All eyes on BoJ’s actions

Mr. Haruhiko Kuroda, BoJ Governor

>> New action from the Bank of Japan

We’ve probably all experienced the situation when a “pegged” currency breaks the bands. The break leads to a dramatic movement in the currency. But it also usually leads to a substantial move in interest rates, for these might have been held “artificially” high to defend a weak currency or vice versa.

When we take note of this, it suggests that if – or when – the Bank of Japan’s target band for 10-year government bond yields breaks it will have significant connotations not just for yields, but also for the yen. That’s why the yen has become so strong recently – and so volatile.

While the market is very familiar with fixed FX regimes, whereby the currency is stopped from going beyond certain levels by intervention and/or interest rate changes; it is very new to trading bands for bonds. We know that when currency pegs break the resulting FX move can be very dramatic. The last one of note in the developed world was the Swiss National Bank’s decision in January 2015 to abandon its prior policy of stopping euro/Swiss from falling below 1.20. When it withdrew this policy euro/Swiss collapsed to below parity within a matter of days.

Notably, the release of the franc also led to a very sharp move in interest rates. Two-year government bond yields, for instance, fell from around -0.35% to -1.16% within two weeks. That was a dramatic move when you consider that 2-year yields had not been more that 20-bps away from the zero level in the preceding two years.

A question for the market now is whether a similar release of the 10-year JGB yield from its permitted -0.5% to 0.5% trading range could create equally volatile moves in bonds and the yen. There is a difference when currency pegs disintegrate to that we’d expect when a target range for bonds is broken.

In FX markets, central banks often use short-term policy rates to ensure currencies stay in their desired ranges. Sometimes this can involve huge moves in rates (Swedish short-term rates rose to 500% in 1992 to defend the krona). But when it comes to a target range for bonds, the central bank cannot impose a level of the exchange rate that might be consistent with maintenance of the band. And besides, it is not even clear if the exchange rate plays a central role in the maintenance of the bond yield target in the same way as rate levels are often central to the durability of a currency band.

>> Will the yen strengthen through 2023?

Instead, the BoJ has had to rely on maintaining the band through “intervention” by purchasing bonds when the upper yield target threatens to break. This is equivalent to a central bank holding a currency band via FX intervention. But this leads to another difference which is that the central bank cannot hoover up all the FX in the market to defend a band.

On the contrary, the BoJ is doing a very good job of owning all (or at least a very large chunk) of the JGBs as it seeks to anchor 10-year yields. The cost of this is that liquidity is very sparce indeed. “We’d certainly argue that it is far more sparce that the liquidity we might see in an FX market just ahead of a band break. This deficiency of liquidity could lead to an absolutely giant leap in JGB yields were the target band to be abandoned. And while the liquidity deficiency within JGBs is clearly not replicated in the yen, we dare say that a huge surge in JGB yields would still produce a surge in the yen”, said Mr. Steve Barrow, Head of Standard Bank G10 Strategy.

In Mr. Steve Barrow’s view, these are all reasons why it probably won’t happen. Or, at least, it won’t happen in one fell swoop. Instead, it seems likely that the BoJ will produce more regular changes to the target range so that the market gets used to more fluidity in the market and, in that way, liquidity conditions might improve so that any ultimate “release” of the 10-year yield from the target range produces a much more limit  ed rise in yields and in the yen. But either way, as long as speculation about the JGB band continues, it will pay traders and investors to own the yen.