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Tinkering or Tightening? - The BoJ's Late-Year Surprise - Global Exchanges

FICC Podcasts Podcasts December 20, 2022
FICC Podcasts Podcasts December 20, 2022

 

In this abbreviated episode, we offer a preliminary reaction to the BoJ's surprise decision to tinker with the parameters of its yield curve control mechanism.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

 

Hi. Welcome to Episode 60 of Global Exchanges, a podcast about foreign exchange markets and related issues. We hadn't intended to publish an episode this week, but the BoJ helped us change our mind. So for this abbreviated episode, my cohost Stephen Gallo and I will offer a preliminary reaction to the BoJ's surprise decision to tinker with the parameters of its yield curve control mechanism. The title of this episode is Tinkering or Tightening the BoJ's Late Year Surprise.

Stephen Gallo:

 

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

 

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Stephen's cohost.

Stephen Gallo:

 

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market, we also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

 

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Stephen Gallo:

 

Okay. It's December 20th, 2022. Thanks for listening. Well, here we are, Greg, five days before we break for the holidays in the west, and the Bank of Japan throws us a curve ball with a December policy shock typical especially for 2022. Greg, before we get into the more interesting aspects of this policy decision and the implications for the Japanese yen, I think it would be good if we give listeners an idea of exactly what the BoJ did overnight. So tell us what exactly the BoJ changed regarding its yield curve control parameters, and then we'll go through some of the implications of this.

Greg Anderson:

 

Hey, Stephen, before touching on yield curve control, let me just start by saying that the BoJ left its target for the overnight rate unchanged at minus 0.1% or minus 10 basis points. The BoJ is now alone in the G10 with a negative overnight rate, so it didn't move its most important monetary lever, although one could argue that they ran a little experiment to see how much the market would react if they did choose to move that main lever, the base rate unexpectedly. Okay, so back to what they did. The BoJ has maintained a policy of targeting the yield on the 10-year JGB at roughly 0.00% since 2016. Now, since implementing the yield curve control six plus years ago, they have tinkered with it before. So the bond was initially set at plus or -10 basis points around zero, then they widened it in 2018 to plus or minus 20 basis points around zero.

Then in March 2021, they widen it again to plus or minus 25 basis points. So I guess this is the third adjustment of the bandwidth. With the adjustment just done and to clarify, the bond is now plus or minus 50 basis points or put in another way, it's 100 basis points wide. That means that the BoJ is not going to come into the market and intervene in the bond market with what they call fixed rate auctions unless or until those thresholds are breached.

So this year, we have entirely been worried about the top side. Hasn't always been the case during the pandemic, we were worried about the bottom side, but this year, we have seen the JGB rise to 25 basis points and the BoJ hold fixed rate auctions to defend that level multiple occasions during 2022. So the fact that they raised the ceiling to 50 basis points conceivably it's allowing that 10-year JGB yield to instantly rise up up to 50. Although that's not what happened overnight. We saw that 10-year JGB yield instantly rise to 40 and then drift up to about 44 basis points, and then it drifted back down to where it closed at plus 40 basis points. So not at the threshold where the BoJ would have to intervene.

Stephen Gallo:

 

You know something, Greg, your comments regarding buying and selling a limited quantities of paper got me thinking of the Swiss National Bank and the predicament it got itself into when it first implemented a floor in Euro Swiss back in 2011. Actually, I tell sort of a lie, it didn't get into a predicament in 2011. Over time, it got into a predicament as it became impossible to defend their Florin Euro Swiss. But the main parameter of the Euros Swiss floor was that the SNB would supply an unlimited amount of Swiss francs to the market at a level of one versus the Euro in an attempt to stop the Swiss franc from appreciating.

And I'm sure you and many listeners will remember the fact that the SNB subsequently removed the floor in an abrupt manner in 2015 and caused enormous dislocation in the spot of X market and massive losses for some financial institutions that were betting on the SMB being able to hold the floor in place forever. So my second question, Greg, are the changes to the yield curve control parameters we observed overnight from the BoJ, the first step to the central bank removing yield curve control?

Greg Anderson:

 

Great question, Stephen. I guess that's the trillion yen question. Look, I think the FX market with its 3% reaction today seems to be assuming that this is the first step in a long policy normalization sequence. And maybe the first half of that sequence would be getting rid of yield curve control in a series of steps and then raising the overnight rate to some positive number. And I would just say, well, probably plus 10 basis points. I do think that this is what the BoJ hopes to be able to do, but I also think that the time horizon for this is going to be just absolutely glacial and waste lower than the market seems to be pricing today. Now, I'll admit, I am stunned that they did this now because Kuroda was down to just having four months left in office and the yield curve control mechanism was sort of his baby.

So I didn't think this shift would occur until late next year, especially after we've had multiple junctures this year where the market has been a buzz with the possibility of them adjusting yield curve control and each time Kuroda came in and just said, "Nope." But look, maybe what he wanted to do is to do his replacement and the BoJ as an institution a favor by getting things rolling in December 2022. That said, I don't think that we'll see the next step until roughly December 2023. And I think that step would just be another widening of the bond may maybe to plus or minus 100 basis points around a target of zero, although I guess maybe they would just scrap the mechanism at that point. I think that any eventual hike in the base rate to a positive number, I think that's a 2024 story or even later than that.

So just timeline reminder, the new head of the BoJ will take over in April, probably be nominated in February. New person is in place, I think they would take a month or two to let things settle and then do a framework review. What's supposed they start that framework review in June, the way these things run, then they're finished with it in November. And so, November, December, that's the earliest I see them possibly scrapping yield curve control. So to summarize and reiterate, yes, this is step one of a multi-step process, but subsequent steps are likely to come in yearly increments as opposed to the next several meetings in meeting by meeting increments.

Stephen Gallo:

 

I think that's a good point you make about getting things rolling for the BoJ in December ahead of the upcoming handover. This leads me into my next question, Greg. I wanted to ask you about the timing of this move. In view of the challenges facing the JGB market, as we all know, and the BoJ huge ownership share of the market, was there anything else besides smoothing the handover process that made December a good month for the BoJ to act? For instance, had the BoJ made this change three months ago, I think it would've caused a lot more volatility in the FX market and probably been a lot more damaging to risk assets. Suppose for instance, the BoJ decided to change its yield curve control parameters when the US 10-year Treasury yield was between four and four and a quarter as opposed to comfortably below 4% like it is now. What might have happened in that case, do you think?

Greg Anderson:

 

Well, Stephen, foremost, I think they did this because the JGB market was frozen and they wanted to restore more normal functioning and liquidity. I also think they wanted to restore a more normal shape to the curve too, because it did have a very sharp kink to it, going into the meeting with the five-year yield at 15 basis points, the 10-year yield at 25 basis points, and then the 20-year yield all the way up to roughly 120 basis points. So now regarding the FX and global implications of this, I do think that this December timing works out a lot better than things would've worked out if they had done this in September. So just looking back to September, that is when the MOF ordered its first big intervention into the FX market. Now, if the BoJ had tweaked the old curve mechanism, then I think markets would've interpreted the move as another aspect of FX intervention.

So doing it now when the FX market has stabilized in the 130s, makes it easier for them to sell the idea that this is not about FX, this is about the Japanese government bond market, and hey, this is merely just the third adjustment of the tolerance bandwidth and therefore it's a tinker and not a tightening like other central banks have clearly done in response to weak currencies. So the other thing, as you alluded, Stephen, the spillover of this move in terms of impacting 10-year yields in other currencies, US Treasury is included, I think there's a whole lot less spillover now than there would've been in the July to October period when US Treasury yields were just spiking. I don't think though that that was a major component of the BoJ's thinking and in coming up with the timing of this, but who knows.

Stephen Gallo:

 

Okay, Greg, so I want to briefly dive into what's coming in the first half of 2023, because after all, this is December and we are in the middle of preparing our annual outlook. I think we're on the same page as one another on this point in that what the BoJ did overnight was tinkering with monetary policy as opposed to monetary tightening. But I also see it as an attempt by the BoJ to hedge itself and its currency against the risk that the yen gets steamrolled again next year if the BoJ is the central bank laggard when it comes to tightening, especially if inflation is not as well behaved as expected and energy prices surge again. What worries me for the first half of next year is that with all the central banks engaging in some form of withdrawal from stimulus, the backdrop for risk assets will be more vulnerable to bad news, and that has implications for broader FX markets because risk-off or fragile conditions and risk assets generally push the dollar higher. What do you think about this, Greg?

Greg Anderson:

 

Yeah. So I completely agree that risk appetite is likely to be restrained for the first few months of next year in restrained risk appetite usually means US dollar index higher. That would be my view for sure for Q1 and probably well into Q2, so we're aligned on that. Now, where it admittedly gets particularly tricky is in dollar yet. Over the course of the last decade, the usual risk-on/risk-off dynamic has been that waning global economic confidence brings lower equity prices, lower commodity prices, and along with lower 10-year US Treasury yields. Those factors in particularly the lower 10-year treasury yields and lower oil, they pull down on dollar-yen. So generally, over the last 10 years, dollar-yen has moved lower when the US dollar index has moved higher in response to risk-off. 2022 has been an exception to that pattern.

For most of this year, we have had the Fed as the primary catalyst for risk-off. So what that has meant is that we've seen the US dollar index rising alongside of US Treasury yields all along the curve, including the 10-year, and that has pulled up dollar-yen. So what about 2023? I admit, it's conceivable that start of the year we go back to a world where risk-off brings dollar-yen lower. However, I guess I'd still be reluctant to make that call for half one and particularly from a 132 starting point in dollar-yen. For now, I would probably stick with risk-off, means dollar index up and dollar-yen up in half one. So I give you a dollar-yen target of the high 130s in the first few months of 2023. But I do think there will be a turn in the second half of the year and probably a more normal situation in dollar-yen where once again, yen becomes a consistent safe haven currency by the end of the calendar year.

Stephen Gallo:

 

Greg, I think that about wraps it up for this BoJ focused Episode 60 and for 2022. We wish you all the very best for 2023, and thank you for listening throughout the year. Bye for now.

Greg Anderson:

 

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

 

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcast, Spotify, or your favorite podcast provider.

Greg Anderson:

 

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy group and be BMO'S marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

 

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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