- Japan’s economy contracted in the March quarter and inflation is moving further away from the BOJ’s 2% target.
- The BOJ meets next week amidst heightened speculation it will tweak monetary policy settings.
- Deutsche Bank says the biggest challenge for the BOJ — should it make a change — will be communicating that this is not the start of a normalisation in policy settings.
Japan’s economy contracted in the March quarter. There are signs its manufacturing sector is starting to weaken, especially those aligned to export markets, and inflation is weak, moving further away from the Bank of Japan’s (BOJ) 2% target in June.
Yet, despite that myriad of underwhelming economic readings, speculation is mounting the BOJ may tweak monetary policy settings to allow for a rise in Japanese government bond (JGB) yields, potentially leading to renewed strength in the Japanese yen.
Some think the change to the BOJ’s bond buying program, known as quantitative and qualitative easing (QQE) with yield curve control (YCC) — designed to anchor 10-year JGB yields around 0% — could arrive as soon as next week.
JGB yields have been rising in response, helping to underpin gains in Japanese yen — a scenario, if sustained, that’s unlikely to help the Japanese economy recover from its current funk.
Should the BOJ decide to tweak its QQE + YCC policy next week, it will present a communications challenge for Governor Haruhiko Kuroda and the BOJ board.
How, with inflation moving further away from it target, can it convince markets it’s not the start of a shift in normalising policy settings, following the lead provided by the Fed, ECB, BoE and Bank of Canada beforehand?
Mallika Sachdeva and Makoto Yamashita, FX Strategists at Deutsche Bank, say this will be the biggest challenge for the BOJ Board if and when they decide to make the change.
“The BOJ’s biggest challenge will be in communicating a policy change, at a time when they are moving further away from their intended target,” they say.
“Inflation has been disappointing and the BOJ is expected to revise down their price forecasts in their Outlook Report, and it has dropped its conviction on reaching 2% in a defined timeframe.
“If the market was to read a message of ‘tightening’ from any action this would be tantamount to pricing a BOJ defeat given it would be reversing policy in conditions of failure. This could mean a much stronger Japanese yen.”
It will be a challenge alright, especially given how far bond yields have already moved merely on the whiff of a potential policy change.
However, Sachdeva and Yamashita think its not an unassailable challenge for the BOJ.
“If it is able to communicate a message of sustainability — namely that they want to ease for much longer, and are making changes to ensure the viability of even more prolonged easing — the takeaway would be quite different,” they say.
“Easing less could mean easing for longer.
“Managing this messaging will be very critical for the market.”
Beyond whether the policy shift comes at next weeks meeting or later, the duo say it will have implications for not only Japanese bond markets but also those abroad.
“If the BOJ does adjust YCC in a way that allows JGB yields to rise, this would have a number of implications, including reduced demand by Japanese investors for foreign bonds,” they say.
“Demand has already fallen significantly — particularly for US bonds — driven by higher costs of hedging.
“But higher domestic yields and a steepening in the JGB curve would reduce the incentives to go abroad even further, [potentially leading to] spillovers to higher core yields globally.“
It promises to be an interesting week ahead.
The BOJ will meet on July 30 and 31. The monetary policy decision and updated economic forecasts will be released after the meeting concludes on Tuesday.
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