— Zürich, August 4, 2023, FiPAX —
Recently, the Bank of Japan (BoJ) has undertaken extensive purchases of Japanese government bonds. This has affected the trading and liquidity of these bonds on the stock exchange. Now, the BoJ is adjusting its monetary policy.
As part of its loose monetary policy, the Bank of Japan (BoJ) has conducted substantial purchases of Japanese government bonds, thereby steering the 10-year interest rate within a specified range. The functioning of the Japanese bond market has been increasingly restricted by the central bank’s control. Over half of the government bonds are now owned by the BoJ, which has led to reduced trading activity on the stock exchange and decreased liquidity. Ultimately, this prompted the Japanese monetary authorities to make an adjustment.
Although the central bank is keeping the target range for the 10-year interest rate at -0.5% to 0.5%, a range it had expanded in multiple steps before, it now refers to reference values instead of rigid boundaries. Bond purchases for yield control will now be flexibly employed above the target range. The critical defense line now lies at a yield of 1%.
Through this gradually more flexible interpretation of the target range, the so-called yield curve control is being weakened, allowing market forces to regain the upper hand.
Changes in Financial Flows At first glance, the adjustment of the monetary policy direction might appear minor, but the significance of this decision for financial markets cannot be underestimated. Japanese investors have invested over three trillion US dollars abroad in search of higher returns. They are significant holders of government bonds and stocks. The high costs of currency hedging are making these investments increasingly unattractive. With the rising yield levels in Japan, a portion of these assets will likely flow back from global markets to the domestic market. This could put pressure on markets where Japanese investors hold substantial portfolios.
Selective Investment in Japanese Government Bonds
In contrast to many regions where yields are likely reaching cyclical highs, Japan has been operating in a low-interest environment with moderate yield increases. This period of calm is likely coming to an end in the Japanese government bond market. Soon after the announcement of the monetary policy decision, yields for 10-year bonds have exceeded the previous upper limit of the target range.
In the near future, market participants will gauge how strongly the BoJ defends the yield level. A surge to the upper limit of 1% is unlikely to happen without resistance from the central bank in the short term. Other maturities that are not the focus of the central bank’s attention will be less affected by the new monetary policy direction. The global economic slowdown and repatriation of assets are likely to ensure more stable yield conditions for 30-year Japanese government bonds, for example. Therefore, investors should approach the purchase of Japanese government bonds selectively.
Declining Yield Disadvantage Supports Yen Recovery
The BoJ’s ultra-expansive monetary policy has weighed on the Japanese yen for years. This has been accentuated by the global interest rate hike cycle over the past one and a half years, as Japan’s yield disadvantage against other regions has become even more pronounced. The purchasing power parity-based valuation is historically low, not only compared to the USD. With the adjustment of the yield curve control, Japan’s yield disadvantage against the global government bond markets is expected to decrease somewhat, benefiting the yen. The global economy is projected to cool down further in the second half of the year, putting pressure on global government bond yields. From the beginning of 2024, the first interest rate cuts are also anticipated in other industrialized countries. In an environment of reduced yield disadvantage, a relatively robust economy in Japan, and increasing demand for safe havens, the yen is likely to appreciate visibly over time, reducing its undervaluation.