Violent market swings await the day the BOJ yield anchor lifts

(Bloomberg) – Even a modest shift in the Bank of Japan’s entrenched monetary policy could unleash a wrecking ball on global markets, if traders expect the last heavy pegging stopping global yields from soaring. finally move.

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Most economists expect Governor Haruhiko Kuroda to maintain control of the yield curve until he steps down in April, even as the yen declines. But there’s no denying that its political cadre has come under more pressure this year than it has at any time since its formation in 2016.

If the Bank of Japan decides to shock investors and ultimately tighten policy, they will face the turmoil inflicted on global markets by the UK’s recently abandoned economic plan, but on a larger scale.

“An abrupt exit could wreak havoc potentially both domestically and globally given the obvious reasons: the scale of the program and its history, the low level of JGB returns and the weakness of the yen,” Jim O said. ‘Neill, a former Goldman Sachs Group Inc. economist and chairman of investment firm Northern Gritstone. “If mishandled, it could have far greater global consequences than the recent British mess.”

Speculation that the BOJ might suddenly loosen its grip on benchmark bonds has been simmering since the debt sell-off distorted Australia’s yield curve control framework last year. This collapse has tarnished the reputation of the Reserve Bank of Australia, while inflating the confidence of bond vigilantes looking for new targets.

Bond Vigilantes rekindles bets on hawkish BOJ policy change

The BOJ currently maintains a 0.25% cap on 10-year yields in an effort to stimulate Japan’s stuttering economy and ensure stable price and wage growth. The bank is holding its next meeting from October 27 to 28. The base case for most economists is to leave policy unchanged.

Scrapping the YCC

In the most dramatic scenario for markets, the BOJ would abandon its framework without warning, sending shockwaves through markets around the world. The bank would let the yield on the 10-year public debt evolve freely while limiting its policy to its control of short-term interest rates.

This would lead to an increase of around 50 basis points in benchmark yields, with the most significant macroeconomic impact being a revaluation of the global term premium – the additional compensation investors demand for holding longer-dated bonds – according to Arjun Vij, portfolio manager at JPMorgan Asset Management.

“In short, we think yields on other developed market government bonds, like the US or Europe, will go up,” Vij said. Persistent Japanese demand for foreign bonds has been a significant driver of low developed market yields and “a reversal in policy could therefore lead to some unwinding of these positions.”

UBS analysts predicted this month that bonds in the United States, Australia and France would be most at risk and that a drop in YCC would send Japanese stocks into a bear market and could send 10 % American and European equities.

Their reasoning was that a shock move could accelerate a rebound in the yen, provide additional impetus for selling in global bond markets and trigger a wave of money flowing back into Japan from foreign assets like Treasuries. .

Volatility risk

Yet jarring regime change like this runs counter to the BOJ’s efforts to build sustainability into its easing framework and to keep markets stable. Some sort of event-based trigger would likely be needed to force the central bank to take this extreme course of action.

“An outright exit would create significant volatility in global rates and destabilize Japanese markets, of which pensions are a major player,” said Calvin Yeoh, Singapore-based portfolio manager at Blue Edge Advisors Pte. “I would actually expect a similar dynamic to what just happened in the UK,” if they did.

And while conventional thinking would suggest the yen would immediately soar from its current 32-year low, easing pressure on the Japanese government to step in to support it, the impact is harder to predict. , JPMorgan’s Vij said.

“It will depend on the prevailing circumstances in the market at the time of the change,” he said.

The Japanese currency weakened past the closely watched 150 to the dollar level on Thursday.

The problem is that an adjustment within the YCC is also likely to trigger a storm, such as the central bank raising its yield target or widening the range of motion around it. Either move would effectively serve as a rate hike and for economists at JPMorgan Chase & Co., that could mean wilder swings in the yen and a repatriation of Japanese funds.

If “national yields are allowed to trade in a wider/higher range, potential yen volatility will also increase as the currency tracks potentially more erratic yield spreads,” a team including Ayako Fujita wrote this month. -this. “Higher onshore yields could weigh on Japanese demand in overseas bond markets, particularly if higher yields lead to replacing currency-hedged Treasury bills with JGBs.”

Review the pressure

Another BOJ strategy could be to request a review that keeps investors guessing and then used to justify a change in policy, such as reducing the maturity of the yield it targets.

Kuroda first used this tactic long before the pandemic to come up with the YCC framework he has now. Its very existence points to the central problem of the BOJ’s inflation campaign. Despite the best intentions of ridding Japan of decades of falling prices, Kuroda’s initial asset-buying spree failed to generate the stable inflation he sought in two years.

The governor used a policy review to justify putting in place a new sustainable stimulus approach that did not involve the purchase of all Japanese government bonds and ETFs.

The most recent review before adjustments made in March 2021 lasted three months, a period that now seems implausibly long given the likely market pressure it would generate.

“Now is not the time to announce a policy overhaul,” said Shigeto Nagai, former head of the BOJ’s international department and head of Japan research at Oxford Economics. “Any such move would trigger a fierce reaction in the markets and raise expectations for adjustments in YCC, regardless of how the BOJ announces it.”

Still, a change in policy could have at least one silver lining: an improvement in Japan’s dysfunctional debt market, where earlier this month the benchmark 10-year bond failed to rise. trade for four consecutive days.

“Bonds will be sold off, with the artificially capped 10-year zone seeing the biggest selloffs to bring it in line with super long yields,” said Masahiro Ichikawa, chief market strategist at Sumitomo Mitsui DS Asset Management. “But the side effects of YCC will disappear and help the JGB market operation to recover. This is a positive impact.

–With help from Sumio Ito and Chikako Mogi.

(Updates the yen level.)

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