Mind the Gap: Why are investors closely watching the BoJ actions?

Since 2016, Japan has held its key policy rate at -0.1% and introduced its Yield Curve Control (YCC) policy which targeted 10-year yields to be held at near zero, as a mechanism to combat deflationary risks - lower rates begets corporate borrowing, which in turn drives economic growth. The initial 0.5% cap on its 10-year government bonds was raised to 1% in July after June's CPI print showed headline inflation in Japan coming in at 3.3%, outpacing U.S. inflation print at 3% Y-o-Y. The BoJ however remains cautious on rolling back its ultraloose monetary policy as officials pointed out that inflationary pressures are driven by the higher cost of imported commodities, rather than an increase in underlying demand. The market reacted by selling off 10-year Japanese government bonds, sending the 10-year yields up to the highest level in nine years at 57bps. While the Yen ended the day trading flat at 139.58, news of a more flexible YCC regime sent volatility shocks in the USD/Yen currency pair.

But why is the prospect of the BoJ reversing course on their YCC policy so important that it sends jitters through the fixed income (and equities) market? Currently, Japan is the only country with interest rates in the negative territory. Even China, which is currently facing deflation, has its one-year loan prime rate at 355bps, about 245bps above that of Japan. The wide interest rate gap between Japan and other markets, has put downward pressure on the Yen, as investors sell off their Yen holdings to invest in countries offering higher yields.

Japan is the largest investor in the United States

Source: Bureau of Economic Analysis | Japan accounts for about14% of the $5.25 trillion worth of foreign direct investment in the U.S. as of 2022.

Depressed yields in their home country have driven Japanese investors to invest in overseas operations, as foreign earnings are more profitable. In 2022, Japan was reported to be the largest investor in the United States. Between 2015 to 2022, Japanese investors have redirected their focus from China to the U.S., amid growing political tensions in China (FT). Nevertheless, while dollar investment returns may be attractive, the hedging costs these investors face on their USD/Yen exposure are costly as Yen value takes a hit on the back of decreased Yen demand. Hence, if the BoJ were to lift its YCC, this would make investment returns at home more attractive - Japanese investors can invest and fund their operations in their domestic currency without the exposure to foreign currency markets. Bearing in mind that the Japanese makes up about 14% of foreign direct investments in the U.S., if Japanese investors were to pull back on their foreign investments, this might cause a sell off in U.S. equities. In the rates market, increased investment in Yen would result in a higher demand for Yen, resulting in a dollar sell off against the Yen.

Historically low Japanese interest rates resulted in short Yen positioning

Source: Investing.com | Higher yields offered in the U.S. bond markets and a stronger dollar result in attractive gains on a carry trade funded by borrowing Yen and investing in USD. Yield spread calculated by subtracting 5Y Japan government bond yields from 5Y USD government bond yields, higher spreads reflect higher interest rate differential.

Yen carry trades, i.e. borrowing Yen to invest in higher yielding currencies such as USD bonds have been attractive. For instance, yields on 5Y Japan government bonds as of 10 Aug was 0.18% while that of U.S. was 4.2%. That means, an investor can borrow cash from the Japanese bond market for 5 years at about 0.18% (plus a spread determined by the asset swap market); and invest in U.S. bonds to earn an annual rate of about 4.2%. Assuming the dollar does not fall significantly against the Yen, which has been the case for the past few years, said investor can earn the interest differential along with any gains in the Dollar rally against the Yen. As a result, there has been a build up of short Yen positioning among hedge funds. Hence, carry traders are closely watching any signs of the BoJ easing on its YCC, as an increase in Japan bond yields leading to a Yen rally can post significant crash risks to these carry trades. Crash risk in a carry trade is the risk of large losses as a result of the funding currency appreciating significantly to the investment currency. In our discussion of the Yen carry trade, Yen appreciating against the USD will result in the Yen borrower having to repay more in Yen than the investor has earned from investing in USD.

BoJ looks set to keep its Yield Curve Control policy - but not for long

While the Japan's CPI print in June showed inflation numbers higher than that in the U.S., Japan's wholesale inflation slowed in July. Wholesale inflation as measured by the Producer Price Index (PPI) tracks prices of goods from the supplier's perspective. Thus, it captures potential price changes that consumers will see in stores as suppliers usually pass on cost increases to consumers. Japan's wholesale inflation eased for a seventh straight month, owing to the Japanese government's subsidy in utility bills.

Japan is a large energy importer - it imports 90% of its energy needs which is mostly priced in dollars. Hence, high energy import costs seen in the past year is the largest contributor to inflationary pressures in Japan. Seeing that the crude oil market right now is in backwardation, (the price for futures contracts in oil are lower than the spot price), inflationary pressures from the energy market might ease in Japan. Hence, the BoJ is not under imminent pressure of increasing interest rates on the back of high inflation.

Nevertheless, I think that the YCC policy in Japan may not be sustained well into 2024. Japan lags other advanced economies such as the U.S. in replenishing its fiscal deficits accumulated from fiscal stimulus granted during the pandemic. Japan's government budget deficit stands at 6.4% of its GDP while the U.S. goverment budget deficit is at 5.8% of its GDP. (Trading Economics). Hence, the Japan government will have to fund its economic expansion plans with revenue, that is by encouraging the return of domestic investors and attracting foreign investors. Moreover, with the high interest rate differential between Japan and the U.S., there will be pressure from the government to prevent continual depreciation of the Yen as the USD/Yen currency pair prods the 145 resistance level on the close of trading day 11 Aug. Japan's Finance Ministry has already intervened three times to prop up the Yen in 2022. In conclusion, investors will be closely watching the BoJ for any indications of easing on the YCC policy - while an imminent reversal is not expected, the BoJ will be gradually lifting its cap on government bond yields as it looks to attract investments.