- Markets continue to ignore the Bank of Japan, and bet on yen strength
- While the "policy tightening" trade is tempting, few clear signs beyond improving GDP growth today
- All in all, our view is that long yen trade can wait
Japan has suffered from weak growth and inflation since the global financial crisis, and the Bank of Japan has frequently experimented with unorthodox monetary policies. In September 2016, the BoJ decided to directly target long-term interest rates. The so-called “yield curve control” (YCC) program fixed 10-year Japanese government bond (JGB) yields at 0%. If yields deviated from the BoJ’s target rate, the Bank bought JGBs (to push rates down) using its balance sheet, or issued new JGBs (to drive rates higher).
Following the implementation of yield curve control, the Japanese yen has been exceptionally sensitive to interest rates differentials. In particular, the yen tends to weaken when foreign 10-year government bond yields rise. When foreign yields fall, the yen tends to strengthen. For reference, a graph comparing USD/JPY and 10-year US Treasury bond yields is shown below:
YCC: once reliable, now not so much
As can be seen above, USD/JPY has predictably followed 10-year US treasury yields. As Japanese interest rates are fixed, investors tend to buy US dollars, in exchange for yen, when US interest rates are rising. The opposite is true when US interest rates are falling.
Starting in December 2017, this predictable relationship appears to have broken down. While US treasury yields have soared from around 2.4% at the start of 2018 to 2.7% today, USD/JPY has weakened (that is, the Japanese yen has strengthened). While yield curve control had a strong influence on the yen when economic conditions were weak, the ongoing economic boom is pushing markets to bet on tighter monetary policy.
An outline of recent GDP growth and inflation in Japan is shown for reference below.
Stronger GDP growth, but few signs of inflation
As can be seen in the graph above, year-over-year Japanese GDP growth has strengthened in 2017. Following several weak quarters in 2016, the last two readings suggest that the Japanese economy is now growing at 2.5% year-over-year. Looking at the latest data, forward-looking indicators suggest that the good times are set to continue. Last week, Nikkei manufacturing PMIs were at an 11-year high. Thanks to strong global growth, the Japanese economy is likely to do well in Q4 2017 and early 2018.
Inflation, on the other hand, remains weak. While December CPI figures were more encouraging thanks to rising crude oil prices, inflation remains significantly below the BoJ’s 2% target rate.
Words versus actions: the Bank of Japan’s dilemma
At the last Bank of Japan meeting on January 23, Kuroda stressed that the Bank remains committed to the status quo. Specifically, he stated that “this is not yet the stage to consider exit timing or approaches”. While the Bank of Japan upgraded its inflation outlook from “weak” to “stable”, he remarked that changes in the Outlook Report will not lead to “any kind of immediate adjustment to the yields under yield curve control”. In previous speeches, Kuroda has emphasized that any exit from the yield curve control program must be managed with great care and communicated well in advance.
Despite the clarity of his words, markets doubted his intentions. Looking at USD/JPY for reference, the pair was trading just above 110.90 at the start of January 23. By the close of January 24, the pair had weakened down to 109.20.
Is this the beginning of policy normalization?
Historically, the Bank of Japan has tightened monetary policies when real GDP growth has outperformed. Today, Japan’s economy is improving while inflation data is heading in the right direction. As the European Central Bank looks set to end its asset buying program in the second half of this year, traders are naturally asking “who’s next?” Since “Japan” is the consensus response, the bet on tighter BoJ policy is tempting.
While Japan will ultimately curtail its yield curve control at some point in the future, betting on yen strength is a tough call to make without clearer indications. On one hand, economic data clearly supports the case for less extreme monetary policy. Kuroda has also noted that YCC harms Japanese financial institutions by lowering their profitability (as banks generate higher profits when long-term interest rates rise). On the other hand, the Bank of Japan is reluctant to push the yen higher. Relative yen weakness has helped spark growth in recent quarters, and Kuroda is unlikely to unilaterally derail Japan’s recovery. Given the facts today, our view is that the long yen trade hasn’t arrived yet.