The market vs. the BOJ, as the Japanese central bank disappoints

There was no change from the Bank of Japan at its meeting this morning, interest rates remain at -0.1% and it is continuing with its yield curve control (YCC) policy for now. Interestingly, the outgoing BOJ governor stuck firm to his policy for his penultimate meeting as governor. It appears that for BOJ Governor Kuroda, he will end his tenure as he began it 10 years ago: by controlling government bond yields. Governor Kuroda leaves a big job for his successor, finally normalising monetary policy, but for now, the BOJ remains out of synch with its global peers like the Fed and the ECB.

BOJ flashes the cash to support YCC

What is so astonishing about the BOJ’s actions on Wednesday is that it sets the Bank up for another clash with the market. Last week the BOJ launched its biggest ever daily intervention in the bond market to defend the 0.5% limit that it has set for 10-year bond yields. Over the past month the BOJ has deployed the equivalent of 6% of Japan’s GDP in attempting to keep the Japanese bond yield within target range. This is approx. $265bn and is a totally unsustainable sum. Everyone knows they can’t keep this level of intervention up, the question now is, when will the market call the BOJ’s bluff?

The market vs. the BOJ

So far, the Japanese bond market is behaving. The 10-year bond yield sunk on the back of the BOJ decision, largely because there had been some expectation that the BOJ could drop YCC at this week’s meeting. Thus, the decision not to change policy caused an immediate whipsaw in the market with both the yen and Japanese government bond yields falling sharply. USD/JPY was trading at 131.40 ahead of the BOJ meeting and sunk to a low near 127.50. However, by the end of the European session, the yen had clawed back some losses towards 129.00. Likewise, the 10-year bond yield also rose to 0.42%, after initially dropping below 0.36%. Thus, could the market be setting itself up for further speculative moves against the BOJ’s policy and to push yields and the yen higher? We think that there is a high chance that this will happen, and it could lead to further volatility ahead.

Why the BOJ matters for investors, and US stock markets

While Japan’s monetary policy may be out of synch with central bank policy in the West, it’s policy decisions matter for all investors. It is a big market that attracts a lot of foreign speculative interest. If the market decides to move against the BOJ, and the yen continues its march higher, then this could further weigh on the dollar. USD/JPY is a large component of the dollar index, and expectations that the BOJ would ditch YCC have been anticipated for months. This is one of the reasons why the USD index has fallen some 12% since the end of October, and it has fallen 3% on a broad basis since the last BOJ meeting. A weaker dollar has big ramifications for global markets as it makes US investments less attractive to foreign investors, if the returns must be converted back to a domestic currency that is rising versus the USD. Thus, watch out for yen volatility in the coming days and weeks, as it could spill over into other asset classes, especially if it weighs on the USD.

What next for the BOJ

Taking a broader view of BOJ policy, Governor Kuroda said that changes to YCC announced last month still had to feed into the market, thus, justifying his decision to do nothing at Wednesday’s meeting. The BOJ raised their short-term inflation expectations, while lowering their long-term expectations for price growth in Japan. However, with headline inflation rising at its fastest pace for 40 years, and core inflation also above the 2% target rate set by the BOJ, YCC is getting increasingly hard to justify, and is likely to be discarded or changed in the coming months, in our view.

UK inflation heaps pressure on the BOE

Elsewhere, UK inflation moderated for a second month to 10.5% in December. This is above the German inflation rate and the EU harmonised rate of 9.2%. Core inflation in the UK also dropped to 6.3% from 6.6%, however, headline inflation continued to rise by 0.4% in December, largely driven by food prices. This must be chaffing for the BOE, as it means that the ECB and the Fed have a slightly easier job in the months ahead. It also heaps the pressure on the BOE for its February meeting to hike rates by 0.5%, especially after surging wage growth for the 3 months to November, when wage growth rose by 6.4% on an annualised basis. This could lead to a divergence between western central banks, as there is growing speculation that the ECB and the Fed could drop the size of their rate hikes to 0.25% when they meet in the coming weeks. This explains the economic drag forecast for the UK, relative to its European and American peers.

Goldman Sachs loses its shine

Elsewhere, US stocks closed a notch lower on Wednesday, and as mentioned above, the USD gained on a broad basis, however, it gave up some gains by the end of the European session. Goldman Sachs failed to make much of a recovery on Wednesday, after dropping some 6% on Tuesday on the back of disappointing Q4 earnings. Its Q4 earnings were down some 69% last quarter. Investors have been looking for more clarity from GS execs about the direction of the company, after its consumer lending unit has failed to produce profits. Its heavy reliance on M&A fees and its investment bank are not performing well in the current environment. Perhaps the new normal, where the Fed doesn’t step into support falling markets doesn’t suit GS for now. Investors are also not willing to give them the benefit of the doubt, and we expect that GS could underperform the US banking sector for some time until it develops a new strategy that can work in all macro environments.