Will the Bank of Japan tweak YCC?

The Bank of Japan could tweak its yield curve control (YCC) policy at the July meeting. Photo: BoJ Governor Kazuo Ueda

>> What can we learn about BoJ's policy?

There’s some important monetary policy meetings coming up this month, not least the Federal Reserve on July 26^th where the market anticipates a return to rate hikes after a pause in June. But the Bank of Japan meeting on July 28^th may be the most significant one, at least where the bond and currency markets are concerned.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy expects the Bank of Japan to tweak its yield curve control (YCC) policy at the July meeting in a similar way to its decision last December. That outcome was a surprise to the market and a July change could also prove something of a surprise to many as the Bank has not been setting the market up to anticipate a change policy in the same way as we might see from the ECB or the Fed ahead of a rate-hike decision.

However, we should not be put-off by the absence of any set-up by the BoJ because the bank can’t really set the market up to expect another widening of the 50-bps band around the zero level for 10-year JGBs, or the elimination of the band altogether. For as we have found out with fixed currency bands in the past, any hint of a future change is almost certain to break the band now. The same would happen to the JGB band if the BoJ were to hint at change on July 28^th and the Bank presumably wants to be in control of this situation, not ‘following’ the market. Hence, almost by definition the BoJ cannot warn of a looming change to the YCC policy.

In Mr. Steve Barrow’s view, there are two main reasons why the BoJ should tweak YCC. The first relates to the yen. Many will argue that yields need to be allowed to rise further in Japan because rate spreads with the US are hurting the yen, even prompting BoJ intervention last September. That might be true but a more appropriate description is that trying to hold JGB yields in a tight range just creates volatility in the yen – and what the BoJ and MoF abhor is excessive volatility in the currency, not necessarily yen weakness.

If we look at 3-month implied dollar/yen volatility it is around 10.5 vol at the moment. That is more than four vol over the same euro/dollar maturity. It is a huge gap for currencies that more traditionally have traded pretty close to one another in vol terms. What is happening is that the suppression of volatility in JGB yields by the BoJ is succeeding only in transferring the volatility to the yen. It is the mirror image of what we often see when currency bands are used because central banks have to move interest rates that much more (or the market does it for the central bank) to hold the currency in a range.

>> Could the new BoJ governor reverse the fall in the yen?

Hence, if the BoJ does not like currency volatility it should widen the band, transfer the range to a shorter-maturity bond, like 5-years, or do away with bands altogether. The latter best removes the currency volatility problem in time – albeit not initially as it would be a huge shock for the market. While it may seem that the justification for wider bands – or no bands – around 10-year JGB yields is all to do with yen volatility, there’s another reason why we feel that the BoJ should act. It is to do with the tightening of monetary policy that is likely to be required in the future.

What we’ve seen from other central banks, like the Fed and BoE is that getting monetary traction is hard when central banks own so many bonds, via QE. For this reduces some of the transmission from higher policy rates to higher longer-term yields. And it is longer-term rates that are crucial to things like corporate and household borrowing, not overnight rates.

Mr. Steve Barrow fears that if the BoJ has to tighten policy in the future, perhaps because inflation does not fall back as anticipated, its large asset holdings (and YCC policy) could be a huge impediment. Don’t forget that BoJ assets are a huge 130% of GDP compared to just 32% for the Fed and around 56% for the ECB. In other words, if these central banks find it hard to gain monetary traction the BoJ seems likely to have a far harder task going forward. It can make this task a little easier – and reduce yen volatility - by tweaking, or better still ditching, the YCC policy as soon as this month’s meeting.