Facing a deflationary/disinflationary economy, since 2013, the Bank of Japan (BoJ) has started the loose monetary policy QE to pump liquidity into the market and stimulate growth.
From 2016, the QE policy was supplemented by BoJ with the yield curve control policy (YCC):
Instead of massively buying financial assets like QE, YCC focuses on buying Japanese Government Bonds (JPB) 10Y to ensure the yield of this bond fluctuates around 0% (2016) or within a narrow band (+/- 0.25% in 2018…).
Since then, BoJ's "ultra-loose" monetary policy has facilitated enhanced liquidity for international markets: as wealthy investors from Japan poured their capital into higher-yield markets like the US and Europe.
But if the US and Europe have benefited for nearly 10 years from Japan's YCC policy, they will soon feel the pinch once BoJ reverses its monetary policy in the coming period.
At that time, what can Fed and ECB do to protect liquidity in their markets?
As promised last week, episode 2 of the series Global Economic Perspective from Viet Hustler will focus on analyzing the impact of BoJ's interest rate and monetary policy on the global economy, especially the US and Europe.
BoJ's moves in interest rate and monetary policy as Japan's economy shifts from deflation to inflation.
BoJ's stubbornness toward the yield curve control policy (Yield Curve Control - YCC).
YCC is a controlled form of QE, where BoJ keeps the 10Y bond yield cap from rising too high at present by buying 10Y bonds, thereby also injecting liquidity into the market to stimulate the economy (similar to QE).
Instead of buying general financial assets like QE, YCC focuses on buying government bonds and controls the purchase volume through maintaining a specific bond yield cap.
Viet Hustler has clearly explained YCC in previous articles:
YCC worked well when Japan's economy was previously in deflation; and BOJ wanted to stimulate growth through investment.
With low short-term and medium-term interest rates, while long-term rates are still adjusted by the free market:
Institutional investors such as pension funds, insurance funds, mutual funds... can safely hold long-term bonds with guaranteed yields.
Meanwhile, businesses can borrow short-term and medium-term capital at low costs.
With concerns over rising inflation in Western countries and Japan: investors sold off bonds, betting on short-term interest rate hikes, including in Japan.
But contrary to Western countries, BoJ did not raise rates amid high inflation, but chose to gradually ease the YCC policy by expanding the control band for JPB 10Y bond yields at the end of last year (December 2022).
This led investors to criticize BoJ for distorting market prices.
In late 2022 and early 2023, investors repeatedly broke the YCC policy by driving free-market yields higher than BoJ's control level (then still 0+/- 0.5%) to force BoJ to intervene against inflation via rate hikes (figure below).
But BoJ still said “no” to rate hikes, and only continued expanding the YCC cap for 10Y JPBs to 0 +/- 1% at the end of July:
Since the last YCC policy adjustment, BoJ has purchased a total of ~ +USD 90 billion in Japanese bonds to defend the YCC band against free-market attacks.
=> This helps BoJ ensure Japanese bond yields fall, but it will come with the Yen continuing to weaken if BoJ keeps defending YCC amid rising global interest rates.
Currently, JPY has fallen to its lowest against USD (~148 JPY/USD) since early November 2022 (not long after, BoJ had to intervene by expanding the yield curve control cap).
The cause is that both ECB and Fed raised rates in July, while ECB is highly likely to continue hiking in September. This has pushed yields in the two Western bond markets higher.
A weak JPY will increase import costs for goods and raw materials into Japan.
If this time the market continues attacking and breaking BOJ's YCC range, will BoJ only further expand the YCC band, or be forced to completely abandon the “ultra-loose” interest rate policy?
(currently, short-term rates in Japan remain at negative -0.1%, medium-term 10Y rates controlled low at 0+/-1%)
BoJ remains silent without any intervention actions. This has fueled investors to continue their aggressive push.
In last week's auction of long-term 30Y Japanese Government Bonds (JPB), demand continued to plunge sharply, pushing long-term government bond yields to the highest since 2015 (red line).
While long-term bonds (20-30Y) are the primary reserve bonds for institutional investors.
BoJ's stance and potential pivot at year-end
BoJ Governor Ueda has signaled that the BoJ may end the negative interest rate period after nearly 1 decade.
But Ueda also affirmed that the BoJ will only raise interest rates when they are certain that:
… inflation will be at the level of 2% in the long term (rather than falling back to deflation right after the global inflation storm passes).
… stable long-term price growth must be ensured by consumer demand + wage growth stable.
Currently, Ueda affirms that the BoJ will continue to maintain negative interest rates and Yield Curve Control (YCC) policy to continue stimulating the economy.
Whether the BoJ raises interest rates or not will be entirely based on economic data that the BoJ considers to be “sufficiently collected by the end of this year”.”
But from now until the end of the year, there are still nearly 4 months left: is the BoJ acting too late?
Can Japan achieve the goal of maintaining “sustainable” inflation in the long term?
There is considerable improvement in price growth and worker wages in Japan:
Consumer demand in Japan has for the first time exceeded supply in the past 4 years:
… this is a positive signal for the Japanese economy to finally shift from deflation to “sustainable inflation” - what the BoJ expects.
After nearly 30 years of slow wage growth, Japanese workers have finally achieved wage growth comparable to other economies (3.6%).
This will boost price growth (inflation) in Japan due to the wage-price spiral effect.
Inflation in Japan has risen above the 2% target, peaking at 4.3% in January 2023, but has gradually declined due to falling raw material prices.
High inflation is a risk for other economies but good news for Japan, a country that has experienced nearly 1 decade of deflation.
However, the BoJ may have reason to worry that the Japanese economy will return to deflation if the global inflation storm passes, because:
Growth in Japanese consumer spending continues to decline -2.7% m/m in July 2023.
The impact of the BoJ gradually exiting YCC on the global economy
As Viet Hustler has previously reported, Japanese investors are at the top in holding US Treasury bonds.
Investment capital flows from Japan to foreign markets have grown strongly for over 2 decades:
This stems from when the Japanese economy stopped growing, forcing the BoJ to implement “super loose” interest rate policies,
… leading to much higher foreign investment yields compared to domestic offered rates.
According to the IMF: Japan is also the world's largest creditor, holding:
net investment position total of +USD 3,200 billion
total value of various bonds: ~ USD 4,300 billion, of which USD 2,085 billion is in portfolio investments.
50% of which are debt assets in the US market,
and ~30% of their investments are in the European stock market.
Abundant capital from Japanese investors to international markets has contributed to increased liquidity in major markets before the Covid period.
Therefore, Japanese investors withdrawing capital from the US and European markets, even partially, could have a clear impact on cash flows, price growth, and industrial output of these two major markets.
In fact, since the beginning of 2022, Japanese investors have collectively withdrawn capital from the global bond market.
The main reason is that hedging costs for foreign markets are increasingly high for them…
… as the JPY exchange rate against other currencies listing bonds/stocks has fluctuated strongly (due to high interest rate policies from central banks).
This is also one of the reasons why liquidity is withdrawing from global markets faster, while pushing up bond yields in the US and Europe (besides monetary tightening by the Fed and ECB).
Therefore, in the long term, as the BoJ gradually exits YCC, Japanese bond yields will rise and even pull back Japanese investors' capital to the domestic market more strongly..
This is the reason US bond yields always rise every time the BoJ expands the YCC band (gradually loosening yield curve control).
If the BoJ completely ends the YCC policy, Japan's 10-year bond yields will surge => even more causing Japanese investors' funds to flow back to the domestic market.
Throughout August 2023, fund flows have actually reversed into Japanese stocks, funded by the selling off of safe US bonds…
… investors believe that price growth is guaranteed by Japan's wage growth, accompanied by the BoJ's monetary policy that remains 'growth-stimulative', will make this market more attractive.
Cash flows into Japanese stocks are funded by selling off one of the safest US bonds: the 10Y US Treasury 'inflation-protected' bond (10-year Treasury Inflation Protected Securities - TIPS).
In the UK: this real estate market was previously always the favorite of Japanese investors. But currently, the Netherlands has surpassed Japan to become the country with the largest investment inflows into this market.
Not only in the bond, stock, and real estate markets, the impact of Japanese investors withdrawing capital from the West back to Asia is also evident in the commodity market:
Previously, in the domestic Japanese market, investors withdrew money from the stock market to buy gold, due to concerns about inflation in the country.
Returns from gold investments have increased (102%), higher than the return growth from stocks (Nikkei: 62%).
And that impact has spread internationally:
ETFs tracking gold prices in Europe and the US have seen outflows (- USD 8.5 billion outflow in the US and - USD 3.6 billion in Europe) in the first half of 2023.
Meanwhile, investments in Gold ETFs in Asia increased + USD 1.6 billion in the first half of 2023, and an additional + USD 132 million inflow in July 2023 alone.
Therefore, once the BoJ officially pivots, the flow of capital out of the US and European markets back to Asia could make the credit crunch in Western economies even more severe, even if the Fed and ECB stop raising or even cut interest rates.
At that time, besides regulating domestic interest rates and monetary policy, the Fed, ECB, and even the BOE will have to grapple with resolving the spillover from the BoJ's monetary policy.
In this case, the Fed (and even the ECB or BOE) may have to buy Japanese bonds (to lower Japanese bond yields, reducing competitiveness against US bond yields and maintaining balance between the two governments' bonds).
CONCLUSION
The gradual easing of yield curve control over the past year is the BoJ's way of exiting the YCC policy gradually, to buy more time before embarking on larger policy changes.
However, the BoJ's process of abandoning the loose monetary policy through YCC is considered too slow. Investors want more decisive action from the BoJ, such as abandoning the negative short-term interest rate policy (-0.1%) and directly raising rates.
However, from the BoJ's perspective, the lessons of a decade of a low-growth/deflationary economy have made the BoJ hesitant to tighten monetary policy. What the BoJ wants is to leverage the global inflation wave to bring prices in Japan back up in the long term.
According to Governor Ueda, the BoJ has also prepared a plan if inflation rises too high, they are ready to raise rates. But that plan can only be implemented from the end of this year when the BoJ's price growth will be sustained long-term.
The BoJ plays the role of the world's third-largest central bank, largely due to the huge influence of Japanese investors on global financial markets.
Their abundant investment capital is one of the reasons liquidity has been plentiful in emerging economies or Europe over the past nearly 10 years. (In fact, this is also true for China - to be analyzed in the next installment of the Global Economic Perspective series).
Soon, when the BoJ completely abandons the YCC policy, or even shifts to a tightening monetary policy if inflation goes beyond their control. Accordingly, the wave of capital withdrawal by Japanese investors from global financial markets back to the domestic Japanese market could cause an enormous credit crunch shock to the US and European markets (even if the Fed and ECB have started cutting rates). Moreover, this impact will spread to all markets: from bonds, stocks, real estate… to the commodity market.
If this really happens, the new hypothesis put forward is: the Fed and ECB may have to extend their reach to control the Japanese bond market by buying Japanese bonds, to create a yield balance between the bonds of major governments worldwide.
But would this intervention go too deep into Japan and Asia, compared to the authority of the Fed and ECB?
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