Bank of Japan moves further away from easy money

Kazuo Ueda, the governor of the Bank of Japan

On a very simple level it looks like a big deal because the BoJ has run with negative short-term policy rates since early 2016 and has not lifted the policy rate since 2007. In fact, it has been so much more than this. For a start it, the easing post-2013 has had a name ‘quantitative and qualitative easing’ and, with this in mind, what the BoJ did Tuesday is not just a rate hike, but a regime change, and regime changes tend to be big, not small. But big in what way?

It could be big in terms of its effect on the budget. Japanese government debt is around two-and-a-half times GDP and the BoJ now owns more than a half of the JGB market thanks to its bond purchases. We’ve seen in other countries not only how government interest costs rise as yields increase but also how an increase in rates paid to banks on reserves relative to bond yields can send central banks into a deficit position. They can’t go bust but it is not a comfortable situation.

Another issue is debt in the private sector and especially amongst so-called ‘zombie’ companies that have relied for years on an ultra-low policy rate environment. Yet more disruption could flow from the hike in Japanese policy rates and the likely rise in bond yields should Japanese investors repatriate large chunks of the assets they hold abroad.

In addition, foreign investors too could shy away from using the yen as a funding currency for carry trades, especially if central banks outside of Japan reduce policy rates significantly. Now quite clearly there is no evidence of any of this at this early stage but this could prove a slow burn regime change with any significant and adverse effects rising over time.

The alternative view, of course, is that this is a very small policy change, at least in terms of the size of the increase in short-term policy rates. Moreover, with the BoJ promising that policy will stay accommodative, it does not seem likely that there will be a rapid rise in policy rates, while continued BoJ bond buying keeps yield increases to a minimum even if YCC has ended.

As for the yen, rather than higher Japanese rates sparking some sort of dramatic rally in the yen we could see this initial ‘sell the fact’ fall in the currency, that resulted from the highly-telegraphed policy move, morph into more yen weakness in the future now that the yen bears have seen rates move up and are no longer fearful that tighter BoJ policy can lift the yen. Concerns that there might be some sort of rout in the JGB market could prove wide of the mark not just because the BoJ will continue bond purchases but also because overseas ownership is relatively low. In short, Japan has a large level of debt but it largely owes this to itself and that could help to placate the JGB bears even as the handbrake of the YCC comes off.

At the end of it all, what’s the answer to the question? Are the BoJ’s actions this week a big deal, or no deal? For now, Mr. Steve Barrow, Head of the Standard Bank G10 Strategy thinks they will look like the latter. The yen seems likely to stay under pressure with its course in coming months probably dictated more by what the Fed does than what the BoJ does. For even though a tightening of BoJ policy at this point is a regime change, while future Fed rate cuts are not, market focus is undoubtedly drawn towards the latter not the former. This psyche could also dictate how JGB yields move in coming months as Fed rate cuts and the prospect of lower treasury yields could help to keep JGB yields down. However, further out, as US rates come down more, but market focus rather moves away from Fed policy, the yen should start to rally and yields should climb. But will it be dramatic? Symptomatic of a major and disruptive regime change? Probably not.