Japan: Long JPY ahead of BOJ meeting
- No major policy change is expected at BOJ Governor Ueda’s first monetary meeting
- Green shoots of sustained inflation suggest that YCC modification remains likely within this year
- The JPY’s response post-BOJ could be asymmetric
- Shifts in inflation outlook/a more nuanced policy guidance may trigger a short squeeze in the JPY
- JPY longs offer a better risk-reward into the meeting
No policy change at the April 27-28 meeting
No major policy change is expected at today and tomorrow’s MPC meeting, the first chaired by the BOJ governor Kazuo Ueda. At the inaugural press conference on April 10, Ueda said that it is "appropriate" to maintain yield curve control and negative interest rates, in view of the current economic, financial and price conditions. He also agreed with Prime Minister Fumio Kishida that there is no immediate need to revise a joint statement between the government and the central bank regarding the roles they must play in overcoming deflation.
Inflation continues to exceed the BOJ’s 2% target but is exaggerated by the supply-side factors including oil price increase and yen depreciation. Headline CPI peaked at 4.4% YoY in January and decelerated to 3.2% in March. Core CPI excluding fresh food and energy continued to rise from 3.2% in January to 3.8% in March, reflecting the second-round effects of import cost increase. Note that Mar-Apr 2022 was the onset of the surge in global oil prices as a result of the Russia-Ukraine war, and the sharp depreciation of the yen versus the dollar as a result of Fed tightening. High base effects should help to lower the headline CPI figures from 2Q onwards. The passthrough effects on core CPI may also dissipate with a time lag.
In the aftermath of the US/European banking crisis in March, JGB yields retreated, and the yen strengthened due to the decline in global risk appetite. 10Y JGB yield slipped to 0.2-0.35% in the second half of March before rebounding to 0.4%-0.48% in April, within the BOJ’s target band of ±0.5%. USD/JPY fell to 130-134 in the past 1.5 months, compared to the peak of 137 in March. Meanwhile, foreign investment in JPY bonds posted a net inflow of JPY787bn on average in the past six weeks, reversing the outflows in the early part of this year.
YCC modification remains likely this year
It is likely that BOJ will modify the YCC policy framework under the new governor within this year (as soon as the June or July MPC meeting). Ueda kept the door open for monetary policy normalisation at the inaugural press conference, citing the emerging positive signs in wages and trend inflation. Meanwhile, news reported that the BOJ will consider conducting a comprehensive review of the impacts of monetary easing in the past two decades at the April 27-28 meeting.
Growth should bottom out in 2H23. The existing drags of exports/manufacturing declines will likely dissipate towards the year-end. The destocking in the global semiconductor sector is expected to be completed by 4Q23. The Chinese economy is expected to enter a broader and more sustained recovery in 2H23. Presuming that the US and Europe will not fall into a sharp recession, Japan’s exports will likely receive a cyclical uplift in 2H23. On the other hand, we think that consumption/services will continue to benefit from reopening; investment will be aided by the long-term demand stemming from automation, digital transformation, and supply chain rebuilding.
The underlying inflation trend will become clearer in 2H23. The inflationary impact of energy price increase and yen depreciation will gradually dissipate towards the year-end. Demand-side factors will thus overtake supply-side factors to become the key driver of inflation. There are currently some green shoots of sustained inflation driven by the demand-side dynamics. During the latest spring labor negotiations, Japanese Trade Union Confederation estimated a 3.8% wage increase on average (preliminary), higher than the 2.2% in 2022 and the biggest in 30 years. The 3.8% increase includes 2.3% base wage hike and 1.5% regular wage adjustment. It will likely translate into 2.5-3% growth in the macro base wages this year, also a big jump compared to 1.1% in 2022. This will also approach the 3% wage growth level seen by the BOJ as a needed condition to achieve the 2% inflation target.
Financial stability concerns will likely still linger, dissuading the BOJ from drastic policy changes in 2H23. With the Fed ending its year-long monetary tightening and global interest rates peaking, an abrupt rise in JPY rates could induce appreciation pressures on the yen and trigger the unwinding of yen carry trades. Meanwhile, the recent banking crisis in the US and Europe serves as a lesson in how a rapid yield increase could negatively impact banks’ financial stability. Japanese banks (especially small regional banks) tended to focus on securities investment in the past decades, in the context of weak lending demand, flat economic growth, and ultra-low interest rates. As of Sep 2022, Japanese banks' aggregate securities investment amounted to JPY256.7tn, equivalent to 18% of their total assets. Nearly half of their securities investment was placed in JGBs and local government bonds (JPY124.8tn). A rapid yield increase could reduce the value of banks’ bond holdings, counteracting the positive impact on interest incomes.
In terms of the steps and measures of policy normalisation, we maintain the view that the BOJ will prefer further widening the 10Y yield band and/or shifting the 0% target to the shorter dated 5Y yield. These measures will have the merits of flexibility, i.e., allowing two-way movements of the long-term yields amidst an uncertain global economic environment. They will also help to improve the functioning of the JGB market and address the problem of poor bond liquidity. The earlier concerns about the side-effects of these measures – an overshooting of the long-term yields amidst a sharp increase in capital outflows – are fading currently, thanks to a more stable global interest rate environment.
Another option is to directly raise the 10Y yield target, while keep YCC in place. As an explicit rate hike, this measure will require a clear and steady improvement in the growth and inflation prospects. If the economy falls back into recession/deflation shortly after the policy rate is raised, such a premature rate hike would be criticized as a failure of monetary policy. As such, the BOJ will need to carefully assess the domestic and overseas economic conditions in the months/quarters ahead before making such a decision.
Abandoning YCC (removing the 10Y yield cap, shifting to a conventional policy framework targeting at the short-term interest rates) is also possible, but the bar is relatively high. In this regard, the BOJ would like to see convincing evidence about sustained inflation, e.g., wage growth maintains a 3% momentum beyond this year to ensure the achievability of a stable 2% inflation. If a stable 2% inflation remains difficult to achieve, the BOJ would need to revise its 2% inflation commitment to pave the way for a YCC exit. The latter would involve discussions with the government to revise the joint statement on inflation, which could be complicated by the domestic political outlook in 2H23, due to the rising chances of a snap general election after the G7 Hiroshima Summit.
JPY: Better odds of a stronger JPY post-BOJ
Should BOJ keep YCC unchanged in line with expectations, downside risks to JPY will be limited. But we see some factors that can potentially catch markets on a wrong foot, and trigger JPY strength.
First, there could be an acknowledgement by Ueda that deflation risks have diminished, which could be construed as the first steps towards preparing for gradual policy normalisation. Indeed, Japan’s trimmed mean inflation—a more robust and stable inflation measure—has already jumped to a multi-decade high of 2.9%. Furthermore, price rises are now very broad-based. The proportion of CPI items which have seen y/y price increases has surged to 82%, far outstripping the previous 2008 peak of 61%. We continue to see the case for further tweaks to YCC to enhance policy flexibility and optionality.
Second, even if Ueda has affirmed that BOJ’s easing stance is still appropriate, his view is not rigidly fixed but dependent on inflation. He had carefully conditioned his view of easing on Japan’s trend inflation staying below 2%. Furthermore, Ueda had also cautioned that a surprise factor for policy is unavoidable, which perhaps indicates concerns that markets could front-run any changes to YCC if advance guidance is given. This means that changes, if there are any, are set to be announced at policy meetings, not in advance.
This week’s policy meeting coincides with updates of BOJ’s inflation forecasts. If there are upward revisions of BOJ’s core CPI forecasts towards 2%, (Jan forecasts: 1.6% for FY23; 1.8% for FY24), it could imply a meaningful shift in the BOJ’s policy view, even with no change in policy. CFTC non-commercial positioning in the JPY has turned quite short. Thus, risks of a short squeeze in the JPY from forecast changes, or a nuanced policy outlook, are present. USD/JPY has recovered from lows post SVB’s failure, suggesting that markets are still quite short JPY and banking on carry trades.
Third, even if there are completely no surprises, JPY downside should be limited by a coming resurgence in tourism inflows starting May. Across a trip through Tokyo, the Tohoku region and Hokkaido, one will observe that Asian tourists are now almost back in force, barring the most economically important mainland Chinese tour groups. This could be partly due to China being relatively late in encouraging vaccination, rendering it difficult for Chinese citizens to fulfil Japan’s entry requirement of having 3 vaccine doses. But starting May 8, Japan will drop all vaccination certification and testing requirements. This should provide a healthy boost to tourist inflows, and catalyze a long-awaited recovery of mainland Chinese arrivals that are still far from pre-Covid levels.
All in, we see an asymmetric JPY response to BOJ risks, and favor JPY longs given the better risk-reward. An unchanged BOJ policy stance should only imply marginal JPY weakness, while surprises to inflation forecasts, or a more nuanced policy guidance, could trigger a trimming of shorts and a stronger JPY. Moreover, Japan’s services sector is poised to receive another boost in May, providing more durable support for the JPY.
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