Bank of Japan stuns markets with change in yield control policy

The Bank of Japan surprised markets on Tuesday with a surprise change to its controversial yield curve control policy, sparking wide swings in currency, bond and stock markets.

Traders described the move as potentially the long-awaited ‘pivot’ by the BoJ, which has become the last of the world’s major central banks to maintain an ultra-loose regime to avoid raising interest rates to combat global inflation.

“We take this decision as a big surprise as we expected a market-like widening of the tolerable range to occur under the new BoJ leadership starting next spring,” said Naohiko Baba, chief economist for Japan at Goldman Sachs.

However, in a news conference, BoJ Governor Haruhiko Kuroda denied that the latest adjustment amounted to tightening monetary policy and stressed that the central bank would not give up its yield target.

Japan’s increasingly extreme outlier status has contributed to the yen’s huge fall this year as markets priced in the differential with the US Federal Reserve.

The central bank said it would allow 10-year bond yields to fluctuate by plus or minus 0.5 percent, instead of the current 0.25 percent. She kept overnight rates at minus 0.1 percent.

Line chart of 10-year yield (%) showing that Japanese bond yields are skyrocketing

Kuroda had previously said that any change in yield curve control (YCC) would effectively result in a rate hike. But on Tuesday he said the adjustment was intended to counter increased volatility in global financial markets and improve the functioning of bond markets to “improve the sustainability of monetary easing”.

“This measure is not a rate hike,” Kuroda said. “The adjustment of the YCC does not signal the end of the YCC or an exit strategy.”

Japan’s core inflation – which excludes volatile food prices – topped the BoJ’s 2% target for the seventh straight month, hitting a 40-year high of 3.6% in October.

But Kuroda had long argued that without robust wage growth, any tightening would be premature, which is why most economists expected the BoJ to remain on course until his departure in April. On Tuesday, the BoJ reiterated its forecast that inflation will slow next year and warned of “extremely high levels of uncertainty” for the economy.

“Perhaps it is an act of generosity by Kuroda to lighten the burden on the next BoJ governor, but it is a dangerous move and market participants feel duped,” said Masamichi Adachi, chief Japan economist at UBS. “US yields are falling now, but if they start rising again, the BoJ would again face the risk of being pressured to hike rates.”

Efforts by the BoJ to defend its YCC targets have contributed to an ongoing reduction in market liquidity and what some analysts have described as “dysfunction” in the Japanese government bond market. The central bank now owns more than half of the outstanding bonds, down from 11.5 percent when Kuroda became governor in March 2013.

Kyohei Morita, chief economist for Japan at Nomura Securities, said the BoJ’s move is probably best viewed as a policy shift rather than a complete pivotal move. “Probably the BoJ wants to help reduce the negative side effects of yield curve control policies,” he said, noting that the bank’s excessive exposure to the Japanese government bond market has caused liquidity to evaporate.

“They want to reactivate this market, even at the cost of yen appreciation,” Morita said.

The yen briefly rose nearly 3 percent against the US dollar to about 133 yen, while the Topix stock index fell as much as 2.5 percent and the yield on the 10-year bond rose to 0.46 percent, its highest since 2015. In the past few weeks, the Japanese currency has recovered from a 32-year low as policymakers in the US and Europe have started to scale back the extent of their rate hikes.

Mansoor Mohi-uddin, chief economist at the Bank of Singapore, said the BoJ’s move is significant because it signaled that the central bank was considering a broader exit from YCC, adding that it would be a key turning point for the yen.

“The BoJ’s decision to raise interest rates in December 1989 resulted in a major reversal in Japanese markets,” Mohi-uddin said. “Today’s officials will be well aware of this history. It reinforces the importance of their signal in today’s markets.”

Benjamin Shatil, FX Strategist at JPMorgan, said the BoJ’s move would now cause the market to price in more policy moves even if none are actually forthcoming.

“These dynamics may start another cycle of higher Japanese yields, testing the new or higher YCC target ceiling and prompting renewed bouts of yen strength,” Shatil said. “It’s also having implications for global markets given the potential for continued reallocation of assets from overseas bonds back to domestic bonds by Japanese investors now that they offer a more attractive higher yield.”

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