The Bank of Japan (BOJ) has bid farewell to its negative interest rate policy (NIRP), yield-curve control (YCC) and quantitative and qualitative easing (QQE), marking the end of an era of extraordinary monetary easing. This paves the way for a more normalized Japanese bond market, offering fresh opportunities for investors who have been wary of this space over the past decade.
Time has come to transition away from NIRP, YCC and QQE
The BOJ's shift from a complex and overly accommodative stance (combining NIRP, YCC and QQE) to a 0%–0.1% positive policy rate and a simpler approach was no surprise. The fundamentals were supportive, and the changes were well-telegraphed ahead of the BOJ's meeting.
Inflation expectations in Japan have been largely reanchored to more positive levels. The combination of global inflation induced by COVID-19 and a weak yen, exacerbated by central bank policy divergences, served as the catalyst Japan needed to break free from entrenched deflationary expectations and offered an opportunity for the BOJ to retire some of its more inflexible policy tools.
The BOJ's pre-meeting communications underscored its expectations that it would maintain an accommodative policy stance, including the continuation of government bond purchases. This cautious rate increase is strategically aimed at managing the potential uptick in bond yields without causing market disruption.
A new inflationary landscape for Japan
The BOJ’s 19 March policy changes, while largely anticipated, should have minimal immediate market impact. However, the medium- to long-term implications could be significant, as the potential scale of the BOJ’s policy changes may be more than the financial markets currently anticipate.
A key question is where Japan’s trend inflation rates will stabilize post-pandemic. Although Japanese inflation has shown signs of moderation, and further moderation is quite possible, we believe the country appears to have settled into a “1-point-something” percent inflation rate, if not 2%. This marks a significant departure from the near-zero percent trend of the past three decades.
This new baseline represents a structural shift in the labor market and corporate pricing behavior. The era of Abenomics (2012-2020) saw a temporary mitigation in the decline of the labor force due to an increase in participation rates, but further improvements are now constrained. The pandemic’s global inflationary impact, coupled with the yen’s depreciation, has been a major catalyst for significant shifts in inflation expectations and corporates’ price and wage-setting behavior. While the BOJ’s 2% inflation target remains elusive, given the country’s still inflexible labor system and low productivity, a reversion to zero percent inflation seems equally unlikely.
BOJ policy in the new inflationary context
Though the BOJ reiterated its commitment to the 2% inflation target, it is improbable, in our view, that the BOJ will maintain its accommodative monetary policy indefinitely to solidly achieve its 2% target. A more realistic approach would be to tacitly accept a 1%–2% inflation range as a practical target for a nation with low economic growth potential. The expansion of the BOJ’s balance sheet to nearly 120% of GDP has yielded only modest inflation at best and has led to various economic and market distortions. Adjusting the inflation target (perhaps informally), while politically sensitive, is not insurmountable given the current political landscape.
The BOJ's future policy direction hinges on the estimated real neutral interest rate – the level where policy becomes neither stimulative nor restrictive. Assuming a fairly conservative estimate of -0.5%, the BOJ could gradually raise its policy rate to near 1%, slightly higher than current market expectations, to reach a neutral stance in line with an adjusted inflation target range of 1%–2%.
The BOJ’s medium-term policy adjustments will likely involve both balance sheet reduction and interest rate hikes. Despite the potential headwinds from a global economic slowdown and rate cuts from other major central banks, the BOJ is poised to reduce its extraordinarily large balance sheet slowly but surely.
Outlook for investors
For investors, the Japanese bond markets should start offering a higher risk premium and modestly higher yields in response to the BOJ's continued policy adjustments and the transition of government bonds back to market forces. As the market digests the new and evolving policy stance, there will be tactical opportunities for active managers to capitalize on the inefficiencies in the Japanese bond and interest rate swap markets during this period of increased volatility.
Structurally, however, Japanese investors are generally underweight Japanese bonds and should consider increasing their allocations over time given higher yield levels. Although we anticipate a modest uptick in bond yields, the trajectory is expected to be gradual and nuanced on the yield curve. Japanese bond yields are correlated with global counterparts, and with major central banks poised to initiate rate cuts this year, any sharp yield fluctuations in Japan could prompt BOJ intervention. The positive carry from Japanese bonds, supported by a steep yield curve, should over time offer a buffer for bondholders against rising yields. We do not expect Japanese investors to significantly influence market dynamics globally. Domestic flows into Japanese bond markets will rise, but we don’t expect urgency for those investors to offload foreign bonds in favor of Japanese duration. Japanese investors possess ample yen liquidity to deploy domestically and there is a discernible demand for U.S. duration to hedge against potential recession risks.
In conclusion, the BOJ's policy evolution should usher in a period of normalization for Japanese bond markets, eventually attracting investors at higher yields who have been hesitant to invest over the past decade.
