BOJ’s warning shot reverberates

But this was anything but a business as usual statement from a central bank that has been deploying QE since 2001 and has had YCC in place since 2016. It shifted the level at which the BOJ will conduct daily JGB purchases to 1 per cent from 0.5 per cent and also revealed that the bank will regard the 0.5 per cent plus-orminus range in which JGB yield can fluctuate as “references, not as rigid limits”.

In part, this is clearly a response to market realities: 10-year JGB yield had been in the 0.4-0.5 per cent range for much of 2023 and had tested the BOJ’s resolve at the upper end of that range on several occasions (see chart). On the other hand, it also did not reflect a capitulation: yield rose in the wake of the July policy statement but not close to the new 1 per cent upper limit of YCC. The BOJ also stepped in to the market with an unscheduled intervention on 3 August, after 10-year JGB yield reached 0.655 per cent – its highest mark in a decade but still well short of the hypothetical 1 per cent cap.

Reinforcing the idea of a measured increase in yield, BOJ governor, Kazuo Ueda, noted in the press conference following the July policy update that “we do not expect long-term interest rates to rise to 1 per cent”.

Bank of America research published on the day of the announcement concludes that the BOJ regards the new upper limit of YCC as a “last line of defence and not an immediate target”, noting that the central bank itself “judges the fair value of 10-year JGB yield to be much lower than 1 per cent at the moment”.

The muted immediate response – which, market participants agree, is exactly what the BOJ would have hoped for – does not detract from the potentially seismic longer-term impact of policy normalisation in Japan. For some, the idea that Japan’s vast pool of investment funds could eventually find acceptable yield in its home market, for the first time this millenium, could set global fixed income on a fundamentally different path.

Rakesh Jampala, co-head of global fixed income at ANZ in Sydney, says the BOJ move could be an early step on the road to unwinding a set of circumstances that have distorted global fixedincome markets for more than two decades. He points to what ex-Federal Reserve chairman, Alan Greenspan, referred to as the “bond conundrum”: the suppression of term premia around the world, which only intensified thanks to successive rounds of fiscal and monetary stimulus in the wake of the global financial crisis and then curves were flattened during the pandemic.

“A number of reasons have been given for the absence of term premia, from the savings glut to QE,” Jampala says. “These factors no doubt played a role, but one of the biggest causes of all has been Japan – the way zero rates in Japan led the huge pool of Japanese savings to buy foreign bonds.”

The direction of travel is now in the opposite direction. The US and UK are conducting QT and the suggestion that the BOJ may be contemplating unwinding YCC could be even more significant. “My thesis is that this is not just a tweak or a minor structural shift but the reversal of what was the biggest single cause of the lack of a term premium,” Jampala tells KangaNews. “If this is correct, I don’t see anything other than a return to pre-2003 market conditions.”

The consideration, if not outright concern, for many global borrowers will be how Japanese investors respond to increasing long-end yield in their local market. A straightforward read of investment patterns from recent decades is based on the idea that Japanese investors have looked to foreign currency allocations to provide yield they cannot get at home. A reversion in outright yield norms, even at the margin, could fundamentally change these dynamics – and therefore either reduce the volume of Japanese funds available to foreign currency issuers or spur outright repatriation of assets.

Daniel Leong, executive director, debt syndicate at Mizuho Securities in Singapore, says gradually increasing JGB yields are already having an impact on the local investor base. He says parts of the market are “clearly hurting” from marks to market – an outcome most of the world’s fixed-income investors went through in the COVID-19 recovery period. The outlook from here is also similar to the global story since 2022, and is positive for fixed income overall.

“My sense is that enthusiasm about the prospects of positive JGB yield and the return of a term premium that is not strictly capped likely trumps the initial pain caused by the direction of travel,” Leong tells KangaNews. “There is certainly a degree of optimism about what the future holds for the fixed-income asset class.”

Policy normalisation will inevitably have an impact on Japanese investor behaviour, Jampala believes. “There is a big difference in the propensity to look outside for returns based on whether 10-year JGBs are offering 0.4 per cent or 1 per cent,” he says. “Even if the Japanese economy is weak, all that would happen is local real money piling into long-end bonds at relatively higher yield – it still reduces the propensity to look offshore.”

On the other hand, even if Japanese yield starts to drift further into positive territory it is far from certain that a full-scale repatriation of assets would be the inevitable outcome.

Damien McColough, head of Australian dollar rates strategy at Westpac Institutional Bank in Sydney, tells KangaNews: “It would be naïve to think normalisation would not have a very significant impact – Japan is one of the biggest influences on the US Treasury market, for instance. But I don’t believe Japanese investors have enough options to facilitate a complete repatriation of assets even if this is what they wanted to do.”

Perhaps more to the point, McColough says there is no reason the simple presence of higher yield in the yen market would lead the vast Japanese real-money sector to abandon a multidecade process of diversification.

“It would likely be quite similar to what we see in Australian superannuation – funds are increasingly invested offshore simply because domestic options are limited, and this is not just a question of theoretical relative value,” he argues. “There would certainly be an adjustment, and all else being equal this would likely put some upward pressure on the funding cost of countries – like Australia and the US – that have benefited from Japanese flows. But I certainly don’t anticipate a collapse in demand.”

A more nuanced understanding of what motivates different groups of Japanese investors to allocate offshore hints at a wider range of responses to changing monetary policy. Leong says Japanese investors in Australian dollar – and other foreign currency – fixed income generally fall into three categories. The first is those with natural holdings in these currencies, including insurance funds, deposits or institutional assets under management.

“These investors will be influenced by higher yen rates, because the relative attractiveness of foreign currency investments to retail investors will be lower,” Leong suggests. “But this will largely be at the margin – maintaining currency diversification is standard investment behaviour and, while the marginal dollar will go into yen product, there is no reason to expect demand to dry up in the longer term.”

The second investor group allocates to foreign currency assets on an unhedged FX basis. It includes life insurance companies, regional banks and a swathe of other institutions. Leong says this group has been notably active recently as yen depreciation has comfortably offset negative carry. In fact, unhedged investors have enjoyed a 40 per cent currency windfall. This type of investment should continue to ebb and flow based on market dynamics, though Leong notes that recent FX gains have been all-but unprecedented – while higher yen yields should also be a structural tailwind for the currency.

Finally come FX-hedged investors. This group requires a material pickup over hedging cost to provide the rationale for buying foreign currency assets – and the level of hedging cost has become elevated.

Leong suggests, for example, that US dollar-yen three-month forward hedging costs are currently 5.68 per cent at five-year tenor – which, he points out, would require investors to buy fixed-income product with credit margins greater than 130 basis points over US Treasuries, similar to triple-B corporate bonds or double-A rated residential mortgage-backed securities, just to break even on the hedge. Higher yen swap spreads would add a structural impediment to this type of allocation.

The bottom line is that higher long-end yield in Japan will almost certainly have some impact on how relatively attractive foreign currency allocations are to local investors. The best-case scenario put forward by most market participants is that the pace of policy change is sufficiently measured that any investor response is minimised and absorbed by the wider market as it occurs.

This outcome is far from inconceivable. “There is a big difference between tweaking YCC and abandoning it, and the latest update from the BOJ is clearly still in the ‘slow and steady’ camp – it does not suggest to me that a major change is on the cards,” McColough says. “The price action we have seen since also isn’t telling me the market is in a hurry to test the BOJ’s conviction at 1 per cent.”

The same view seems to prevail among Japanese investors themselves, and to have reached key Australian dollar borrowers. McColough says he raised the topic of policy normalisation at each of more than 25 investor meetings he attended around the Australian Office of Financial Management (AOFM)’s forum in Tokyo in May – and in every single case the response was that expectations of asset repatriation are far more elevated outside Japan than within it. This was before the most recent BOJ announcement, but McColough still believes normalisation will take place in an extremely measured manner.

Meanwhile, Anna Hughes, Canberra-based chief executive at the AOFM, tells KangaNews the issuer’s expectation is that a shift in the BOJ’s long-term strategy – and consequent changes in investor behaviour – will play out over an extended period. “We are confident that policy normalisation will be measured and well articulated, in such a way that allows us and other market participants to respond,” she comments. “It is also worth noting that there is a broad range of Japanese investors, and we would not expect them all to respond in the same way or for everything to happen at once.”

While acknowledging that the outlook is inevitably speculative, McColough says a reasonable base-case expectation might be for the BOJ to go no further than additional policy “tweaks” this year before exploring a further shift in 2024 – if the trajectory of growth and inflation remains on the course that led to the previous moves.

This is far from certain, however – and there is widespread expectation that most major central banks will start cutting rates by the second half of next year. It would be a significant surprise if the BOJ felt further tightening remained the correct course of action even as much of the rest of the world returned to easing territory. However, Jampala says, the fundamental change in global market norms only requires the restoration of term premia. The BOJ has every reason to continue on this path even if it does not move to monetary tightening in the front end.

He explains: “There is a big difference between not having YCC and abandoning zero interest rate policy. I don’t expect the BOJ to raise the cash rate for a number of years, as it happens. My base case is a US recession next year and the Fed cutting rates – in which case the BOJ can say it has played things perfectly, by getting rid of YCC without causing huge upheaval.”

Should further stimulus be needed, the BOJ could easily return to buying 10-year JGBs – just at a higher level than before and as guided by the market. “The issue for Japan might come if this is not the end of the cycle and rates elsewhere stay where they are or go up further – it might then have to raise its own cash rate. But I think we can divorce this from what is happening at the back end,” Jampala argues.

This means a change in how Japanese investors allocate their funds is likely whatever the next phase of the cycle holds, Jampala believes. He says the most likely outcome is the return of term premia across global fixed-income markets, the primary consequences being higher cost of debt for issuers but more appeal of the asset class to investors.