BOJ’s recent indications suggest an imminent regime change

The key question we have wrestled with this year regarding our own market has been whether the secular rally in the Japanese equity universe, particularly in names trading below book and with prospects of higher payouts could overcome the external negative backdrop that we continue to think leaves exporters and multinationals that are well represented in the Nikkei index particularly vulnerable. 

Moreover, the geopolitical risks, especially in regards to export restrictions of tech to China which we have repeatedly warned about in our past notes seems to be finally gathering market’s attention and whether the Chinese hoarding of equipment will come to an end soon. To be sure, markets seem more preoccupied about the bigger picture as prospects for lower US interest rates have now been pushed out.

Markets also seem to be grappling with the tectonic shifts in the global economies moving away from free trade and low trade barriers to a more protectionist stance that may be ushering in higher inflationary trends. Meanwhile, some evidence is emerging to suggest less economic sensitivity to rising interest rates. Chair Powel’s testimony last week suggested that the US economy as a whole remains strong enough to handle more rate hikes. 

Focusing back on Japan, as we have noted more recently, we think prospects of BOJ abandoning its ultra-loose monetary policy error, before the year end has risen dramatically as the yen has been held hostage to more sell-offs should Japan’s central bank continue to suppress long term rates. We have argued this has needlessly torpedoed yen’s risk-off haven characteristics which had been a huge merit for Japan’s economy.

We also believe that BOJ’s policies have been needlessly eroding the nation’s purchasing power and raising the scope for higher imported inflation. The idea that BOJ could be simply waiting for the Fed to loosen no longer sounds believable either as “higher for longer” is becoming consensus as also suggested by the narrowing inversion of the US curve. Japan’s own ten-year benchmark yield is also rising ever closer to BOJ’s 1% line in the sand which it only recently drawn to allow more flexibility in its yield curve control. This comes despite its special bond purchasing interventions. 

BOJ’s recent change in narrative that wage hikes look encouraging and inflation is likely to go down BUT then go up again, all seem to suggest a creation of an off-ramp for the governor, Ueda-san to finally abandon Kuronomics. His latest speech at the National Credit Union Conference saying that unions have to be fully aware of the impact that changes in the interest rate environment have and conduct appropriate risk management also seems to suggest that a regime change looks fairly imminent.

We have also explained, if YCC is abandoned, we don’t see long term rates spiking too high in the near term with untethered ten-year JGB yield likely to remain below 1.5% from just below 0.9% currently. This is because there is huge pent-up demand from Japan’s domestic institutional investors as they desperately seek higher yields. 

This was more evident by recent reports from some life insurance firms buying US treasuries without hedging their currency risks which has become too expensive. It may also mean that yen’s likely immediate rally soon after a BOJ policy change may not last long should rate differentials remain too high. But we are not there yet to ponder that too deeply at this stage, especially as the initial repatriation of assets back to Japan could prove fairly big. 

Come what may, with Kishida’s government now proposing temporary income tax cuts, effectively to buy votes as his current standing in the polls remain too low for LDP’s comfort, there will undoubtedly be a big increase in JGB issuance next term to finance Japan’s expanding budget deficit already stemming from big rise in defense spending, sizable household subsidies being extended, not to mention, child bearing incentives to tackle its fast-ageing demographics.

This comes on top of increasing refinancing costs which have already swelled to a quarter of Japan’s national budget. All this may suggest that Japan’s bond yields could rise much further in the coming years but for now there seems to be strong appetite for JGBs at slightly higher yields.