Plotting Japan’s path to monetary policy normalisation

The normalisation of monetary policy in Japan and what this might mean for global bond and currency markets was a dominant theme towards the tail-end of last year. Eva Sun-Wai, Global Macro Bond Fund Manager, asks: Is this still the case in 2024?

The Bank of Japan (BOJ) has been an outlier in the global monetary policy tightening cycle over the past couple of years, opting to stick with its ultra-loose monetary policy despite inflation remaining above-target for more than a year.

This situation has fuelled speculation among market participants that the BOJ might change course and end negative interest rates. Policymakers have been cautious to unwind their massive stimulus programme and the BOJ left rates unchanged after their meeting in January. However, expectations of a policy shift in 2024 continue to grow. 

“Policymakers certainly don’t want to hike too soon and cull any potential inflation.”
 

There have been some modest changes to the seven-year-old yield curve control (YCC) policy, which caps the yield on 10-year Japanese government bonds (JGBs). The BOJ has tweaked the policy to allow yields to rise to a soft limit of 1% and yields have been creeping up. Rather surprisingly, the relaxation of the yield cap was accompanied by significant weakening of the yen versus the US dollar last year, but this was arguably driven by the wide differential between interest rates in the US and Japan.

Broadly, YCC is slowly being dismantled, but the market is expecting a larger shift from the current framework. However, the situation is complicated. The BOJ wants to see sustainable inflation in Japan and appears relatively relaxed about keeping policy loose to achieve this. At the same time, it is in a regime where, in an economic downturn, they have nowhere to go as they can’t cut rates which are currently at -0.1%. 

YCC is also very beneficial for the government because it means it can borrow money at low rates. With a very large debt-to-GDP ratio of c.250%, significantly higher borrowing costs would be challenging for the government. 

These are difficult dynamics and there is no great incentive for the BOJ to raise rates. Policymakers certainly don’t want to hike too soon and cull any potential inflation. Even if they were to end negative rates, they don’t yet believe that inflation is sustainable enough domestically to warrant large tightening of monetary policy. They are also concerned about the potential consequences of higher interest rates on the country and Japanese banks after such a long period of ultra-loose policies. Therefore, the timing of monetary policy tightening continues to be uncertain, especially as the yield differentials between Japan and other developed markets have narrowed after a significant bond market rally in the fourth quarter of 2023 (bond prices and yields move in opposite directions). This move has stabilised the yen somewhat, and JGBs have been moving broadly in line with the wider global bond market. As a result, the pressure on policymakers to aggressively continue bond purchases and keep yields down has lightened. 

At this juncture, if external pressures continue to relax (i.e., Japan’s policy continuing to diverge from other central banks), then rate normalisation becomes almost exclusively dependent on the domestic Japanese economy, and whether the BOJ is certain that 2% inflation is sustainable.

There is plenty of discussion about what could happen to the yen if the BOJ ended negative rates. Japanese investors hold a lot of overseas assets, and are collectively the largest foreign owner of US Treasuries. 

One potential consequence of higher yields in Japan could be the repatriation of Japanese money back to the domestic market, although we are yet to see the start of this movement. If the negative interest rate policy and YCC are phased out and we begin to see repatriation flows, this could potentially have significant consequences for the Treasury market as well as the yen. 

Given that the yen tends to act as a ‘safe haven’ currency, it could benefit from any global slowdown in the months ahead. Therefore, we think the potential for an inflection point in the yen means that it will be important to pay close attention to developments in Japan in 2024.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.