Bilal’s Macroscope: Japan’s Gamble on Controlling Yields Gone Wrong

Some things last so long you forget why they started in the first place. The Bank of Japan’s yield-curve control (YCC) policy is one of those things. Back in 2016, the BoJ decided it would directly control the yields 10y bonds as well as the more standard overnight rate. Today, many people think the BoJ started YCC to keep 10y yields low as another monetary easing measure. Yet, the actual reason was to stop 10y yields from falling further! At the time, the BoJ was actually worried that the yield curve was flattening too much and hurting financial institutions, so YCC was a tool to stop that.

The Real Reason for YCC

BoJ’s first major speech in 2016 after they announced YCC said as much:

‘it is becoming increasingly evident that an excessively lowered and flattened yield curve could weaken the transmission mechanism of monetary easing by squeezing banks’ profit. In addition, a decline in expected rates of returns of insurance and pension products may have an adverse impact on consumers’ confidence.’

The performance of banks was validating this view. Japanese banks stocks had underperformed the overall index by 40% since the introduction of more aggressive QE in 2013 up until the announcement of YCC in 2016. This was caused in part by declining net interest income of banks around this period. The introduction of YCC was therefore to stop flattening the curve in order to help Japanese financial institutions.

Yet, the yield curve flattening trend in 2013-2016 period was not just a Japan issue – both the US and Euro-area were seeing something similar. And the irony was that global yield curves started to steepen of their own accord in late 2016 thanks in part to the election of President Trump and expectations of fiscal stimulus. In hindsight, the BoJ may not have needed to introduce YCC, global factors could have stopped the Japanese curve from flattening as it did for European markets.

Unlimited Buying Has Its Limits

For most of past six year, the BoJ has been able to maintain YCC as global long-term bond yields have been fairly stable. One sign of this is that the BoJ has rarely needed to offer unlimited purchases of JGBs to keep YCC in place. In 2017, it had to do this twice and in 2018 it had to do it four times. But 2022 has changed all this. Bond yields and inflation have surged around the world and upward pressure on JGB yields has been significant. The BoJ had to offer unlimited purchases a total of 177 times in 2022 – that is, for the majority of the year. And in total, it has been forced to buy JPY24 trillion of JGBs ($200bn). Yet, 10y JGB yields have continued to hit the upper bound of the YCC range.

Even the YCC widening from +/- 25bps to +/- 50bps hasn’t been enough to stop JGB yields rising. They are currently trading above 0.5%. And this has occurred even as the BoJ has constantly been offering unlimited purchases of JGBs. Most recently, on Thursday, it bought JPY 2.9 trillion of JGBs.

Moreover, the rationale for the December YCC widening was that the JGB market was dysfunctional. One measure of this is that bond yields directly bought by the BoJ are trading at different yields from other JGBs even with similar tenors. It appears that the YCC widening hasn’t done enough to stem this.  All of this suggests that the maintenance of YCC is becoming untenable.

The examples of other nations that engaged in YCC also suggest this. The RBA attempted YCC in March 2020 only to end it 20 months later in November 2021. The US tried it during World War 2 but could only keep it going for 5 years from 1942 to 1947. Meanwhile, the UK tried it for two years just after the War. The BoJ is currently in its seventh year of YCC – the longest in modern history.

All the signs are there for the BoJ to exit YCC in 2023. The BoJ is having to engage in almost daily unlimited offers to buy JGBs to maintain the policy, the JGB remains broken and the global yield backdrop argues for higher yields. As for the timing of the YCC exit, it could start with another YCC widening at the January 16 meeting and then an exit in the months after. But either way, maintaining YCC is no longer tenable.

Our Current Discretionary Trades

We like to wait until the second week of January to publish our favourite trades to start the year. This time, we have proposed seven themes, each associated with a set of trades, that we think are set to perform over the next quarter. Thus, we are adding to our portfolio:

• Rest of the world catch-up: long EUR/USD (target: 1.12) and short USD/JPY (target: 125)
• UK rolls over: UK 2s10s steepener (target: 70bp)
• Euro (bond) supply issues: sell BTP vs bund 10Y (target: 250bp)
• Aussie rebound: sell GBP/AUD (target: 1.70)
• Too much Swedish love: receive Swedish vs Euro area 2Y swaps (target: 50bp)
• No time for tech: long SPX vs Nasdaq

Meanwhile, we continue to be:

• EM FX crosses: long THB/TWD (target: 92)
• China reopening: short USD/CNH (target: 6.75),short USD/CLP (target: 820), long HSI (target: 21,000)
• EM rates rally: receive 1s5s MYR IRS (target: -10bp)

What Are Models Signalling?

We have turned bullish on EUR and JPY (vs USD), but do our models agree? Some do:

• Momentum models are net-bullish EUR/USD and net-bearish USD/JPY. They are also signalling for European equity outperformance, higher US yields, and for EUR/CHF to distance itself from parity.
• Hedge funds are coming to the idea, too. The latest CFTC data shows hedge funds exiting EUR and JPY shorts. Elsewhere, NZD and CAD saw the largest reduction in HF net-shorts.
• However, carry models disagree; EUR has entered the short side of Classic Carry.

Recent Questions From Clients

• Will the BoJ widen the YCC band or exit completely?
• Will JPY 5s20s steepen or flatten on YCC change?
• Are commodities in a new uptrend?
• How will MAS adjust policy next?
• Does short EUR/JPY work?
• What could cause US inflation to pick up in Q2?

What I Am Reading

• Amazing video of the sun
• Craziest highway interchanges of Japan
• Mapping the college curriculum across 7,292,573 syllabi. Amazing guide to what is studied.
• The haunting of Prince Harry. New Yorker review of Harry’s new book.
• Thanks to Artificial Intelligence, You Can Now Chat with Historical Figures: Shakespeare, Einstein, Austen, Socrates & More
• Scientists Have Reached a Key Milestone in Learning How to Reverse Aging
• 40 Ways to Let Go and Feel Less Pain

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)