Japanese stocks have been hitting record highs in recent months, with the Topix and the Nikkei 225 both reaching levels last seen in 1987. But as the central bank’s surprise move to ease yield curve controls hands yet more volatility to the bond market, could it also bring the country’s stock market screeching to a halt?
After a two-day policy meeting, Japan’s central bank on Friday 28 July held its benchmark rate at –0.1% but announced plans to “conduct yield curve control with greater flexibility” – in a move that might seem small but could in fact act as a crucial stepping-stone towards a landmark rate hike for the country. As one trader put it: “That’s one small step for the BoJ, one giant leap for Japan.”
The Bank of Japan (BoJ) has long bucked the global trend of hawkish monetary policy, with an aggressive quantitative easing strategy that has lasted almost two decades, in a bid to combat the country’s persistently low inflation rate. Friday’s move might signal a new direction for the bank, but it’s one that shouldn’t come as much of a surprise.
In fact, economists predicted this way back in April, when Governor Yazuo Ueda first took the reins.
In his first meeting as governor, Ueda initiated a comprehensive review of Japan’s ultra-loose quantitative easing program over the coming 18 months. Swiss Re Institute’s senior economist Jessie Guo and chief economist Asia Pacific John Zhu called it early on, stating in a research note exactly three months ago that: “No change does not mean unimportant… We think it is a matter of when, not if, the BoJ adjusts YCC [yield curve control].”
A piece of the continent
The decision indicates an increasing awareness of Japan’s own role in the global economy – and the understanding that it does not and cannot operate in isolation.
BoJ specifically referenced “significant downside risks” to Japan’s economic activity and prices in its Friday statement, including the impact of tightening global financial conditions on overseas economies; and warned of “extremely high uncertainties” that make it imperative for the country to pay closer attention to international capital and FX markets and their impact on its own operations.
Higher-than-expected inflation is another key factor, and the latest figures show consistent upwards price movement. The central bank believes that although consumer price increases will be counteracted by a decline in real interest rates due to its monetary easing policy, “strictly capping long-term interest rates” is likely to impact the effective functioning of its bond markets – as well as contributing to increased volatility in other financial markets. With these concerns at the fore, countering through YCC is a logical next step.
A part of the main
But despite all the noise, it should be remembered that the central bank has not actually yet made any material change. All it has done is indicate that, going forward, it plans to regard the current +/- 05% yield range for its 10-year treasuries as a “references, not as rigid limits” in its market operations.
“Obviously they left the policy unchanged, but they gave themselves room to move the rate upwards. So the talk right now is whether this is just a tweak, or is it a tide change? That’s what’s going round on the Street,” said Anthony Santostefano, director and lead EMEA equity sales and trading at Cabrera Capital Markets in New York, speaking to BEST EXECUTION.
“A lot of people feel it’s just a small dip into the water to see how markets react. But it could certainly be a first step towards raising rates – or towards normalising that concept, at least.”
Higher bond yields would bring Japan more in line with global regulatory policy, and possibly also strengthen the yen, which has been weakened by the rising interest rates in other markets. But it has wider implications. Should Japan raise its benchmark rate, to which this cautious first step represents a possible pre-cursor, the move would reverberate across the global economy – not least because of Japan’s enormous foreign debt holdings.
For whom the bell tolls
“The big issue is how it’s going to affect the US Treasuries,” agreed Santostefano. ”Japan owns around US$1trn of US government paper – are they going to repatriate money home and begin owning their own debt? If so, we might see a slide in US Treasuries, and hence, US yields jumping higher. It’s all about how long this is going to take and how the markets digest it but right now, that’s the main concern.”
The news had an inevitable impact, with 10-year Japanese government bond yields bouncing up by over 10bps following the announcement, at one point hitting 0.575%, their highest in almost nine years, while the yen floundered against the dollar before making a quick recovery. The 10-year US Treasury yield also spiked over 4%, backing up fears that a Japanese move towards normalised monetary policy could bring with it significant repercussions.
“Assuming the BoJ takes a measured approach… we don’t believe this is significant for US fixed income markets,” said Solita Marcelli, chief investment officer, Americas for UBS Global Wealth Management, in Friday comments. “However, more aggressive action could bias global yields higher. Japan is the largest holder of US Treasuries, and while JGB yields are still a long way from US yields, any meaningful increase reduces Japan’s incentive to invest in foreign bonds at the margin.”
It tolls for thee
While bond yields unsurprisingly soared on the news, equities did not escape the impact either. The Nikkei 225 also slipped by as much as 2.5% during the day, ending Friday down –0.40%, while the Tokyo Stock Price Index (Topix) lost around 1.8% during the day, but clawed it back to close –0.20% down.
This marks an unusual reversal for Japanese stocks, which have had an exceptionally strong year to date (up 22.61% and 27.38% for the Topix and Nikkei 225, respectively, as of 28 July) – outpacing most other developed markets, even if a weak yen might have eroded some of these gains for overseas investors.
According to Taku Arai, deputy head of Japanese equities at Schroders, a key driver of this performance was the call to action by Tokyo Stock Exchange earlier this year for its listed companies to start focusing on achieving sustainable growth and enhancing corporate value, while the return of (mild) inflation is another key factor. “Rather than facing a downward deflationary spiral, Japan may now be entering a sustained period of higher corporate investment, wage growth, and increased consumer spending,” he predicted in June.
Could that really grind to a halt, just because of a (potential) tweak? It seems unlikely – but the news certainly contributed to volatility in Friday trading, in Europe as well as the US.
“Whatever bleeds in from Asia is going to affect the European opens. Europe usually is more inclined to be sensitive towards China but obviously, the BoJ press conference was going on right as Europe was opening, so there was definitely some volatility. We’re still at an unquiet level right now, and the markets are still trying to figure it out,” explained Santostefano. “Japanese equities have had a strong run this year. Will the prospect of a rate increase bring that to an end? It’s hard to say.”
Asset allocation trends are likely to be crucial to any longer-term shift in equities, once the initial reaction subsides. There are already some indicators that the AI craze in the US may have (for now at least) run its course, with Bank of America’s Michael Hartnett recently categorising the craze as a “baby bubble”. US equity funds have already seen substantial outflows in recent weeks (-US$5.73bn in the week to 26 July, according to Refinitive Lipper) as investors flee a 1999-style tech rally.
“People may look at shifting a little overseas to take some profit, and that could benefit Japan – although as of today, we still see the Nasdaq up by about 1.5%. I think for the second half of the year, it’s going to be all about asset allocation,” agreed Santostefano. “Right now though, the market is just adjusting its short-term reaction to the news.”
No man is an island
In fact, the biggest impact is ultimately likely to be felt neither in fixed income nor equities, but in the FX markets, as the yen adjusts itself into a stronger global position. Back in March, Deutsche Bank predicted that the currency could surge as much as 60% against the US dollar if the central bank went ahead with monetary policy normalisation. In a research note to clients, the bank suggested that the yen could hit JPY85 per dollar assuming that the BoJ completely normalised its policy in combination with an easing of the US Federal Reserve stance.
READ MORE: Markets ‘quietly confident’ despite another Fed hike.
“Normalising monetary policy in Japan is the main reason for our view of a stronger JPY versus the USD moving forward,” agreed Marcelli.
While the yen remains up at around JPY141 (and the Fed has not yet relaxed its grip on rates), this could be the first step. In the same note, Deutsche Bank estimated that 10-year JPG bond yields could hit up to 2.5% in the event of a “full-scale” normalisation by the central bank – although 1.5-1.6% would be its equilibrium estimate.
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