Markets prepare themselves for new Bank of Japan governor’s first policy decision

“After two full terms, the eight-year Kuroda era is over and the Bank of Japan will make its first monetary policy decision under his successor and new governor, Kazuo Ueda, on Friday, but although the Governor is different, the issues remain the same,” says AJ Bell investment director Russ Mould.

“Mr Ueda is already hinting that he wants to keep policy loose to ensure Japan does not slip back into its old, deflationary ways, but while he wishes to be ‘creative,’ to use his word, the new Governor must also keep a close eye on both the currency and bond markets and keep them sweet.

“How this struggle between traders and the Bank of Japan plays out could have implications for central bankers and monetary policy in London, Washington, Frankfurt and elsewhere.

“Unlike the US Federal Reserve, the European Central Bank and the Bank of England, the Bank of Japan is yet to raise interest rates and it is yet to officially try to sterilise Quantitative Easing and launch Quantitative Tightening, whereby its balance sheet starts to shrink.

“The Bank of Japan’s zero-interest-rate policy (ZIRP) dates back to 1999 and QE to 2001.

“Those dates could be a clue as to how hard Western central banks might find it to put these policy tools back in their box, at least on a sustained basis. The US Federal Reserve is already getting a flavour of this as core inflation remains sticky on one hand, but higher rates, improved returns on cash and tighter liquidity pressure the banking system on the other (or at least its weakest links) and also cool some of the hottest spots of the financial markets, including initial public offerings (IPOs), Special Purpose Acquisition Companies (SPACs), meme stocks and cryptocurrencies.

“Moreover, the Fed is now admitting that a mild recession is indeed possible in the USA in 2023, and the Bank of Japan’s experiences show how it finds it hard, if not impossible, to tighten monetary policy for long before something, somewhere, goes wrong.

“In 2016 it even launched QQE, or Quantitative and Qualitative Easing, so it could bring in Yield Curve Control (YCC). Under YCC, the BoJ stated it would buy unlimited amounts of Japanese Government Bonds (JGBs), and therefore in effect print unlimited amounts of money so it could bend Japan’s fixed-income markets to its will and hold the yield on the benchmark 10-year JGB below 0.25%.

Source: Bank of Japan, FRED – St. Louis Federal Reserve, Refinitiv data

“After seven years of that, even Japan has begun to see the sort of inflation for which its central bank has strived after decades of near-deflation in the wake of the debt-fuelled equity and property bubble that finally popped as the 1980s ended and the 1990s began.

“At 3.2%, inflation in Japan stands above the Bank of Japan’s 2.0% target, but the rate is cooling and Mr Ueda seems more concerned about this than he does about an overshoot to the upside (which in some ways is understandable given Japan’s huge sovereign debts, which would become a crushing burden in the event of deflation).

Source: Refinitiv data

“However, the relentless fight against deflation is coming at a cost.

“The yen tanked in 2022, hitting its lowest level against the dollar since 1998, and it did so just as the bond market rebelled against the ongoing QQE and money printing.

Source: Refinitiv data

“Something had to give, and the Bank of Japan blinked. It decided to support the yen, perhaps in the view that a collapse in its currency could import more inflation than it would like, especially given Japan’s reliance upon foreign supplies of crude oil for its energy. The Bank of Japan raised its cap on the 10-year JGB yield to 0.50% from 0.25%, so it did not have to buy quite so many bonds and print quite so much money.

“But that did not ease the pressure for long. The yen has rallied by some 10% from its lows, but the yield on the 10-year JGB flew out to 0.50% straight away. Bond vigilantes continue to probe that mark and test the BoJ’s commitment to defending it.

Source: Refinitiv data

“The job of deciding how best to manage the currency, the national debt, the BoJ’s balance sheet and its JGB holdings now falls to Mr Ueda, although his initial public comments suggest that he may start by maintaining the course set by his predecessor.”

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