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Investors are anticipating that the Bank of Japan will maintain its current monetary policy on Friday, but prominent investment banks are warning them to be prepared for a surprise.
While most major central banks are nearing the end of their rapid tightening cycles in response to post-Covid inflation, the Bank of Japan has been holding steady. Japan’s relatively low inflation has gradually increased after years of stagnation, and the central bank seems content with this modest progress.
In a recent Bloomberg survey of 50 economists, 42 expected no changes from the Bank of Japan, which has been buying bonds to keep yields down through its yield curve control policy. However, previous adjustments to this policy have caused significant market shifts in Japan and globally, leading some banks to advise caution this time around.
UBS economist Masamichi Adachi believes that the Bank of Japan will make some adjustments to its yield curve control policy, stating that many have misunderstood recent remarks made by BoJ governor Kazuo Ueda regarding patience in achieving 2% inflation.
If there is a policy change, UBS predicts that Japanese government bond yields will rise, the yen will strengthen, and the country’s stocks, which have performed well compared to other global markets, will decline.
Other banks, including Goldman Sachs, JPMorgan, Nomura, BNP Paribas, and Morgan Stanley MUFG, have also suggested that the Bank of Japan will loosen its grip on the bond market. SMBC Nikko even speculates that there is a 50% chance the Bank of Japan will completely abandon its yield curve control policy this week.
The future of Japan’s loose monetary policy is closely watched as inflation continues to rise in Asia’s most advanced economy, contrasting with the decreasing rate of consumer price increases in the US and Europe. In June, headline inflation in Japan reached 3.3%, surpassing the US figure for the first time in eight years.
In the US, the Federal Reserve has ended new bond purchases and raised its key interest rate by 5 percentage points since March 2022. The Fed is expected to increase rates by an additional 0.25 percentage points this week before pausing.
The European Central Bank has raised rates from -0.5% in July 2022 to 3.5% and is likely to raise them again this week before applying brakes soon after. Meanwhile, the Bank of Japan’s base rate remains at -0.1%, and it maintains 10-year yields at 0%, allowing for only a 0.5% movement on either side of the target.
Officials have led most investors to believe that this framework will remain unchanged. BoJ board member Seiji Adachi has also suggested that the market has been functioning smoothly since the last tweak in December, making it appropriate to maintain the current policy.
However, UBS’s Adachi argues that the central bank could argue for a policy tweak to improve the bond market’s functioning based on the strengthening of underlying inflation. The Bank of Japan can then continue its other easing measures, such as negative interest rates, until it is more confident in achieving sustainable 2% inflation.
“If the BoJ doesn’t make a move, we believe it would be unwise and highlight the central bank’s extremely cautious outlook on inflation,” Adachi said. Economists expect the Bank of Japan to raise its core inflation forecast for the 2023 fiscal year from 1.8% to over 2.5%.
Last December, the Bank of Japan adjusted its yield curve control policy by widening the tolerance from a quarter to half a percentage point. This move surprised economists and caused government bond prices to decline. Now, some banks anticipate that the Bank of Japan will expand the tolerance band to a full percentage point on either side of zero.
Mark Dowding, chief investment officer at BlueBay Asset Management, correctly anticipated the policy shift in December. He believes that the Bank of Japan will raise the upper band of its yield curve control policy by 0.75 to 1 percentage point this week, in line with his expectations of increased BoJ inflation forecasts.
Supporting his view, Dowding revealed that he has been betting against Japanese government bonds and on the undervalued yen since March. He added that Ueda has downplayed speculation to prevent speculators from profiting. If the Bank of Japan changes its stance, Dowding expects the yen to rise to at least ¥135 per dollar.
The yen is currently trading at approximately ¥141.2 against the dollar, close to its lowest level in two decades, reflecting the stark contrast in monetary policy between Japan and the US. Although the Japanese currency has recovered from its lows last year, it remains weak compared to the dollar.
Similarly, Japanese government bonds have weakened slightly, but with 10-year yields at 0.46%, the market is not significantly challenging the Bank of Japan’s current policy.
If the Bank of Japan delays changing its yield curve control policy, Chief Japan Economist Takeshi Yamaguchi of Morgan Stanley MUFG warns of a higher risk of a disorderly exit, as the market will start pricing in the beginning of a rate hike cycle.
“If the BoJ waits until it achieves its 2% target, it will be severely lagging behind,” Yamaguchi stated.
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