Yen’s derating continues as do BOJ’s policy errors

Japan’s central bank left its monetary policy unchanged with its governor, reiterating the view that the bank thinks inflationary pressures will fall off below 2% and Japan’s economy is still too fragile for its zero-rate policy to change. BOJ’s refusal to adjust its inflation outlook based on its insistence that the trend will prove transitional has once again left it on the sidelines, and the yen looking poised for another big round of depreciation. 

We have long argued that policies of Kuronomics have not only failed to help Japan’s domestic economy but it has caused big anomalies in Japan’s capital markets that need urgent fixing. The obvious one is allowing longer term rates to be determined by market forces. This is especially the case as Japan’s institutional investors are looking to pounce on buying more JGBs at higher yields, ensuring that rates will not spike up too much. 

The bank’s inaction comes in the face of strong evidence, not only of higher rate of core inflation but what looks to be the start of big nominal wage gains in Japan which was once a precondition for BOJ to normalise. We had argued that even if BOJ’s “cost push” thesis proves right, leaving rates at zero is a very dangerous gamble, especially as other central banks are tightening. 

However, more recently, we have come to the conclusion that BOJ’s policies are likely heavily influenced by political considerations despite its boasts of independence. With Japan’s government pledging huge spending plans with no plans yet put forth in how to pay for this big expansion in Japan’s budget, we suspect MOF is petrified of rising government financing costs which not many had seen coming after decades of deflation.

Indeed, it seems that Abenomics’ entire premise was based on rates staying low for long term. Worth adding that almost a quarter of Japan’s budget now is allocated to refinancing its debt which has risen to over 250% of GDP. Moreover, BOJ’s aggressive QE has now left the bank owning 60% of all JGBs. 

Looking back, Kishida’s first choice for the new central bank’s governor, Amamiya-san was a strong indication that the establishment wants Kuronomics which he was a co-architect of to continue. We think the choice of Mr. Ueda must have come with some reassurances that under his leadership, the bank will not dismantle the monetary experiment anytime soon. 

The idea that BOJ might not be data dependent, at least for the foreseeable future has huge economic implications, not only in terms of direction of Japan’s currency, which previously enjoyed the merit of being a safe haven but also to ensure that inflationary pressures don’t become embedded and further eat into household spending.  But, we have also argued that if BOJ’s monetary policy doesn’t change as we had expected it to do by now, the markets will simply force the issue which will prove more painful.

The first battle on their hands is to quell the current yen turmoil. Some suggest that the dollar/yen rate is unlikely to test the 150 levels of last October when MOF ordered BOJ to intervene. However, at that time there was a growing expectation that a monetary policy change was at hand, with BOJ having tweaked its YCC in December and Kuroda on his way out to retirement.

Indeed, at the start of the year, we had predicted that the yen should strengthen further towards 120 level to the dollar as policy change should lead to big repatriation of funds. However, with Ueda practically giving the green light to speculators to raise their yen carry trade positions, and with no obvious off-ramp, we think MOF will be forced into action soon to support its currency once again. 

We suspect the second battlefront will likely be the JGB market as investors could re-test BOJ’s resolve to defend its YCC as weak yen brings with it more inflationary pressures. This creates a vicious feedback loop that could only ultimately break once Japan’s monetary authorities move towards normalisation, and more in line with other key central banks.