth and the inflation outlook.

 

Despite low expectations, Kuroda has changed his tone

While the BoJ has historically focused on excessive yen strength, in recent times Kuroda has acknowledged that currency strength is not the only factor driving monetary policy. As we wrote two weeks ago, the governor said that the Bank was “very mindful” of the BoJ’s impact on small regional banks given its negative interest rate policy. Specifically, he alluded to the concept of “reversal rates”, a point at which low rates hurt the banking industry and undermine loose monetary policy. He also said that “we will consider where our short- and long-term rate targets should be in order to create an appropriate shape of the yield curve” in a speech delivered at the University of Zurich.

Given negative deposit rates and 10-year Japanese government bond yields fixed at 0%, banks have been struggling to make lending profitable.  The BoJ’s policies have been criticized by Japanese banks, who are calling for higher interest rates across the yield curve. As banks borrow money in the short-term and lend money in the long-term, positive interest rates and a steeper yield curve helps improve banking sector profits.

 

With no immediate changes expected, guidance in Q&A will drive yen trading

Despite Kuroda’s warnings regarding the dangers of excessive monetary policy, no immediate changes are expected. Between low inflation and a weak outlook for the US dollar, the BoJ is in no hurry to catalyze yen strength. Instead, Kuroda is likely to signal that the institution will adjust how it assesses its policies in the future. Markets will thus be primarily focused on the Q&A session, which will focus on the topic of reversal rates and natural yield curves.

While Kuroda launched the BoJ's massive quantitative easing program in 2013 with a ‘whatever it takes’ attitude, today the Bank is becoming more mindful of its impact on banks. Instead of focusing on inflation alone, Kuroda is likely to signal that financial system stability is also a factor in determining future monetary policy. While this is ultimately bullish for the yen, the governor is likely to dampen expectations by suggesting that any change in policy will not take place until late 2018 or 2019. Similar to its counterparts such as the ECB, the BoJ has to perform a delicate balancing act between raising guidance and limiting currency strength.    

Topics: Japanese yen

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