The week ahead: Waiting for the BOJ

US financial markets are closed on Monday for Presidents Day, yet anticipation is brewing about what to expect from Tuesday’s Bank of Japan policy meeting. After the shock announcement from the BOJ in December that it was changing its yield curve control (YCC), allowing the 10-year Japanese government bond to rise as high as 0.5%, up from its previous cap of 0.25%, the market is poised for another big announcement, but will the notoriously cautious BOJ really rock the boat two months in a row?

After December’s shock move, what now?

The market reaction to the December shift in YCC has been huge. USD/JPY has fallen 7% since then, USDJPY has now retraced more than 50% of the uptrend from February 2022 until peaking in October 2022. The yen has rallied on a broad basis by 5% since December. Likewise, Japanese government bond yields surged after the last BOJ meeting, with the 10-year government bond yield continuing to rise in recent sessions, the yield is currently 0.51%, which is a breach of the 0.5% cap imposed by the BOJ last month. The 2-year Japanese bond yield, which is less closely followed than the 10-year yield, has also been on the move. It has burst out of negative territory and is currently trading at + 4 basis points! To put this into context, the 2-year Japanese government bond yield had traded below zero since January 2016. Thus, the recent moves in Japanese bond yields are historic and should be noted.

Japanese inflation supports further YCC adjustments

Considering the BOJ is sensitive to a rising yen and financial market volatility generally, will they have the guts to loosen YCC once more to combat rising inflation? Last week, the BOJ intervened in markets and bought $39bn of JGB’s of varying maturities, to help to bring the yield down from Friday’s high of 0.54%. It managed to supress the yield to 0.51% on Monday, however Friday’s intervention in financial markets, was its biggest one-day intervention ever. The fact that the BOJ appears to have lost control of its YCC, suggests that the market believes that it will eventually drop YCC altogether. Traditionally, yield curve control was designed to boost the Japanese economy and get it out of deflation. That is no longer a problem. Japanese inflation rose to 4% in December, which is lower than levels seen in Europe and the US, but in contrast to Europe and US where inflation is falling, in Japan prices are continuing to rise. Headline inflation in Japan has taken some time to flow through the pipeline, largely due to economic and cultural differences with the rest of the world, however, headline inflation grew at its fastest pace for more than 4 decades, while core CPI rose to 2.7%, the 7thmonth that inflation has been above the BOJ’s target rate of 2%.

BOJ still defending its bond market as it tries to iron out the kink

Thus, Japan is facing the same fundamental concerns that Western economies are facing right now, and markets are rational to assume that this will mean that the BOJ will follow more a conventional monetary policy path going forward. However, while inflation has been rising in recent months, the Japanese yield curve developed a kink. The BOJ only targeted 10-year yields, thus traders sold other durations, for example, 5, 7 and 9 – year bond yields, which pushed up their yields to a level that was higher than the 10-year bond yield. This is what the BOJ said it was trying to correct when it adjusted its YCC for 10-year yields last month.

Fireworks likely after Tuesday’s meeting

However, while the writing is on the wall for the BOJ, the fact that it made its largest ever unilateral daily intervention in its bond market at the end of last week, is a sign that old habits die hard for the BOJ. If the BOJ does not adjust policy at this week’s meeting, then expect financial markets to test their resolve, and push both the yen and Japanese bond yields higher. However, this could trigger even more intervention by the BOJ to cap yields, which could create excess volatility. Japanese markets are large, and they attract a lot of foreign speculators, thus, excess volatility in these markets could lead to some whipsaw risk off behaviour as we move through the week, which is negative for stocks and good news for the dollar.

Overall, the BOJ is at a cliff edge, if it throws in the towel on YCC no one would blame them, but there is a chance that change is happening too fast for this conservative central bank, and thus we may have to wait for the new governor, who takes their place in April, before formal change is enacted. I suspect that the market does not have the patience to wait until then.

Banks expect loan losses to rise, but JPM comes out on top

Elsewhere, the US markets may be closed on Monday, however, there is a packed calendar of Q4 corporate earnings from the US this week. This includes Goldman Sachs and Morgan Stanley on Tuesday, United Airlines and Just East Takeaway on Wednesday, Netflix, Proctor and Gamble and Costco on Thursday, and State Street on Friday, along with plenty of others. Netflix is one to watch, along with GS and MS on Tuesday. JP Morgan, Bank of America, Wells Fargo, and Citi all reported earnings last Friday. Their stocks prices all rose, however, their earnings for Q4 were a mixed bag. JPM did the best, its sales rose 6% on a year ago to $11bn, while revenues rose 18%. However, it has put aside $1.4bn in loan loss reserves as it expects a mild recession in the US where the unemployment rate rises. BOA saw a 2% rise in profits in Q4 from a year ago, while Citigroup saw profits fall 21%, although revenues rose, and Wells Fargo saw profits drop 50% last quarter due to a $3bn fine from the regulators. At this stage, bank earnings have not been as bad as expected, even if the messaging has been more downbeat than we have been used to.