The Bank of Japan Disappoints and the Yen Shakes It Off, Telegraphing Hidden Strength

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The Bank of Japan (BOJ) met this week after a growing expectation that it would end the longstanding policy of yield curve control (YCC) — and thoroughly disappointed those expectations by keeping things the same.

The disappointment created by the BOJ was widely expected to weaken the Japanese yen against its peers, perhaps dramatically so… but it didn’t.

That lack of weakness is the dog that didn’t bark. It suggests the hidden forces driving the yen higher, and contributing to a tightening of global financial conditions, are stronger than expected.

Holy Wage Growth, Batman

We explained in late 2022 how the BOJ’s surprise announcement shortly before Christmas — in which it widened the upper band on the Japanese government bond (JGB) 10-year yield from 0.25% to 0.50% — was seen as a de facto rate hike and a step toward the inevitable end of quantitative easing.

Anticipation of “the end” for Japanese QE is strong because, after decades of absence, inflation has returned to Japan — it just hit a 41-year high — and wage growth is returning to Japan too.

On Jan. 5, Japanese Prime Minister Fumio Kishida made a plea for higher wages to Japanese business groups. “The core of a virtuous economic cycle lies in wage growth. I’m calling for pay rises that beat inflation and the government will back such efforts,” Kishida said.

And boy, did Kishida get a response.

Fast Retailing, the largest clothing retailer in Asia and the parent company of Uniqlo — a fashion brand juggernaut in Japan — announced company-wide pay increases as high as 40%. Forty percent!

Other Japanese businesses are following suit on double-digit-percentage wage hikes — not as big as Fast Retailing, but sizable — to help employees cope with rising goods and services prices.

Japan has been stuck in a deflationary funk for decades, and now it is finally getting an inflation jump start. And if the wage growth trend endures, Japan’s exit from deflation could actually stick.

That is because household consumption (powered by rising wages) is the key to domestic economy growth, and Japan’s great failing of the past few decades was stimulating the corporate side but not the household side (pouring huge sums into infrastructure and export subsidies as wages stayed flat).

From Hope to Disappointment

Given this return-of-inflation plus stirrings-of-wage-growth backdrop, and the BOJ’s aforementioned de facto rate hike just before Christmas, there is a growing belief Japan will soon exit its long-running QE experiment.

The JGB market is also creating pressure for the BOJ to act.

That is to say, the 10-year yield is pressed up hard against the 0.50% upper band and trying to push above it.

The way yield curve control (YCC) works is that in order to maintain the 0.50% yield cap, the BOJ has to purchase all JGBs sold at a given price floor. (Because bond yield moves inversely to price, a bond yield ceiling and a bond price floor are effectively the same thing.)

This in turn means that as more JGBs get sold, the BOJ has to buy more and more — and it can only do that for so long, or so the theory goes, because the act of printing yen to buy JGBs threatens to make Japan’s underlying inflation worse.

Then, too, there are reports that, in some parts of the JGB market, the BOJ owns more than 100% of all maturities issued. How is that possible, you ask?

Because the BOJ bought up all the bonds on offer… and lent out some of its inventory to short sellers… and then had to repurchase the bonds that were sold short. (Shorting can be weird; synthetic short situations can happen in stocks too.)

So getting back to the Japanese yen: The growing drumbeat of anticipation was that, at the BOJ meeting that just occurred, the BOJ would finally announce an end to YCC, or otherwise announce a definitive end date for QE in general, because inflation pressures, wage growth pressures, and bond market pressures are all getting too strong to deny.

The BOJ did no such thing though. The meeting was business as usual, and Governor Haruhiko Kuroda said the policy of YCC would be maintained — more or less “move along folks, nothing to see here.”

The Yen Was Supposed to Tank, But Didn’t

This is where the interesting part kicks in.

• Prior to the meeting, the narrative was that a whole bunch of macro managers and forex traders had got long the Japanese yen against its forex counterparts in anticipation of “the end” of YCC and QE, with this week’s BOJ meeting the announcement catalyst.
• Implied volatility measures for dollar-yen-related options also surged prior to the meeting, suggesting that traders were braced for a big yen move in the meeting’s aftermath.
• The meeting took place and it was a big nothingburger — which at first caused the yen to fall sharply. “The Bank of Japan has defied market pressure and left its yield curve control measures unchanged,” said the Financial Times, “sending the yen diving and pushing stocks higher as it stuck to a core pillar of its ultra-loose monetary policy.”
• But then, after the initial sharp decline, the move in the yen began to reverse. As of this writing, the yen has clawed back most of what it lost versus various counterparts.

This is a clear indication that forces are driving the yen higher (making it stronger). Why?

Because the BOJ’s lack of action was bad news relative to expectations… and the yen was supposed to weaken dramatically in response to disappointment… and something else happened. The yen weakness showed up temporarily, but as of this writing it has mostly been erased.

It’s Still Got to Move

Our view is that, even though the BOJ did nothing at this latest meeting, “the end” is still coming.

Haruhiko Kuroda, the longest-serving governor in the Bank of Japan’s 141-year history, will be stepping down in April.

Because April is so close (just three months away), it is likely Kuroda wants to let his successor make the call of ending QE, which would create a sense of continuity — new BOJ governor, new monetary policy era — and also give Kuroda’s successor an ability to manage the new policy era as they choose.

Either way, though, the market is still anticipating “the end” for Japan’s QE policies — it is still just a matter of time, even if it didn’t happen this week — and that means higher JGB 10-year yields as YCC is loosened or abandoned, and a stronger yen as Japanese investment capital comes rushing home.

At the same time, the yen will be even more likely to surge against AUD/JPY and EUR/JPY (our short forex positions that benefit from a strengthening yen) in the event of a “risk off” scenario, where the current bullish euphoria evaporates.

Right now the bulls are raising a glass of champagne to historically warm weather in Europe, rosy reopening prospects in China, and hopes of a soft landing in the U.S. — but all of that optimism could disappear as quickly as it came.