The state we’re in
20 February 2018
One of the criticisms of the Bank of Japan’s (BoJ) aggressive monetary policy experiment has been that it has impeded price discovery mechanisms in financial markets. Recent evidence points to a strong causality between policy and market performance. The Bank’s frequent intervention in the Japanese government bond (JGB) market through its ‘rinban’ or fixed-rate operations have significantly reduced the sensitivity of Japanese rates to the G10 fixed-income complex, even if the directionality has until recently held. Likewise, the BOJ’s ¥6trn in annual ETF purchases have been executed increasingly tactically, i.e. more as a stabilisation fund, with buying largely centred on down days. However, even markets with less-direct intervention have been well-behaved until very recently, with the 2017 USD/JPY trading range of less than 10% having occurred only three times since 1980 (1983, 2006 and 2015). The latest bout of market volatility has allowed us to test the extent of the BOJ’s control in key markets and draw some conclusions about its potential response to higher financial stress.
Perhaps the most striking feature of recent market disruption has been the relative decoupling of long-term bond rates from US rates. While US Treasuries saw a 15bps sell-off since end-January, JGBs have rallied 4bps (see Chart 8). Given the BoJ carried out fixed-rate purchases at the beginning of February, it is easy to conclude this largely reflects a renewed sense of commitment to Yield Curve Control and confirmation of its preponderance in the market. However, it may also reflect a belated recognition of the diverging trajectory of price and growth fundamentals between the US and Japan. In contrast, equity market movements are largely consistent with global trends, with the Topix Index falling 10.9% from peak-to-trough while the S&P 500 fell 10.2%. As a key barometer of the success of Abenomics, the sharp decline may prove politically problematic. However, it still leaves the stock market above its level of a year ago, negating the need for any policy refinement like increasing the size of ETF purchases.
Policymakers have been less sanguine about recent currency fluctuations, with Governor Kuroda and Cabinet Secretary Suga both raising concerns. The magnitude of the recent yen move has certainly been striking but it has not been inconsistent with past bouts of risk reduction (see Chart 9). The disquiet seems to stem from the timing of the adjustment and questions about its persistency. The fact that the correction comes ahead of the fiscal year (FY) may impact Japanese exporters’ hedging activity in the year ahead. Hedge selling orders in FY2017 have been consistent with internal USD/JPY assumptions set at 110. However, a drop in these assumptions for FY2018 to, say, 100-105 could result in pressure for the USD/JPY to sell down to that level in the 12 months ahead. The ultimate determinant of the persistency of the recent yen strength is likely to depend on the approach adopted under the new BoJ leadership. On balance, the re-appointment of Kuroda and the selection of BoJ executive director Amamiya and reflationist academic Wakatabe as deputy governors has been interpreted as dovish in tone. However, widening US-Japan rate differentials has proven insufficient to drive the FX market. This largely reflects concerns about policy ammunition going forward. New leadership will require new ideas if policymakers are to retain influence over the direction of USD-JPY.