BOJ's pivot speed after Shunto - impact on global financial markets

Next week, the two most important central banks globally, the Fed and Bank of Japan (BOJ), will both meet and provide guidance on interest rates for the coming period.

For the Fed, keeping interest rates at their peak in March this year is almost certain: due to labor market data, although more positive, remains tight and the February CPI report harboring the risk of inflation rising again.

In contrast, the BOJ meeting early next week is the most anticipated event in the financial world, with many hopes that BOJ will soon exit its negative short-term interest rate policy. Especially after the Japan Trade Union Confederation (Rengo) successfully negotiated a preliminary wage increase of 5.28% at Shunto, confidence in maintaining long-term 2% inflation will further support BOJ's decision. 

However, after more than 3 lost decades, over a decade of the economy accustomed to a super loose interest rate and money supply environment, Japan's current new financial generation may be surprised by the policy pivot of BOJ. Therefore, BOJ is likely to proceed cautiously in gradually changing its interest rate and monetary policy. 

Not to mention, the influence of capital flows from Japan has deeply rooted in the global financial markets. A BOJ pivot could create a major adjustment in the global capital markets.

On the eve of the BOJ meeting tomorrow, Viet Hustler's weekend Macro Economics column presents readers with an in-depth analysis of BOJ's interest rate-monetary policy and its impacts, with 2 main contents:

• The process of changing BOJ's interest rate-monetary policy in the coming period.

• What impacts on global capital markets once BOJ makes major changes in its policy targets.

Shunto success exceeds expectations: how will BOJ's pivot process unfold?

Last Friday, the Japan Trade Union Confederation - Rengo announced preliminary results of Japan's annual Shunto wage negotiations:

• With a record wage increase beyond expectations +5.28% y/y (average level).

  

• Called beyond expectations because previously, G20 only expected an increase >4%.

• While last year's increase was only 3.6 - 3.8% and was enough to keep inflation in Japan above 2%.

Previously, BOJ Governor Kazuo Ueda directly stated before the Japanese National Diet: 

Last week, BOJ made the first move to reverse QE policy:

From 03/11, BOJ has stopped buying ETFs in the Japanese market - despite Japanese stocks unexpectedly falling from their peak.

• This is regarded as BOJ's first move to gradually reverse the super loose monetary policy (QE) - buying large quantities of financial assets in the open market for over a decade (since 2013).

  • (Japanese source - Translation below from Google Translate) 

  

• FYI: At the end of February 2024, as Japanese stocks recently rose, unrealized gains from ETF assets that BOJ bought over many years increased by an additional +JPY 34,000 billion (~USD 231 billion).

  

The question is: will BOJ pivot in next week's meeting? and what will the pivot speed be like?

• BOJ will soon issue new JGB purchase guidance - gradually reducing the amount of bonds purchased (specifically Japanese Government Bonds 10Y) (Reuter).

• Meanwhile, Kyodo also predicts BOJ will raise short-term interest rates out of negative territory (currently at -0.1%) right in next week's meeting:

If BOJ raises rates next week + the above information:

That means BOJ may choose to abandon the negative short-term interest rate policy first, then gradually dismantle the Yield Curve Control (YCC) policy.

• This is quite understandable because BOJ can avoid mid-term interest rates (from yields of benchmark 10Y bonds) surging unexpectedly if YCC is suddenly completely removed.

However, if BOJ raises rates without ending QE or YCC, balancing finances - Japan's public debt, as well as stabilizing the JPY value by BOJ, will face issues, because:

• Japan is facing public debt ~252% GDP - the highest among developed countries - this was not a big problem when interest rates were still low before. 

  

• But if BOJ raises rates causing bond yields to rise, the Japanese Ministry of Finance will face higher borrowing costs.

• Meanwhile, to fund ongoing QE or YCC programs, BOJ will need cash to buy bonds / stocks.

  => BOJ may need to issue more JPY: creating additional pressure making JPY even weaker in the short term.

• In addition, if raising short-term rates (leading to higher short-term bond yields) while still keeping YCC controlling 10Y bonds at 1%.

  => Japan's yield curve risks inverting like in Euro-US markets.

  • Japanese commercial banks will have incentives to trade in the short-term bond market (money market) and abandon 10Y bonds.

Therefore, BOJ needs to maintain the “two-tier system” (corresponding interest rate-monetary policy system): 

• Or QE accompanied by YCC + keep negative interest rates for another 1-2 months:

  => market disappointed, and BOJ's balance sheet remains high.

• Or stop QE and YCC + raiseinterest rates:

  => but that would create a major shock to the debt market in Japan and globally.

If BOJ has to choose either to raise interest rates first, or stop QE/YCC first, then Viet Hustler believes BOJ should still choose to stop QE/adjust YCC this month first and wait 1-2 months before raising interest rates.

Because stopping QE is easy (stop buying financial assets), but rebalancing BOJ's balance sheet after more than a decade of QE is very difficult: 

• When BOJ's balance sheet is valued at ~128% of Japan's GDP - much higher than Fed or ECB currently.

  

• Therefore, reversing QE needs to be done earlier than raising interest rates, so that BOJ can gradually normalize its balance sheet.

In addition, BOJ also has other incentives to delay raising interest rates until the April meeting because:

• Although the negotiated wage increase was successfully achieved in March, it will take a certain period of time for the wage decision to be implemented and for the impact of the wage increase on increased consumer spending (inflation increase).

• In addition, BOJ may want more macroeconomic data through the business sentiment survey “Tankan” (04/01) and the quarterly report of commercial banks in April.

Bloomberg survey: most experts also believe BOJ should pivot from April, although quite a few think BOJ could pivot as early as next week:

Impact of BOJ pivoting monetary policy interest rates in the near future

Viet Hustler has mentioned many times the impact of the policy shift from BOJ on the global financial system in previous articles:

Related articles:

• BoJ and the times it shook the world economy

• Japan's economy in the Kuroda era and its global impact.

• Explanation of Yield Curve Control and why BOJ had to expand YCC from the end of 2022 when global inflation increased.

• BoJ expands YCC limit in 07/2023 (second half of the article).

Therefore, Viet Hustler will only summarize the impacts below:

The rise of the Japanese economy and Tokyo stock market:

• Japan maintaining high wage increases (meaning the ability to maintain inflation) means increased consumption.

• With consumption, there will be a market – this will awaken the land of the rising sun back as a good investment destination – especially replacing China with declining consumption.

  • Retail sales in Japan have been steadily recovering over the past year after 3 decades of losses.

  

Optimism about economic prospects is also spreading throughout the Japanese financial market:

• Although last week, Japanese stocks unexpectedly dropped from the peak due to BOJ stopping ETF purchases, Japanese stocks are expected to continue growing.

  • Viet Hustler has mentioned this many times, as a large amount of Japanese securities are trading below their intrinsic values.

• Japanese banks are starting to train employees on “what to know when interest rates change”:

  

  • They are also restructuring trading departments - preparing for the recovery of Tokyo's derivatives market (which has been weak for over 2 decades).

  

  • Accompanying that are research projects on changes in the Japanese economy as the monetary policy interest rate pivot turns.

For the global economy:

Japanese investors are also creditors of ~USD 2.2 trillion in global debt: 

• As of November 2023: they hold about 4% of the US bond market value (~USD 986.4 billion), 4% of the UK bond market, up to 10.9% of the Australian bond market value, 5.5% French bonds, 9.4% Dutch bond market, many bonds in Europe…

When the monetary policy interest rate pivot turns, they have every reason to “repatriate” their capital!

Remember at the end of 2022-early 2023, when BOJ first intervened lightly by expanding the YCC band and buying JPY to protect their currency value. 

• The yen value increased by 20% in 3 months - compared to the bottom in October 2022.

At that time, the cost of hedging exchange rate risk due to unexpected exchange rate fluctuations increased quite high! Because:

• Japanese investors bought USD or EUR bonds/stocks earlier - when Euro-US bond yields were high (also when JPY value was low).

• Then when BOJ protected JPY value right after, they faced the risk of losses - when they ultimately had to convert that USD/EUR income back to JPY.

• As a result, at the end of 2022, besides major central banks raising interest rates high, the wave of Japanese investors selling foreign government bonds partly fueled the storm for the skyrocketing speed of global bond yields…

That was just a small intervention from BOJ to make JPY rise for a short time - after that JPY depreciated again due to the interest rate policy differential between BOJ and Fed/ECB.

In the near future, if BOJ stops both QE/YCC and negative short-term interest rate policy, the impact on the repatriation capital flow of Japanese investors to the global market will not be small.

• The value of the JPY will then be gradually adjusted upward in the foreign exchange market, with no forces left to pull the JPY value down (since at that time BOJ will no longer maintain an ultra-loose interest rate policy compared to Fed and ECB).

Therefore, the "repatriation" of Japanese capital flows could drag down the global bond market!

Not only the repatriation of capital from Japanese investors, but capital from abroad is also pouring into Japan:

• Many global financial funds are also considering buying Japanese bank stocks — they are just waiting for BOJ's pivot decision.

CONCLUSION

As presented above, the possibility of BOJ immediately raising interest rates at the upcoming 2-day meeting is uncertain. Because there are many significant implications for the public debt situation, JPY value, or the certainty of wage impacts on inflation or the macroeconomic outlook that BOJ needs to consider. 

But one thing is certain: BOJ is starting to gradually dismantle its ultra-loose monetary policy (QE) by stopping ETF purchases in the open market, and gradually reducing the pace of buying stocks and bonds (for YCC). 

In any case, BOJ should raise interest rates once it stops QE and YCC; otherwise, public debt pressure and continued bond purchases while extending YCC will force BOJ to issue more cash: the JPY will continue to depreciate in the short term, at least until QE and YCC stop. 

Not to mention, raising short-term interest rates while still controlling medium-to-long-term rates (YCC for 10Y bonds) will invert the yield curve (short-term rates equal to or higher than long-term rates). Japan's capital market will gradually face imbalances like the current Europe-US markets as investors pour money into high-liquidity Money Market Funds.

The consequences of BOJ's monetary policy pivot are now quite clear to Viet Hustler readers through previous articles. In fact, in the 1980s-1990s before the three lost decades, the Tokyo stock market was once the world's second most dynamic market (after the New York exchange in the US). Now, the revival potential of Japan's economy and financial markets here could be very close. Capital from both domestic and international investors is returning to the Japanese market - but it is also a warning signal for liquidity in the global capital market.