The Bank of Japan shook world markets on Tuesday in a monetary move that at the least reminded everyone the entity still exists.
It’s been a long, long while since Governor Haruhiko Kuroda logged into global markets. Seeing that the green light next to his avatar had switched on was enough to send the yen higher, currency traders scurrying and People’s Bank of China (PBOC) officials in Beijing wondering what gives.
The last thing Chinese leader Xi Jinping needs as he works to revive Asia’s biggest economy is Tokyo unleashing global market chaos at a moment when the US is sliding toward recession.
Now for some sobriety. The BOJ is not about to disrupt China’s 2023.
By shifting its yield curve stance – allowing 10-year bond yields to rise to around 0.5%, double the previous upper limit – all Kuroda did was the monetary policy equivalent of liking a tweet or sharing a Facebook post. It was, in other words, the barest of gestures the BOJ could make to remind global markets Tokyo’s monetary cops have not abandoned their beat.
Fair enough, and it was wise for Kuroda to offer some proof of life as Japanese inflation surged the most in 40 years.
But three things are worth remembering here. One, the interest-rate hike cycle for which many traders are bracing is not in the offing. Two, widening the yield curve band could just as easily pave the way for the BOJ to ease more. Three, Team Kuroda is more trapped in the world’s boldest experiment with ultra-loose policy than markets seem to realize.
“Tuesday’s adjustment confirms that Governor Kuroda can be counted on to pull a rabbit out of his hat,” says economist Stefan Angrick at Moody’s Analytics. “Still, the broader economic context hasn’t changed.”
Much of the BOJ intrigue stems from the fact Kuroda is stepping down in March. Since March 2013, the BOJ’s longest-serving leaders have cornered the Japanese government bond market, becoming by far the biggest holder of stocks via exchange-traded funds. The BOJ gorged on assets across the economy in a bid to end 20-plus years of deflation and malaise.
The expectation now is that Prime Minister Fumio Kishida will name another activist BOJ leader to outdo Kuroda’s exploits – just in the other direction.
Kuroda was tapped by the late Shinzo Abe, prime minister from 2012 to 2020. Kuroda didn’t disappoint. His “shock-and-awe” campaign was so aggressive that it drove the yen down 30% in short order. By 2018, the BOJ’s balance sheet topped the size of Japan’s entire $5 trillion economy, a first for a Group of Seven nation.
But the odds of Kishida taking big chances on the next BOJ leader seem a reach. Since October 2021, Kishida has been as cautious a Liberal Democratic leader as Japan in decades.
This year, runaway inflation, Tokyo’s deteriorating security situation, a series of scandals among his cabinet members and fallout from Abe’s assassination in July pushed Kishida’s approval rating below 30%.
Among the demerits voters hold against Kishida: the complete failure to implement any part of his “new capitalism” scheme to raise living standards and rekindle innovative animal spirits. Now that Japan is getting the inflation Kuroda was hired to generate, it’s the “bad” kind: imported via elevated commodity prices via an undervalued exchange rate.
As Angrick points out, “demand-driven price pressure remains preciously scarce. While further policy tweaks by the BOJ are a possibility – especially under a new governor next year – it’s hard to see a fundamental shift. The factors that have kept Japanese policy rates close to 0%, especially the lack of robust wage growth, are unlikely to change soon.”
In other words, Japan isn’t as ready for tighter monetary policy as many believe. It could thrust the economy back onto a deflationary path. Wages have flatlined for 25 years, a pre-existing condition made worse by the last two-plus years of Covid-19 trauma. Nothing Kishida has done these last 14-plus months is likely to increase Japanese prosperity.
Economist Takeshi Yamaguchi at Morgan Stanley MUFG, says there’s a risk markets go too far in assuming BOJ tightening is on the way.
“Kuroda has stressed the importance of wage increases, and repeatedly stated his view that range expansion for the long-term rate would represent a tightening move,” Yamaguchi says.
“Thus,” Yamaguchi adds, “the abrupt range expansion appears to be incongruent with the BOJ’s explanations to date. We see a risk that the latest move will further lower the market’s confidence in the explanations provided by Kuroda and the BOJ and result in the market pricing in further monetary tightening.”
Some sense Kuroda may be more optimistic that demand is about to perk up. “In addition to the upward revision of the outlook for the domestic economy in the statement, Governor Kuroda also indicated … rising momentum of higher wages and inflation,” says economist Ayako Fujita at JPMorgan Chase.
“We think this is a signal that the BOJ is becoming slightly more confident about achieving the target inflation in a stable manner,” Fujita adds, noting that the yield curve move is “the first step toward policy normalization.”
But as political wags start to bet Kishida’s days are numbered, he is turning to that most typical of political crouches: a pivot toward national security. In recent days, Kishida rolled out plans for Japan’s biggest military buildup since World War II with plans to double defense spending as a percentage of gross domestic product (GDP).
On December 16, Kishida greenlit three major documents bolstering Tokyo’s capabilities involving the National Security Strategy, the National Defense Strategy and the Defense Force Development Plan. These “counterstrike capabilities” give it latitude to attack another country’s territory if it deems necessary. It’s quite a departure from the pacifist post-war constitution.
To many security analysts, it seems more like a political Hail Mary – a reach for relevance to keep power. It’s also somewhat of a distraction from the mandate Kishida received from voters: to revive an economy rapidly losing competitiveness to China.
Yet the odds of Kishida applying his sudden courage on national security matters to the BOJ seems farfetched. The reason: Japan Inc’s “mutually-assured destruction” problem.
Japanese government bonds (JGBs) are the cornerstone asset held by banks, exporters, local governments, pension and insurance funds, universities, endowments, universities, the sprawling postal system and rapidly growing ranks of retirees.
If yields were to surge – as they began to on Tuesday – every sector and participant of the world’s No 3 economy gets hurt. That applies, too, to Tokyo’s stock market, whose valuations are predicated on sub-0.5% yields on 10-year JGBs.
“An abrupt and substantial rise in interest rates would have severe consequences,” says economist Richard Katz, publisher of the Japan Economy Watch newsletter.
“As rates go up, the value of existing bonds held by banks, pension funds, and insurers goes down, straining their balance sheets. Meanwhile, a quarter-century of near-zero interest rates has created a host of Japanese companies addicted to essentially free money,” Katz says.
A jump in bond rates above 1% would also trigger shifts in the so-called “yen-carry trade.” Twenty-three years of zero – or sub-zero – rates quickly morphed Japan into the globe’s largest creditor.
Since then, free BOJ money has become the fuel propelling global assets higher. Traders borrowing cheaply in yen and carrying those funds over into higher-yielding assets from the US to South Africa to Poland to New Zealand to China has long been one of the most lucrative bets anywhere.
That’s why aggressive gyrations in the yen tend to take currency, bond and stock markets, real estate investments and now even cryptocurrencies down with them. And, it follows, Japan-driven volatility would cause troubles for China’s economy at arguably the very worst moment.
“It’s important not to underestimate the impact this could have, because tighter BOJ policy would remove one of the last global anchors that’s helped to keep borrowing costs at low levels more broadly,” says economist Jim Reid at Deutsche Bank.
In recent months, as the yen plunged by more than 30% against the dollar, economists including Jim O’Neill, formerly with Goldman Sachs, worried and warned about a possible Asian Crisis 2.0.
O’Neill made his name popularizing the idea of the BRICs – Brazil, Russia, India and China – and there strong potential for driving global growth way back in 2001. More recently, he argued that China would see the yen weakening to 150 to the dollar as an “unfair competitive advantage” with “perfectly obvious” parallels to the 1997 crisis.
“China,” O’Neill says, “would not want this devaluing of currencies to threaten their economy.”
The risk works the other way, too. Skyrocketing yen rates would trigger an earthquake in world markets, slamming mainland bond and stock bourses everywhere, says strategist Mitul Kotecha at TD Securities.
As China reopens from its “zero-Covid” era, Xi is determined to boost growth from 30-year lows and lure back the tidal waves of capital that fled over the last two-plus years.
China hardly needs fresh volatility from Japan at a moment when the US is stumbling. After all, the BOJ has shocked world markets before, observes strategist Martin Whetton at Commonwealth Bank of Australia. He notes that the BOJ blindsided global investors in 2014 with an unexpected move to increase bond purchases. Years before that, in 1989, Tokyo hiked rates during the holidays.
“It was about this time 33 years ago when, unhappy with dollar-yen, the BOJ hiked 25 basis points to 4.5% on Christmas Day,” Whetton recalls.
The good news for China is that the BOJ is too deep into yen-denominated assets to step away from the bed Kuroda’s team made for itself over the last decade to slam on the monetary brakes.
Just ask Toshihiko Fukui, the BOJ governor from 2003 to 2008 who tried to normalize rates. First, Fukui ended the quantitative easing experiment that his predecessor pioneered. Beginning in 2006, Fukui started raising rates – two rate increases, in fact.
But the empire struck back. By 2008, angry politicians and panicky markets managed to browbeat Fukui’s successor into slashing rates back to zero.
Then came Kuroda in 2013 to make quantitative easing (QE) great again. Odds are, if Kuroda or the next BOJ leader tried hiking rates, markets would pounce and remind the BOJ who’s boss.
Bottom line: the BOJ is now a risk factor for China in the year ahead. But it’s a much smaller threat to Xi’s revival hopes than many investors may think and fear.
Follow William Pesek on Twitter @WilliamPesek