Are You Focusing on the Wrong Central Bank?
With all the attention on the U.S. Federal Reserve, it can be easy for U.S. investors to forget about the impact of other monetary authorities. Policy changes at the Bank of Japan (BOJ), in particular, have the potential for major impacts on global financial flows and markets.
- For over a decade, BOJ policy has enabled Japan to be an important source of investment funding. Zero (or negative) interest rates in Japan have allowed investors to borrow cheaply in yen and then purchase investments in other countries offering a higher return.
- Since October of last year, BOJ policy has served to offset the impact of the Fed's quantitative tightening (QT) on global financial conditions, keeping them from tightening and coinciding with the rally in stocks and bonds.
With Kazuo Ueda set to be the new head of the BOJ in April, might a shift in policy result in an unraveling of this borrowing and a repatriation of capital back to Japan prompting turmoil across global markets in the coming months?
A popular strategy known as the "yen carry trade" takes place when investors borrow yen at a very low interest rate then purchase investments denominated in another currency in a country that pays a higher rate of return. This trade generally works if exchange rates are stable. But should the value of the yen increase, carry traders must then pay more dollars or euros to pay back the yen initially borrowed. If the rise is significant enough, they could go bankrupt if they don't act swiftly to mitigate losses. As a result, the carry trade can unwind quickly and lead to outsized cross-market volatility.
According to data from the BOJ, the yen carry trade has led to net investment outflows for more than a decade, with only a couple of modest periods of reversal. But late last year, as the BOJ shifted policy, hedged foreign bond positions started to offer negative carry. In response, Japan's net capital outflow turned into sizeable inflows, as you can see in the chart below.
Carry trade starting to unwind?
Source: Charles Schwab, Macrobond, Bank of Japan data as of 2/24/2023.
Yield curve control
Keeping rates capped at 25 basis points (bps) while other central banks were hiking led to sustained outflows that weighed on the yen as carry traders sold borrowed yen to buy investments denominated in other currencies. When the BOJ finally shifted the target range higher for the 10-year JGB yield late last year, the yen strengthened (a drop in the line of yen-per-dollar in the chart below) as the carry trade reversed. Now, the market is challenging the yield curve control (YCC) range again as the yen weakens and yields climb above the BOJ's stated 0.5% cap. With BOJ head Kuroda's term ending with the BOJ meeting in March, the market believes YCC is due for another change with new leadership under Governor Ueda.
Markets testing BOJ yield cap
Source: Charles Schwab, Macrobond, data as of 2/25/2023.
The expected change in policy is not merely the result of the change in leadership. The increasing demands of maintaining the yield curve control rate are becoming harder to justify. The 10-year Japanese government bond (JGB) yield has consistently closed above the 0.5% ceiling, forcing the BOJ to step up its bond purchases as it attempts to constrain the yield, as you can see in the chart below. The uptick in purchases has pushed the BOJ ownership to over 50% of Japan's government bonds.
Bank of Japan purchases of government bonds
Source: Charles Schwab, Macrobond, Bank of Japan data as of 2/24/2023.
All this quantitative easing (QE) by the BOJ to maintain the yield cap and limit the unwinding of the carry trade has been impactful on a global scale. From mid-October through the start of February, the BOJ's QE more than offset the impact of the Fed's quantitative tightening (QT). This net global QE has helped support stocks' rally since October, as you can see in the chart below.
BOJ's QE more than offset Fed's QT in past few months
Source: Charles Schwab, Macrobond, Bank of Japan, European Central Bank, US Federal Reserve data as of 2/24/2023.
The options for the BOJ include: a wider yield curve range, targeting a shorter bond maturity, or abandoning yield curve control entirely followed by eventual rate hikes. Any of these may result in less QE and a further unwinding of the carry trade, posing a risk to global markets.
Inflation in Japan
After bucking the global trend of central banks tightening policy with rate hikes and QT over the past year, a shift in policy at the BOJ may finally be at hand. The BOJ's target for inflation is 2%, but currently, inflation is running at around 4%, the highest level in 40 years following decades of deflation in Japan. Wages are on the rise, suggesting higher inflation may be sustained. Just last week Toyota and Honda have both agreed to union demands for wage hikes of 5% this year. Fast Retailing, best known for its UNIQLO brand, will raise wages by up to 40% beginning in March. Nintendo plans to increase workers' base pay by 10%.
At the parliament hearing on Friday, the BOJ's new leadership team seemed to point to a gradual transition and emphasized being "creative" in policy. Although Mr. Ueda did mention that there are occasions that policy decisions need to be made with a "surprise" and outgoing Governor Kuroda demonstrated a fondness for abrupt tactics during his tenure, the chances that current Governor Kuroda does something at his final meeting on March 10 are very small. It is more likely that the markets may begin to price in the risk of a change beginning with Ueda's first meeting as Governor on April 28. The potential for volatility in global markets stemming from changes at the BOJ in the coming months could be significant, overshadowing the impact of future Fed's actions.
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