Analysis: Japan Unshackles Its Sliding Bond Market by Reuters

By Rae Wee and Brigid Riley

SINGAPORE/TOKYO – The Bank of Japan took a significant step on Tuesday, signaling a shift in its approach to government bond yields and effectively ending its strict control on long-term rates that had lasted for seven years.

The central bank set a new reference point at a 1% cap for the 10-year Japanese government yield, softening its previous commitment to control this rate. Investors responded by pushing yields along the Japanese curve up to their highest levels in a decade, with the 10-year yield surpassing 0.95%. Meanwhile, yields in European and U.S. markets remained relatively stable.

Marcel Thieliant, head of Asia-Pacific at Capital Economics, remarked, "The Bank of Japan today effectively abolished yield curve control," referring to the now-modified policy that had kept long-term rates artificially low.

Gone is the BOJ’s daily promise to purchase bonds at a yield of 1%. Instead, the bank has adopted a more ambiguous commitment to buying bonds, taking into consideration "market rates and other factors." This change was interpreted by market participants as a signal for rising yields.

This decision follows modifications to the BOJ’s yield control strategy in December and July, which had already suggested a gradual easing of its ultra-loose monetary policy. The yen fell by approximately 0.9% to 150.4 against the dollar, while Japanese stocks saw a 0.5% increase, particularly in sectors like insurance and banking, reflecting investor relief that more drastic measures were not announced.

The ramifications of this policy shift are expected to resonate globally, marking a gradual exit from an era characterized by extremely low interest rates. Japanese authorities will no longer be aggressively countering the global trend of rising interest rates.

This adjustment is poised to lead to higher borrowing costs for the Japanese government, businesses, and consumers. Additionally, it may reduce outflows of foreign investment from Japan, the world’s largest creditor, as domestic rates become more appealing.

Frederic Neumann, chief Asia economist at HSBC, stated that global investors would pay attention to the BOJ’s recent policy change, viewing it as a movement toward the normalization of global monetary policy.

A SHIFTING YEN

Domestic inflation is accelerating, interest rates abroad are on the rise, and a weakening yen prompted policymakers to act, leading to expectations for an increase in short-term rates. On Tuesday, two-year Japanese government bond yields jumped, reaching a 12-year high of 0.14%.

Inflation has now exceeded the BOJ’s 2% target for 18 consecutive months, prompting the bank to revise its forecasts upwards, expecting inflation to remain above this target this year and next. Moreover, the disparity between 10-year Japanese yields and their U.S. counterparts surpassed 400 basis points, the widest gap in more than 22 years, contributing to the yen trading near three-decade lows.

In October, the BOJ reportedly spent approximately 9 trillion yen in its effort to defend its yield cap. Hirofumi Suzuki, chief FX strategist at Sumitomo Mitsui Banking Corporation, indicated that the BOJ’s insistence on maintaining the 1% cap risked necessitating massive bond purchases, which could further weaken the yen.

The BOJ appears to be adopting a measured approach to ending yield curve control, in contrast to the sudden cessation seen with the Reserve Bank of Australia in 2021. As a result, the yen was left lingering around 150, with market analysts predicting that a significant rally would depend on either declining U.S. interest rates or a sufficient increase in Japanese rates to counteract "carry" trades, where investors exploit interest rate differentials between countries.

BOJ Governor Kazuo Ueda stated that there are no predetermined plans for when yield curve control or negative rates will be phased out, yet he does not anticipate the 10-year yield exceeding 1% substantially. On Tuesday, the yield did not surpass this threshold. However, Ueda acknowledged that the BOJ is prepared to "accommodate a rise in long-term interest rates that reflect fundamentals."

Market participants will likely test the BOJ’s response to rising yields to determine how aggressively the bank will engage in bond purchases in the future. Naka Matsuzawa, chief macro strategist at Nomura, commented that this change may lead to increased volatility in the global rates market, emphasizing the importance of the BOJ’s approach to purchasing operations.