A core pillar of Japan’s ultra-easy monetary policy – known as yield curve control (YCC) – has come under increasing market skepticism in recent months, raising the possibility that the country could eventually abolish it altogether, according to strategists within Goldman Sachs’ Global Banking & Markets.
The Bank of Japan originally introduced YCC in September 2016 to head off deflationary risks and to achieve an inflation target of 2%. But now a number of factors including the risk of inflation well exceeding BOJ’s expectations, prospects for higher wage growth, deteriorating Japanese government bond market functionality and an impending transition to a new BOJ governor make a change of course possible, says Ryoya Wakamatsu, a yen rates market strategist.
Wakamatsu says the BOJ could make further adjustments to YCC as early as its next Monetary Policy Meeting (MPM) in March. “Policymakers now arguably have a very good window to unwind YCC at a time when YCC is appearing to become less and less sustainable,” Wakamatsu says. “While the BOJ has repeatedly stressed the necessity for stronger wage growth to accompany rising inflation prior to any YCC adjustments, we and the market view every upcoming MPM to have high chances for significant policy change.”
However, the BOJ’s path ahead on YCC is far from certain, according to Wakamatsu. He answers some important questions about the policy and how it could change going forward:
How does Japan’s yield curve control work? What’s the reason for it?
For a long time, Japan’s economy remained stagnant and faced deflation. In 2013, the Japanese government and the BOJ announced a “Joint Statement” to achieve sustainable economic growth. The BOJ established a 2% target for the sustainable inflation rate and deployed a number of different tools to achieve that goal.
The BOJ set the policy rate at -0.1% in January 2016 to address short term yields. Then in September 2016, they introduced YCC by setting the 10-year JGB target at 0%. As the name suggests, yield curve control has allowed the BOJ to control the shape of the entire yield curve, not only keeping short-term rates low, but keeping medium-term rates low too. This is important for Japan because these medium-term rates allow corporate borrowers to borrow money at a cheaper rate, in turn fueling more business and economic activity.
So what’s changed recently?
Market sentiment greatly changed around the December BOJ meeting – prior to that, the BOJ's communication had implied no changes until wages were seen to accompany a sustainable 2% inflation rate. But December came around, and the BOJ surprised markets by lifting its cap on 10-year government bond yields from 0.25% to 0.5%. The BOJ explained that this was a technical adjustment to address market functionality. However, market participants saw this as potentially just the first step in unwinding YCC. Markets prior to this were thinking this change is going to happen in March or maybe in January 2023. However, the December shock has shifted the timeline for how people were thinking of YCC. Incidentally, January’s MPM saw heightened market expectations for further YCC adjustments. In fact, markets were massively selling 10-year Japanese government bonds to test the YCC yield cap and the BOJ had to purchase 9 trillion JPY ($70 billion) of 10-year JGBs in just two weeks leading up to the January MPM to maintain YCC. While the BOJ ended up making no policy adjustments and reiterated its dovish stance, we continue to see a good chance for changes in the ensuing meetings.
Why might the BOJ choose to abandon YCC?
Several factors have led to this possibility. Firstly, if you look at Japan's latest core CPI, the latest print as of December 2022 was 4% (remember—the BoJ’s target has been 2%). While the BOJ maintains that this inflation is supply-side driven, imported and transitory, they have continued to revise up their inflation forecasts. We are beginning to see signs that large corporations are making sufficient wage increases and the risks of inflation well exceeding BOJ’s expectations is increasing. The current inflation cycle could offer the BOJ a good window to claim victory against deflation and unwind this policy.
Secondly, the JGB market’s functionality has deteriorated because of BOJ’s massive purchases to protect YCC. When Japan was not facing inflation and global yields were low, YCC worked well with 10-year JGBs around 0%. However, with global central banks hiking policy rates and Japan facing high inflation, JGB yields have also risen to test the BOJ’s 10-year yield cap. This has forced the BOJ to purchase an unprecedented amount of JGBs with some issues being 80-90% held by the BOJ, according to BOJ and market data.
Finally, BOJ Governor Haruhiko Kuroda’s tenure is coming to an end in April. With new leadership arriving this spring, there is the opportunity to embark on policy normalization. Of course, it's going to be difficult for the next governor, but I think markets are excited that this change at the top gives a good opportunity for the BOJ to change course.
What do you expect to happen when the BOJ does change YCC?
The degree of market impact will vary depending on how the BOJ changes YCC. Will it move the 10-year YCC target to a 5-year YCC target? Could they increase the cap further? Or could they abolish YCC entirely? Nevertheless, all these scenarios could point to higher Japanese rates and a stronger yen. With that in mind, investors may find Japanese government bonds more attractive than some global bonds and fixed income investments may continue to repatriate back to Japan as we saw in 2022. Japan is arguably one of the largest global fixed income investors, so the impact to global fixed income markets could be significant.
Is Japan’s YCC working and achieving its desired goals?
This is quite widely debated with no clear answer. YCC’s original aim of maintaining a low yield curve has worked for over six years until now. When you look at the inflation front, the current inflation rate is double that of the BOJ’s 2% target and one could say the BOJ has accomplished what they first set out to achieve.
On the flipside, the BOJ has stressed that the current inflation is supply driven and transitory. Additionally, the BOJ has been forced to ramp up JGB purchases to maintain YCC (the BOJ now holds over 50% of outstanding JGBs, according to BOJ and market data), which has arguably caused the JGB market dislocations and deterioration in the functionality of the market itself, making the policy increasingly appear unsustainable. Moreover, in my view, Japan’s economic activity has remained relatively stagnant compared to its global peers and real wages remain negative at the moment.