The significance of BOJ’s regime change

US stock indices touch new highs on better trade talk prospects
US stock indices continued their march towards record highs, as prospects for more gains and sectoral rotation out of defensives towards industrials and financials have gained more momentum. Despite still some uncertainties lingering about removal of US tariffs that China deems as a precondition to a Phase One trade agreement, we continue to think it is now in the interest of both parties to agree to the first stage and kick the can on stickier points to next year. Although not all tariffs might be removed, chances  of more import duties have fallen significantly, providing the market with some visibility. 

Japan looks poised for further gains but we focus this week on BOJ
With global economic activity showing signs of improving, mixed earnings results mostly out of the way and Fed’s decision to pause received favourably, we don’t see much to be cautious about. Indeed, we have become increasingly bullish about our own market in Japan which we feel is poised for much more upside, a stance we first adopted in late August after 20 months of being fairly negative. However, this week we really want to focus on Japan’s changing monetary policy which we believe is hugely under-appreciated.  

BOJ’s policy shift since early September looks hugely significant  
We remain highly encouraged by BOJ’s efforts to steepen the yield curve by tapering longer dated JGB purchases from early September which we actually believe helped trigger the initial global bounce in government bond yields. We think BOJ’s shift in stance towards a more aggressive yield curve control came after months of pressure from many financial industry heads, correctly arguing that without a healthy financial system, just lowering rates is not only futile but brings with it systematic risks. With BOJ  and MOF having been alarmed by banks’ surging real estate loan assets and more recently their voracious appetite for risky CLOs, the bank had to finally abandon its unrealistic inflation target and its expected time-line and cautiously begin tapering.

Most economists still don’t get it!
This important change in monetary policy has been somewhat muted by BOJ’s own face-saving narrative that it is ready to inject much more liquidity and lower rates if the economy warrants it. This has confused many Japan economists, most of whom have not fully caught on how big a change is taking place. However, we suspect the riddle of central bank’s contradictory signals lies with the Japanese currency and one which has not at all acted as one would have expected once BOJ tapered. 

Weaker yen comes as a huge relief as BOJ tapers
In fact, the yen has only weakened since then helped by a growing ‘risk on’ appetite while technically, the Y$ rate has just broken above its 200 day moving average, looking poised to advance towards 110. We believe this has come as a huge relief to BOJ whose governor, Kuroda-san has openly encouraged the government last week to provide a fiscal boost and most importantly, for MOF to print more longer dated bonds in helping his cause in steepening the yield curve. 

Current curve in Japan suggests much more upside for long term rates
To put things into perspective, since early September, yields on 10 government bonds of the US and Germany have jumped by 36% and 65% respectively. During the same period, the equivalent JGB yield has risen by a whopping 80% and it is quickly approaching zero. However, what is even more interesting is that despite this major reversal out of curve inversions, the difference between Japan’s 2 to 10 year yields is only 14bps versus 26bps in the US and 62 basis points in Germany. We think this simply shows that with the blessing of BOJ and as long as the yen behaves as well, Japan’s long term rates are likely to surge further, helping Japanese financial stocks to continue to outperform.