Key Points:
- The Bank of Japan (BOJ) has widened the 10-year yield trading range.
- There is reason to be cautious about the yen’s rally.
- Global long-term interest rates may exert upward pressure on JGB yields.
- If global yields spike, the BOJ may have to defend its yield cap.
- The BOJ has revised its 10-year trading band in the past.
- The yen remains sensitive to the spread between the 10-year JGB and the BOJ policy cap.
The Bank of Japan (BOJ) widens the 10-year yield trading range.
The BOJ announced on 19 December that it is raising the 10-year yield cap from 25 basis points (bps) to 50 bps. This change has been seen by some as the first in a series of hawkish moves from the BOJ, leading to a rally in the yen. However, caution is advised as there are potential risks to the yen’s rally.
Previously, when Japanese government bond (JGB) yields rose towards the BOJ cap, the yen weakened. The recent policy change briefly restored this dynamic, as the higher yields strengthened the currency in expectation of capital inflows. However, there are reasons to be cautious about the nascent yen rally.
While the market expects the BOJ to loosen its yield curve control (YCC) further, the bank’s next move in that direction may still be months away. Additionally, rebounding global long-term interest rates may exert upward pressure on JGB yields, leading to a weakening of the yen. The co-movements between global long-term sovereign bonds, as outlined by Governor Lael Brainard of the US Federal Reserve, can play a role in strengthening or weakening the yen.
Co-Movement in Global Long-Term Interest Rates
If global yields spike, the BOJ may have no choice but to defend its new 50 bps yield cap by creating new cash reserves to buy 10-year JGBs and reestablish curve control. However, this would come at a cost: the yen would weaken as short USD/JPY momentum unwinds. The BOJ’s intervention weakened the yen in the past when the 10-year JGB yield tested the policy ceiling, and there is a risk of that happening again until YCC ends.
Japan 10-Year Yield vs. Yield Curve Control “Ceiling”
Potential Triggers for Renewed BOJ Yield Curve Defense
As the global economy continues to evolve beyond pandemic-related disruptions, various factors can trigger renewed BOJ yield curve defense. Revived overseas growth and greater demand for energy commodities, among other factors, may offset demand destruction dynamics. For example, in the United Kingdom, the government plans to extend its energy subsidy plan into spring 2024. Japan’s economy is sensitive to global commodity prices, and a price spike could lift domestic inflation expectations and exert upward pressure on the 10-year JGB yield.
The anticipated timeline of BOJ hawkishness may be decoupled from market developments. If rising yields test the BOJ’s yield curve defense early in the first quarter, the BOJ may print money to finance yield defense at its 50 bps line in the sand. On the other hand, softer-than-expected global growth, a return to fiscal austerity among major economies, easing geopolitical tension, and falling commodity prices could lower the 10-year JGB yield and reduce the likelihood of forceful BOJ interventions. The yen remains sensitive to the spread between the 10-year JGB and the BOJ policy cap.
In conclusion, while the BOJ’s recent policy change may have boosted the yen, there are potential risks that could lead to a decline in the currency. The BOJ’s future moves in YCC, global long-term interest rates, and various market developments can all impact the yen’s strength. The BOJ has yet to signal its readiness to abandon yield curve control altogether, so it is important to monitor these factors when considering the outlook for the yen.
