The BoJ’s struggle

The Bank of Japan was forced to defend its 0.25% upper limit  for 10-year JGB yields.

Bond yields have been rising sharply across countries, and this clearly poses a particular problem for the Bank of Japan given that its 0.0% 10-year yield target only has plus or minus 25-bps of wiggle room. The upper limit  was approached last week, prompting the BoJ to offer to buy unlimit ed amounts of certain 10-year issues to rebuff the increase.

However, Mr. Steve Barrow, Head of Standard Bank G10 Strategy said that markets can be insistent whenever central bank imposed limit s are reached. The Reserve Bank of Australia was forced to abandon its 3-year yield target not so long ago as the market no longer believed that policy rates would be left unchanged through the whole of the life of the bond. The BoJ has not targeted a zero yield for 10-year JGBs because it wants to guide expectations about the longevity of current policy rates, as the RBA has done. Nonetheless, upward pressures on JGB yields seem likely to continue. If the BoJ successfully rebuffs this pressure, keeping yields artificially low at 0.25% or lower, it will seemingly free the US/Japan 10-year yield differential to rise much further, assuming of course that US yields continue to rise.

Unsurprisingly dollar/yen traders see this as being like a red rag to a bull. Evidence suggests that there is a positive correlation between dollar/yen and this yield gap over time, and the bulls are presumably betting that this will continue. However, there are a number of considerations to bear in mind here. The first is the 0.25% yield limit  itself. This is because the top of the target band could act in a similar sort of way to the top of a currency band in the sense that any break of the band is likely to initiate a very sharp increase.

In this case, it is clearly not dollar/yen that is banded but Japanese yields and if the 0.25% limit  is broken by the market it could generate a very sharp rise in Japanese yields and, as a result, the very real prospect of a slump in dollar/yen as the US/Japan yield differential contracts sharply. In other words, the relationship between dollar/yen and yield differentials is potentially altered by the fact that 10-year JGB yields sit atop this 0.25% limit .

Another issue is that rising US rates relative to those in Japan at the front end of the curve increase hedging costs for Japanese investors and that can eat into the attractiveness of treasuries. “Evidence concerning the extent that Japanese investors hedge their foreign bond holdings is somewhat piecemeal but we’d argue that a ballpark figure of around 50% as a hedging ratio is probably not too far wide of the mark. As hedged foreign bond positions should have no bearing on the spot rate, the dollar/yen bulls are probably dependent on a reduction these hedge ratios. That could happen although it is worth pointing out that the US monetary policy situation is very fluid at the moment and hence Japanese investors might think twice before taking a gamble with unhedged currency positions. Dollar/yen volatility has also moved higher recently and this too might mitigate against Japanese investors taking too many chances on the yen”, Mr. Steve Barrow said.

Putting all these factors together, Mr. Steve Barrow is reticent to suggest that the ‘barrier’ posed by the BoJ’s 0.25% 10-year JGB target necessarily implies a significant rise in dollar/yen. Moreover, as he anticipates a longer-term downtrend for the greenback, it seems more likely that dollar/yen will slide back towards 100 in time even if the yen does not spring to mind as the currency that’s likely to make the most significant gains against the dollar over the long haul.