Will the BOJ be the last dovish domino to fall?
The Bank of Japan (BOJ) is coming under increasing pressure as they stick to their guns and retain their easy policy settings. Governor Kuroda likely sees this as a rare opportunity to reverse the entrenched deflationary nature of the Japanese economy. Their Yield Curve Control pins their 10-year bond yield at 0% with a 0.25% fluctuation allowed on either side. In order to ensure the yield stays fixed, the BOJ has to undertake unlimited amounts of purchases to keep the yield constant (will only get worse as the Fed continues to tighten the screws). This has led to a ballooning in their balance sheet, with an ownership percentage of just under 50% of JGBs. This would be an historic moment as no central bank has crossed this threshold before. This inflection point could see the BOJ reconsider their policy of YCC and potentially lead to a regime shift. The obvious capitulation trade is short JGB and long JPY. Traders and hedge funds such as BlueBay are betting that the BOJ is forced to remove their upper YCC cap by positioning short of JGBs via futures or swaps. Those instruments are left to undergo true price discovery as the BOJ only intervenes in the cash market. This divergence can be seen in the below image.
(Source: Bloomberg; Blue line - Cash bond, White line - Swap)
Due to this intervention, the yen has been used as the outlet valve to absorb these pressures. USDJPY is now at levels last seen in October 1998. FX traders will remember the sharp reversal in the yen against the dollar back then, falling some 22% in the space of three months.
So what are the potential scenarios which could play out? 1) Let’s start with the most basic and bullish for the yen - scrap YCC in its entirety. 2) Widen band around YCC target (currently is -0.25% and 0.25%) 3) Raise actual yield target outright instead of widening of bands 4) Target a different maturity, belly of the curve, say 5-year or 7-year vs the current 10-year yield 5) Sit on their hands and do nothing, hoping FX intervention from the MOF will solve their problems (USDJPY would need to move above 140 at least). Will it be enough though as the bulk of the yen’s move has been down to policy divergence and keeping YCC in place will not change that. Anything that allows the spread between US 10-year yields and Japanese 10-year yields to compress, will be very bullish for yen. Additionally, speculative positioning although recently trimmed is still significantly net short, providing a tailwind if we were to see a positioning unwind. Lastly, from a valuation perspective the yen is undemanding.
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