- The BOJ continues to implement accommodative monetary policy, despite signs of rising inflation
- Policy normalisation would render domestic Japanese assets more attractive than foreign investments
- Since 2022, high US rates have made currency-hedged USD bonds unattractive for Japanese investors
- Fixed income investors should not be complacent with duration risk
Japan’s inflation conundrum. The Bank of Japan (BOJ) gave the world a Christmas shock in 2022 by widening the trading band for 10Y JGB yields from ±25 bps to ±50 bps about zero under its yield curve control (YCC) framework – no doubt showing that it can no longer stand idly by while its citizens deal with the rise in domestic prices. Apparently, even an economy famed for its secular stagnation – for which the term “Japanification” came about – was no longer immune to the inflationary pressures that have engulfed the globe. Notably, Japan’s CPI rates are at highs not seen for the last 30 years.
Policy at odds with reality. Such price pressures make the YCC policy – where the BOJ purchases whatever quantity of JGBs it takes to keep 10Y yields near 0% – look increasingly anachronistic; unsuited for the times they are in. As the rest of the world raced to tighten monetary policy, the BOJ worked in reverse; in effect sacrificing the JPY to support their bond markets and resulting in the c.30% decline of the JPY against the USD at its peak in 2022. While famed for being an export juggernaut in the 1980s, today’s Japan is more import reliant, and the weaker yen only stands to (a) raise imported inflation and (b) widen the already significant trade deficit observed in 2022.
The impending great unwind. The facts suggest that an exit of accommodative policy is not a matter of if, but when; given that it is no longer beneficial to have an ever-weakening yen. Yet it is difficult to imagine a stoppage or reversal of decades of QE without important financial consequences. To give perspective on the task at hand, consider that the US Fed is currently “only” reducing its balance sheet by USD95b a month (or USD1.14t a year, approximately 4.4% of annual GDP) to taper excess bank reserves. Given reserve balances of c.USD3.1t, this would take them c.33 months to bring said reserves to zero.
The BOJ, on the other hand, has amassed a gargantuan JPY451t in excess reserves. To normalise policy at the same rate as the US would imply the reduction of c.JPY164t in JGBs per year, a massive 30% of annual GDP – close to seven times the US amount in %-GDP terms. Put another way, should Japan begin normalisation immediately at the same pace as the US (in %-GDP terms), it would still take more than 18 years from today to reduce excess reserves to zero.
The unnoticed risk for bonds. It is no wonder then that policy change is consistently met with such inertia. That, however, does not absolve the fact that inflationary pressures continue to mount in the background, as large Japanese corporates are already planning sizeable domestic wage increments from this year onwards (e.g. Uniqlo, a Japanese casualwear brand announced pay increments of up to 40% for about 8,400 employees), introducing further threats of a potential wage-price spiral. We believe that the upward pressure on yields in Japan is an under-appreciated risk for fixed income investors, warranting caution on long duration exposure.
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