Yen strength likely with further BoJ ill communication, asymmetric risks

This post previews Wednesday’s highly-uncertain but very important Bank of Japan policy meeting, featuring the Comprehensive Assessment of monetary policy. Overall, there’s a strong risk of BoJ disappointing dovish market expectations thereby generating Yen upside and a bond market sell-off (although the FOMC decision will also impact) and smaller market moves are likely should the BoJ try to surprise on the dovish side. The main points are:

  • Even though BoJ policy thus far hasn’t propelled the Japanese economy out of its low-inflation state, Kuroda et al seem very unlikely to change tack. Recent comments indicate that the Comprehensive Assessment could be interpreted by the market as a back-slapping PR exercise hoping to influence household/firm behaviour. That would fail to eliminate the dissonance with financial market participants’ scepticism.
  • Indeed, declines in financial market and survey-based inflation expectations, and the adverse reaction to January’s NIRP, indicate a worrying nascent loss of BoJ credibility.  The associated recent rises in Japanese real interest and Yen strength can be self-reinforcing.
  • The BoJ board faces difficulties reaching a consensus on fresh measures this week, hence likely disappointing dovish market expectations and reinforcing the likely (overly) sanguine Comprehensive Assessment.
  • That would tend to further stoke market concerns about the limits of monetary policy being approached and hence potentially reinvigorate the recent ECB-inspired global bond market sell-off (which has abated somewhat in recent days).
  • Combined with higher risk aversion, that will likely provoke JPY upside. USDJPY falling to around/below 100 is possible, while riskier currencies (GBP, AUD, EM) could be hit most and funding currencies (SEK) could benefit absent offsets from a dovish Fed.
  • Going forward, the BoJ faces a major dilemma in finding a combination of measures which support activity but do not damage banks. Further interest rate cuts, skewing the maturity of JGB purchases (to avoid yield curve flattening) and increasing riskier asset purchases all face constraints.
  • Nevertheless, BoJ comments indicate that the focus will likely to shift back towards interest rates as the main policy instrument, to likely market scepticism, although QQE tapering is not close.
  • It’s also possible that the BoJ could again extend the period over which it expects to hit the inflation target.  More radical steps options such as yield caps, price level targeting or helicopter money seem highly unlikely to be currently on the BoJ’s radar.
  • Indeed any initial Yen depreciation and bond market rallies on dovish BoJ surprise that falls short of true “shock and awe” will be vulnerable to relatively-quick unwinds.
  • It would be a major surprise if the Fed didn’t stand pat this week and shift down the dots plot this week (only a 20% chance of a rate hike is priced), given recent divergent FOMC views (Yellen’s and Rosengren’s more hawkish shifts versus Brainard’s continued dovishness) and disappointing recent US activity data. But it may well be a “hawkish hold”, leaving open the option of a December rate hike, even if markets remain sceptical.

The drugs don’t work, as the BoJ suffers from ill communication

The unfortunate bottom line for the BoJ is that inflation has remained stubbornly low (CPI ex food and energy was only 0.3% y/y in July and falling, see Chart) i.e. far from the BoJ’s 2% target despite its unprecedented ¥80 trillion per year QQE purchases and negative interest rate policy (NIRP). The previous inflation support from the higher import prices associated with the Yen’s rapid 2013-15 depreciation has reverted to import price deflation as the Yen has re-strengthened. And that will likely drag down overall CPI inflation (ex food and energy) in the coming months unless it reverses – given the lags involved and the lack of domestic inflationary pressures. Contractual cash earnings were, after all, running at a measly 0.3% y/y in July.


The renewed Yen strength has itself been driven by the BoJ’s mis-firing policy as shock and awe has morphed into considerable market scepticism. The negative interest rates policy (NIRP) introduced in January backfired as the market concluded that the adverse impacts on banks’ profitability (despite the BoJ’s tiering scheme) outweighed the domestic demand boost. The perceived unsustainable nature of the policy, with some viewing it as an act of desperation (recall that Kuroda had previously implied that NIRP was unworkable) underpinned the Yen appreciation and hence gave further impetus to import price deflation.  The BoJ’s July announcement of increased ETF (equity) purchases also disappointed, being viewed as having minimal macro benefits.

Inflation expectations look concerning, mutually reinforce Yen strength

Moreover, it’s notable that both survey-based and financial market inflation expectations have been low to falling (see chart). Such developments indicate a worrying nascent loss of BoJ credibility.  Ideally, the BoJ would fight this with more aggressive and effective policy easing.  But, as discussed below, effective easing aren’t easy to find.  And in any case the BoJ could blame at oil price falls and market factors affecting inflation breakevens (although Draghi recently admitted that this was a stretch for the fall in EA inflation breakevens).


But inflation breakevens have actually fallen more than nominal rates, so Japanese real interest rates have risen in recent months.  That’s both bad directly for macro prospects and supports Yen strength (given that US and EA real interest rates have continued falling, see Chart above). And given that such Yen strength feeds into import price deflation and hence lower inflation breakevens this dynamics can potentially become self reinforcing.

Comprehensive Assessment could be interpreted as back-slapping PR exercise; policy seems likely to refocus on rate cuts  

Despite this, the BoJ appears to remain optimistic about the outlook and that it’s policies are net beneficial.  They could well point to continued falls in nominal interest rates since the start of the year as evidence that the policies are working, even though real rates are actually up, the tiering policy protecting bank margins and falling non-performing loans easing the pressure on banks.

Overall the BoJ faces a major dilemma in finding a combination of measures which support activity but do not damage banks. Indeed, last week Japan’s Biggest Bank (Mitsubishi UFJ Financial Group) urged BOJ to weigh policy side effects.

But Kuroda’s 5 September speech somewhat pre-empted the Comprehensive Assessment by arguing that there was thus far little damage to financial intermediation from NIRP, and that policy could be extended further.  Specifically, Kuroda stated that “There is no free lunch for any policy. That said, we should not hesitate to go ahead with (additional easing) as long as it is necessary for Japan’s economy as a whole.” And “There may be a situation where drastic measures are warranted even though they could entail costs” and “there is still ample space for further cuts in the negative interest rate”.  Similarly BoJ Deputy Govermor Nakaso argued that a static and uniform judgment that rules out any further deepening in the negative interest rate in view of financial institutions’ profits wasn’t the right approach.

This suspicion that the BoJ will shift it’s focus back towards interest rates as the marginal policy tool was reinforced by last week’s Nikkei newspaper report that negative interest rates will be the “the centrepiece of future monetary easing”.  In principle the BoJ could further offset the adverse impacts of negative rates by following the ECB approach of offering subsidised loans (complementing the tiering policy). But Kuroda has also been clear that the Comprehensive Assessment will not result in any reduction in policy accommodation.  So it’s extremely unlikely that there will be any discussion of tapering of the QQE programme for at least a few months.

But overall there’s a strong danger that Comprehensive Assessment could be interpreted by the market as a be back-slapping PR exercise with few major critiques. While in principle that could in principle usefully support households and business confidence, such a sanguine conclusion seems very unlikely to bridge the gap to financial market participants’ scepticism about BoJ policy.

Apparent internal BoJ divisions reduce chances of immediate policy move: likely near-term bond market sell off and JPY upside

Media reports highlighting apparent divisions within the BoJ Board on future easing measures mean that there’s a substantial risk of the BoJ board failing to reach a consensus on easing measures this week.  Specifically, the WSJ reported that seven supporters of easing on the nine-member BOJ policy board are split on how to ease. Indeed, the BoJ will be tempted to delay more substantive BoJ easing discussions until the next BoJ Outlook report, due on 1 November.  In July they predicted growth of around 1% in each year until FY2019 and inflation rising to target by end of FY2017 i.e. giving them little reason to immediately ease (although they will want to control .  Abe’s economic advisor Hamada also recently argued that the BoJ should wait to see what the Fed does before contemplating its next policy decision.

Such immediate BoJ inaction would likely disappoint market expectations and hence potentially further stoke market concerns about the limits of monetary policy being approached.  So the recent hawkish ECB-inspired global bond market sell-off, which has abated somewhat in recent days, could be be reinvigorated with JGB yields likely rising most.

Such relative yield moves will, combined with higher risk aversion, likely provoke JPY upside. USDJPY falls to around/below 100 seems possible in this scenario.  Riskier currencies (GBP, AUD, EM) could be hit most in a risk-off environment, while funding currencies (SEK) could benefit as some carry trades are liquidated.

That said, the BoJ will want to avoid unnecessary excessive market moves, which could conceivably tip the balance in favour of a small interest rate cut.  And obviously the BoJ has form on surprising the market.  But that seems pretty unlikely this time around.  So Kuroda will likely resort to strong dovish hints: reiterating that further BoJ action is possible, and directing the markets to the November meeting. Indeed, on 5 September Kuroda argued that the domestic economy may need “drastic” monetary easing to move toward the 2% inflation (warning that there would be costs and that some sectors could suffer). So further BoJ easing seems likely in the coming months: it seems like a question of time, with interest rate cuts taking the lead.

With Kuroda, however, it’s impossible to completely rule out the possibility that the press leaks about BoJ Board disagreements are a cunning plan to maximise the impact of a surprise policy easing on Wednesday.  But if that easing is a limited form of “more of the same” (small rate cuts) then the market will likely quite in any case quickly see through the smoke and mirrors and potentially further downgrade the BoJ’s communication strategy. So any initial Yen depreciation and bond market rallies on dovish BoJ surprise that falls short of true “shock and awe” will be vulnerable to relatively-quick unwinds and hence should be faded.

A dovish Fed could in principle offset the deterioration in risk appetite and ameliorate the bond and FX market moves.  It would be a major surprise if the Fed doesn’t stand pat this week and shift down the dots plot, given recent divergent FOMC views (Yellen’s and Rosengren’s more hawkish shifts versus Brainard’s continued dovishness) and disappointing recent US activity data.  But it may well be a “hawkish hold”, leaving open the option of a December rate hike, even if markets remain sceptical.

BOJ QQE tweaks face constraints, but won’t be tapered any time soon

The BoJ’s apparent preference for focussing on interest rates as the marginal monetary policy tool likely reflects the fact that the BoJ’s ¥80 trillion per year QQE purchases have left it holding over a third of outstanding Japanese government bonds.  And, like the ECB, it faces prospective problems sourcing further purchases over an extended period given that.

Skewing QQE purchases towards the short end of the curve (i.e. a reverse operation twist) has been mooted as an option aiming to try and steepen the Japanese yield curve and hence help out banks, insurers and pension funds. Indeed, rumours of such a policy switch have seen the Japanese yield curve steepen in recent weeks, extending the move from around July (see Chart).  But given that the BoJ already owns around 40% of front-end bonds and around half of intermediate bonds (belly of curve) this would likely soon face liquidity/market functioning constraints. So the market would likely quickly infer that the policy couldn’t be pursued for long and hence bring forward expectations of tapering.  Indeed, the long end of the curve is the main part where the BoJ hasn’t cornered the market. But that’s for the very good reason that further depressing long yields would further damage banks etc and hence offset any activity boost.


Increasing the pace of ETF (equity) purchases from the current ¥6 trillion per year wouldn’t face such supply limitations given that it only represents around 1% of the market capitalisation. But the BoJ has seemed reluctant to pursue this option, probably reflecting risk considerations.

Purchases of foreign bonds also seem highly unlikely – given that it would be equivalent to FX intervention, which is the Ministry of Finance’s responsibility, and would in any case raise concerns from foreign governments.  Setting a yield curve target also seems very unlikely given the difficult issues it raises.  And previous BoJ comments have seemingly ruled out helicopter money.  But while Japanese inflation remains disappointingly low market participants will likely continue hoping that it eventuates.

Fiscal policy unlikely to rise to the rescue in the near term

Of course, the BoJ will be hoping that the Government will help it out by loosening the fiscal strings.  Unfortunately, while clearly better than nothing, Abe’s recent fiscal announcement seems unlikely to provide the demand fillup which would give inflation a fighting chance of rising back towards the 2% target.  It will be interesting in the following months whether, when confronted with a likely still-struggling economy and potential greater distortionary impacts of monetary easing, the MoF relents and opens the spigots.




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