USDJPY soared on dovish BOJ YCC tweak; gold slips; Dow gains

On Tuesday (31st October), some focus of the market was also on BOJ apart from ongoing Israel-Gaza war tensions and an expected hawkish hold by the Fed on 1st November. Last Thursday (26th October) ECB also went for a hawkish hold stance. Although various BOJ/JP officials are now jawboning less dovish under the leadership of new BOJ Governor Ueda, the market was unanimously expecting a hold this time as usual and BOJ ‘approval’ to allow 10YJGB bond yield to +1.50% from previous cap of +1.0% as a part of its great YCC tweak policy (10Y JGB bond yield was already hovering around +0.9% for the last few days in anticipation of less dovish BOJ move).

As unanimously expected, on Tuesday BOJ kept all policy rates unchanged. The Bank of Japan (BOJ) kept its key short-term deposit facility (reverse repo) rate unchanged at -0.1% and that of the long-term reverse repo rate equivalent to 10Y JGB yields at around 0.10% in its October meeting by unanimous vote. At the same time, as highly expected, the BOJ redefined +1.0% as a ‘loose upper bound’ rather than a rigid cap and scrapped a pledge to guard the level. Since July, the 10YJGB bond yield has been ‘rigidly’ capped at +1.0% (under YCC), an increase over the previous cap of 0.5%. In October, BOJ decided on YCC by an 8-1 vote.

In its latest quarterly outlook report, the BOJ revised higher core inflation (CPI less fresh food and energy) forecasts for FY23 and FY24 to 3.8% from 3.2% and 1.9% from prior projection of +1.7%, respectively. Meantime, BOJ policymakers viewed that Japan's economy was likely to continue recovering moderately, supported by pent-up demand but highlighted downward pressure from a slowing global recovery. The board reiterated that it will not hesitate to take extra easing measures if needed. The BOJ is now projecting Japan’s real GDP growth at +2.0% from the prior estimate of +1.3% for FY23 and +1.0% vs +1.2% for FY24.

Although, BOJ is famous for its negative rate policy (NIRP), in reality, the effective reverse repo rate is around 0% or +0.10%, while the repo rate is +0.30% and no banks ever make the ‘complementary deposit’ above a certain limit in a special current account with BOJ, so that it has to pay an interest of +0.10% to BOJ under reverse repo rather than the usual opposite. BOJ’s repo rate is still now +0.30% (unchanged since Dec’2008) against the Fed’s current rate of +5.50% and ECB’s +4.75% despite comparable core CPI 3M average of around +4.30%, resulting in a deep negative real repo rate around -4.00% against Fed’s +1.20%. The bank lending rate (BLR) of Japan is now around +1.48% against the US +8.50% and China +3.45%.

Highlights of BOJ MPC statement: 31st October’2023

·         Inflation expectations heightening moderately

·         There is a possibility wage growth may not strengthen as expected next year onward, causing prices to deviate downward

·         BoJ scraps reference to daily fixed-rate bond-buying operations

·         Japan's economy is likely to continue recovering moderately

·         BoJ makes no change to its forward guidance

·         BoJ decides on YCC by an 8-1 vote

·         BoJ will add to easing without hesitation if needed

·         We will keep easing patiently for the price goal with wage gains

·         BoJ sees FY 2023 core CPI (w/o fresh food only) at 2.8% vs 2.5% previously

·         BoJ FY 2024 GDP forecast is 1.0% vs 1.2% previously

·         BoJ changes language around 1.0% 10-year JGB yield cap

·         BoJ adjusts yield curve control (YCC) policy

·         BoJ keeps 10-year JGB yield target around 0%

·         BoJ Reference Deposit (Special Reverse Repo) Rate Actual -0.10%; Previous -0.10%; Exp. -0.10%

·         The upper limit for long-term yields is 1% as a reference

 

Full Text of BOJ statement of monetary policy: 31st Oct’2023

At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan decided to further increase the flexibility in the conduct of yield curve control. Specifically, while the Bank will maintain the target level of 10-year Japanese government bond (JGB) yields at around zero percent, it will conduct yield curve control with the upper bound of 1.0 percent for these yields as a reference and will control the yields mainly through large-scale JGB purchases and nimble market operations. In this manner, the Bank will patiently continue with monetary easing.

The Bank decided on the following regarding yield curve control and the guidelines for asset purchases.

(1) Yield curve control

a) The Bank decided, by a unanimous vote, to set the following guidelines for market operations for the intermeeting period.

The short-term policy interest rate:

The Bank will apply a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.

The long-term interest rate:

The Bank will purchase a necessary amount of JGBs without setting an upper limit so that 10-year JGB yields will remain at around zero percent.

b) Conduct of yield curve control (an 8-1 majority vote)

The Bank will regard the upper bound of 1.0 percent for 10-year JGB yields as a reference in its market operations, and to encourage the formation of a yield curve that is consistent with the above guideline for market operations, it will continue with large-scale JGB purchases and make nimble responses for each maturity by, for example, increasing the amount of JGB purchases and conducting fixed-rate purchase operations and the Funds-Supplying Operations against Pooled Collateral

(2) Guidelines for asset purchases (a unanimous vote)

With regard to asset purchases other than JGB purchases, the Bank decided to set the following guidelines.

a) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) as necessary with upper limits of about 12 trillion yen and about 180 billion yen, respectively, on annual paces of increase in their amounts outstanding.

b) The Bank will maintain the amount outstanding of CP at about 2 trillion yen. It will purchase corporate bonds at about the same pace as prior to the COVID-19 pandemic so that the amount outstanding will gradually return to the pre-pandemic level of about 3 trillion yen. In adjusting the amount outstanding of corporate bonds, the Bank will give due consideration to their issuance conditions.

2. The outlook for Japan's inflation rate, measured in terms of the consumer price index (CPI), has been revised upward from the July 2023 Outlook for Economic Activity and Prices. This is mainly due to the prolonged effects of a pass-through to consumer prices of cost increases led by the past rise in import prices and the recent rise in crude oil prices. Toward the end of the projection period, the Bank expects that underlying CPI inflation will increase gradually toward achieving the price stability target of 2 percent, while this increase needs to be accompanied by an intensified virtuous cycle between wages and prices.

The Bank will patiently continue with monetary easing under Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control, aiming to support Japan's economic activity and thereby facilitate a favorable environment for wage increases. It will continue to closely examine developments in economic activity and prices, including the virtuous cycle between wages and prices, from the perspective of sustainable and stable achievement of the price stability target.

Meanwhile, with extremely high uncertainties surrounding economies and financial markets at home and abroad, it is appropriate for the Bank to increase the flexibility in the conduct of yield curve control so that long-term interest rates will be formed smoothly in financial markets in response to future developments. In this regard, currently, the Bank considers that strictly capping long-term interest rates by fixed-rate purchase operations at 1.0 percent for consecutive days, which it has offered every business day in principle, will have strong positive effects, but could also entail large side effects. Given this, it decided to conduct yield curve control mainly through large-scale JGB purchases and nimble market operations.

3. With extremely high uncertainties surrounding economies and financial markets at home and abroad, the Bank will patiently continue with monetary easing while nimbly responding to developments in economic activity and prices as well as financial conditions. By doing so, it will aim to achieve the price stability target of 2 percent in a sustainable and stable manner, accompanied by wage increases.

The Bank will continue with QQE with Yield Curve Control, aiming to achieve the price stability target, as long as it is necessary to maintain that target in a stable manner. It will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds 2 percent and stays above the target in a stable manner. The Bank will continue to maintain the stability of financing, mainly of firms, and financial markets, and will not hesitate to take additional easing measures if necessary.

Note:

Voting for the action: UEDA Kazuo, HIMINO Ryozo, UCHIDA Shinichi, ADACHI Seiji, NOGUCHI Asahi, NAKAGAWA Junko, TAKATA Hajime, and TAMURA Naoki. Voting against the action: NAKAMURA Toyoaki. While Nakamura Toyoaki was in favor of the idea of further increasing the flexibility in the conduct of yield curve control, he dissented, considering that it was more desirable to increase the flexibility after confirming a rise in firms' earning power from sources such as the Financial Statements Statistics of Corporations by Industry.

Highlights of BOJ Governor Ueda’s comments: BOJ presser 31st Oct’2023

·         Currencies need to move stably, reflecting the fundamentals

·         The possibility remains low for monetary policy to fall behind the curve

·         We are getting gradually closer to achieving the price target

·         We considered FX as part of the potential side effects

·         We wanted to tweak YCC before side effects increased

·         Will patiently continue monetary easing with decided new measures

·         Today's steps came partly as a result of rising US long-term rates

·         I don't think that long-term rates will come under pressure to exceed 1%

·         The BoJ will continue its large-scale bond-buying

·         Today's decision was aimed at making the YCC operation more flexible amid extremely high uncertainties around the economy and financial markets

·         We won't hesitate to take additional easing measures if necessary

·         It's appropriate to improve the flexibility of YCC

·         We are not in a situation to foresee sustainable and stable price increases

·         We are to carefully monitor if a wage-price cycle takes hold

·         We will closely scrutinize the economy and price situation by examining wages and prices

·         I expect inflation to slow in FY2025

·         Japan's economy is recovering moderately

·         We will patiently continue monetary easing with decided new measures

·         Next spring's wage negotiations will be an important factor

 

Conclusion:

Japan’s core inflation was around +4.2% in September from +4.3% sequentially, continues to be around the highest since Dec’1980 and is still substantially higher than Jan’23 reading of +3.2% as well as the BOJ target of +2.0%. In 2019 (pre-COVID), Japan’s core inflation was hovering around 0.5%, and fell below 0% during COVID (Jan’20-Mar’22); in Mar’22 it was around -0.7% but soon jumped above +0.8% in Apr’22 as oil/energy soared after Putin’s Ukraine invasion started in Feb’22. Japan is dependent on imported fuel/energy and food. Thus Japan is also a big victim of Russia-Ukraine/NATO/G7 geopolitical tensions and subsequent economic sanctions on various Russian commodities (like EU/Europe). Now Israel-Hamas Middle East geopolitical tensions along with devalued currency, the threat of more imported inflation is quite prominent.

Japan suffered double-digit inflation (hyperinflation) and also above +20% core inflation in the 1970s. Thereafter lower core inflation in Japan may be a combination of various factors: lower fuel tax, lower housing demand/price, lower growth in household income, lower pricing power by producers, unfavorable demography/aging population, and excessive automation; in brief, demand is lower than supply in Japan. But now, the situation has changed drastically and JP's economy is suffering from huge imported inflation. A local household/lower-middle class family now needs a minimum JPY 400-500K.month for a comfortable standard of life against the present average JPY 450K wage.

And BOJ is not ready to hike the policy rate despite higher core CPI than the target since Oct’22 because BOJ wants to see sustainable higher core inflation due to elevated demand, wage pressure and thus not ready to normalize policy as BOJ thinks the present elevated core inflation is a result of supply shock and currency depreciation (higher imported inflation)-thus transitory!

There is a deflationary mindset in Japan, but Japan is the biggest exporter of capital due to almost zero yield locally; it’s the biggest foreign bondholder for the U.S. Now higher Japanese bond yield above +1.50% may cause capital flight back into Japan, and also cause higher global bond yield. Thus the risk trade is under pressure on higher borrowing costs on both sides of the Atlantic as well as the Pacific (U.S.-Europe-Japan).

Overall, there is a huge policy divergence between the Fed and BOJ. If we adjust the average core inflation, the real U.S. /Fed repo rate is now around +1.20% against BOJ/Japan’s -4.00%. Also, BOJ is still running QE, while Fed is on QT. This is causing huge JPY depreciation against USD and even EUR, and GBP, causing a vitreous cycle of higher imported inflation and stagflation despite the advantage in exports. Also, geopolitical tensions with Russia and China are causing significant supply chain disruptions in Japan, causing more imbalances between constrained supply and demand.

As per Taylor’s rule, for Japan:

Recommended policy repo rate (I) = A+B+(C+D)*(E-B) =0.00+2.00+ (0+0)*(4.00-2.00) =0+2+2=4.00%

Here:

A=desired real interest rate=0.00; B= inflation target =2.00; C= permissible factor from deviation of inflation target=0; D= permissible factor from deviation of output target from potential=0.00; E= average core inflation=4.00% (2023 average)

As per Taylor’s rule, Japan’s repo rate should be around 4.00% instead of the present +0.30%. Normally, a Central Bank should do its job to bring down inflation/ensure price stability by hiking rates into the restrictive zone (real positive rate) so that the resultant higher borrowing costs curtail demand/consumer spending, corporate and even government spending, so that constrained supply side of the economy matches, and ultimately inflation normalizes/falls. This is exactly what is being done by the Fed, ECB, BOE, and almost all other G20 central banks, where core inflation is still running substantially hot.

But despite that BOJ/Japan Government is not ready to hike or even normalize/exit the current ultra-easy monetary policy as Japan is the only major economy in G10, which is paying around 12-15% of its tax revenue as interest on a huge public debt against U.S. 9.5% and EU/China’s 5.5%, far ahead of the AEs, which is a red flag and thus despite various narratives, BOJ is not in a position to normalize policy rate even after core inflation now hovering above +4.0%, substantially higher than the target.

Japan/BOJ has no option but to keep the bond yield/coupon rate at an artificially ultra-low level to keep borrowing costs minimal, so that it does not go above the 15% of the revenue red line. Japan/BOJ improved the borrowing cost ratio to 11.67% in FY22 from 13.50% in FY21 (relative to total revenue). BOJ now holds almost 50% of the total JP public debt and is also the largest beneficiary of interest payments.

Japan/BOJ has no option but to keep the bond yield/coupon rate at an artificially ultra-low level to keep borrowing costs minimal, so that it does not go above the 15% of the revenue red line. Japan/BOJ improved the borrowing cost ratio to 11.67% in FY22 from 13.50% in FY21 (relative to total revenue). BOJ now holds almost 50% of the total JP public debt and is also the largest beneficiary of interest payments.

But decades of artificially lower bond yield environment are also weakening Japan’s bank & financials, wage growths, and overall consumer spending. Japan is now entering a deflationary to a stagflationary cycle. If core inflation continues to surge and becomes sticky/elevated around 5%, then BOJ’s ultra-easy monetary policy may cause more devaluation for the currency/Yen and cause more imported inflation, everything being equal (despite BOJ/Japanese government jawboning that they are ‘watching’ Yen movement).

Market impact:

BOJ policy impact: Less hawkish hold; USDJPY jumped; export-heavy JP stocks also soared

·         As a result of the Bank of Japan's minimal adjustments to its yield-curve-control settings, which disappointed some in the market who had anticipated a broader easing of its accommodative monetary policy stance, the yen declined

·         Japan's currency fell as much as 0.7% to 150.10 per dollar, 10-year bond futures began to recover, and stocks gained as a result of the central bank's decision to maintain its negative interest rate and to maintain the 1% restriction on long-term yields (USDJPY jumped)

On Tuesday, Wall Street Futures also edged up on ease of Gaza war tensions as Israel is now under increasing global pressure including the U.S./Europe to consider a humanitarian ceasefire, while intense backdoor negotiations are also going through Qatar mediation for the release of all hostages. Hamas may agree to release all the foreign hostages shortly, while Israel is insisting on the release of all hostages including Israelis. But Israel is also officially denying any significant progress on the hostage deal with Hamas. Thus overall risk trade is still under stress, while Gold and oil are quite volatile.

Looking ahead, whatever may be the narrative, technically, USDJPY now has to sustain over 153.00 for a further rally to 156.00 levels; otherwise sustaining below 152.50-152.00, USDJPY may again fall to 146.00-136.00 levels (if BOJ intervened seriously, Fed sounded more dovish than expected, and Israel goes for some peace/ceasefire agreement with Hamas).