By Sam Vereecke & André Figueira de Sousa,
CIO Fixed Income & Fund Manager


Founded in 1882, the Bank of Japan (BoJ) is one of the world’s oldest central banks. It was initially funded with 10 million yen and granted a 30-year license to operate. During and after WWII the BoJ has undergone various changes, making it responsible for the regulation of currency, control and facilitation of credit and finance, and the maintenance of the credit system based on national policy.

Today, the BoJ’s mandate is to oversee the issuance and monetary control of the Japanese currency to ensure the smooth settlement of interbank funds and other financial instruments vital to the stability of Japan’s financial sector. Additionally, the BoJ aims to achieve price stability, contributing to the sound development of the national economy in terms of its currency and monetary framework. Financial stability is crucial for any economy to thrive.

In April 2013, the BoJ implemented a loose monetary policy, which was further increased or modified in subsequent years. This has resulted in a divergence between the BoJ and other central banks in the current hiking cycle. While other central banks began their tightening cycle in late 2021 or early 2022, the BoJ maintained its policy rate at -0.1% and its yield curve control target at a cap of 0.25% for the 10-year government bond yield.

On December 19th, markets were surprised by the BoJ’s decision to increase the cap on 10-year Japanese government bond (JGB) yields to 0.5%, up from 0.25%. This move was expected to take place in 2023, but the pressure on Governor Kuroda had been mounting as he fought to keep a lid on yields while the finance ministry and other policy agents in Japan grew increasingly concerned about the weakness of the yen. There have been increasing reports that the BoJ will conduct a policy review once Kuroda’s tenure ends in April 2023.

Japan is currently experiencing its highest inflation rate since 2014, driven mainly by rising prices for food, fuel, and utilities. However, service inflation remains low. As Japan is a net importer of commodities and other products, a weaker currency will continue to push up the prices of imported goods, adding to inflationary pressures.

Throughout 2022, the rate differential between Japan and the United States has increased due to a divergence in the two countries’ monetary policies. While the US has been extremely hawkish, Japan has taken a more dovish approach. This divergence, combined with Japan’s yield curve control framework, has had a significant impact on the currency, with the yen losing approximately 16.4% against the dollar this year. Now that the Federal Reserve (FED) is losing its hawkish momentum, Japan’s opportunistic move to shift towards a more hawkish stance is likely to have a greater impact on the currency than if the FED were still taking a more hawkish approach. The chart below shows the difference between the 10-year US Treasury bond yield and the 10-year Japanese government bond (JGB) yield (green line) and the movement of the currency (red line). Changes in the relative policy stances of the two countries are likely to have an impact on the currency.

Figure 1: Japanese yields against currency

Source: Bloomberg – DPAM, 2022

The outlook for 2023 remains uncertain, and as a policymaker, it is important to make policy changes as smoothly as possible. Unfortunately, the Bank of Japan (BoJ) surprised the market with its recent decision to increase the cap on 10-year Japanese government bond (JGB) yields to 0.5%, up from 0.25%. This move was unexpected as previous statements from BoJ members had defended the yield curve framework and downplayed concerns about the weakening of the yen.

As a result of its active buying, the BoJ now holds over 50% of JGBs and a significant amount of corporate bonds. Higher rates lead to lower bond prices, which can negatively impact the equity of the central bank. While this may not be a problem in and of itself, it could raise concerns about the solvency of the central bank and potentially require government-funded recapitalisation to maintain financial stability. On the other hand, Japanese corporates also hold large quantities of JGBs, and if the government were to increase the issuance of JGBs to recapitalise the central bank, it could put additional pressure on the already fragile JGB market, reminiscent of the gilt market earlier this year.

An important discussion that will take place early in 2023 is the succession of Governor Kuroda. Currently, the two main candidates are Deputy Governor Masayoshi Amamiya and former Deputy Governor Hiroshi Nakaso. While Amamiya is a strong advocate for low interest rates to stimulate the economy and the need for yield curve control, Nakaso has criticized the ultra-loose monetary policy and, if elected, we would expect a much more hawkish presidency.

Throughout 2022, the BoJ was fully committed to preserving its yield curve control framework by actively managing the 10-year government bond yield. Although there were a few attempts to test the BoJ’s resolve, the 10-year yield remained largely below 0.25% for most of the year. However, other asset prices not subject to BoJ intervention started to be priced differently. One indicator of this divergence was the spread between the 10-year JGB rate and the 10-year Japanese swap rate. The difference between the two reached almost 50 basis points, compared to a few basis points at the beginning of the year (see graph below). The swap rate is not yield curve controlled and therefore provides a better indicator of where the fair value of the 10-year JGBs should potentially be pricing.

From the graph below, we can see that the 10-year JGB yield (green line) moved closer to the 10-year swap levels (red line) following the adjustment of the yield curve control framework to 0.5% on December 19, 2022. The spread between bonds and swaps (orange line) narrowed, but remains elevated. Based on this, we see the recent adjustment as only the first change to the yield curve control policy and expect another adjustment of at least 25 basis points, bringing the JGB yield closer to the swap rate, in early 2023.

Figure 2: Japan – 10 year bond yield versus swap yield

Source: Bloomberg – DPAM, 2022

Monetary policy typically works with a lag and follows a specific sequence, such as ending quantitative easing (QE) before increasing policy rates. However, in the current environment, we believe it is possible that the Bank of Japan (BoJ) will normalise its policy rates from -0.10% to 0% or above while still implementing some form of yield curve control, albeit at a higher level than currently. This would make the BoJ the last central bank to exit its negative interest rate environment cycle. The wheels of change have been set in motion.


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