Japan: YCC policy and Yen
- The BOJ meeting on Friday is highly likely to involve an upward revision in inflation projections.
- However, it is unlikely that substantial policy changes will be introduced.
- There is a 30% possibility of YCC policy modifications being discussed.
- An unexpected YCC policy tweak could lead to a reflexive JPY surge.
- No change to YCC could trigger modest JPY weakness, limited by risks of MOF intervention.
BOJ meeting preview
There is a high likelihood that the Bank of Japan (BOJ) will revise its FY23 inflation projections upward during the upcoming meeting on Friday. Presently, the BOJ forecasts the core-CPI to average 1.8% in FY23, with core-core CPI projected at 2.5%. However, in the first three months of this fiscal year, core-CPI and core-core CPI have far exceeded expectations, reaching 3.2% and 4.2%, respectively. This clearly signals the need for an upward revision to align with the current inflation trend.
While adjustments to the short-term inflation outlook are likely, uncertainties still surround the projections for FY24-25. The BOJ currently predicts the core-CPI to remain stable at 2% in FY24, easing slightly to 1.6% in FY25. Similarly, the core-core CPI is expected to ease to 1.7% in FY24 and 1.8% in FY25. Factors such as the pause in the rise of oil prices and the stabilization of the yen indicate that imported cost pressures and their passthrough may gradually fade in the medium- to long-term.
Wage data is a pivotal determinant for the long-term inflation outlook. A report released by the BOJ's Monetary Affairs Department in May sheds light on the input cost pass-through to consumer prices. The report suggests that the pass-through of increases in producer prices and exchange rates tends to be transitory, while wage growth pass-through exhibits greater persistence due to the observed higher inertia. The report identifies a threshold of around 2.5% wage increase, beyond which the pass-through to core CPI strengthens, and a threshold of around 3% for core-core CPI.
Presently, the latest wage data has not surpassed these critical thresholds. Following this year's Shunto, total wages increased by 2.5% YoY in May, while base wages increased by 1.8%. To make a more informed assessment of whether inflation could reach a stable 2% in the medium- to long-term, the BOJ may opt to wait for more comprehensive Shunto wage data, which will be available in Aug-Sep.
Substantial policy changes such as Yield Curve Control (YCC) exit or rate hikes are not expected to be introduced during the upcoming meeting. Implementing such changes would require firmer wage data over a defined period and an upgraded long-term inflation outlook. The BOJ may also choose to time such policy moves strategically, coinciding with the completion of its 1-1.5 year broad-perspective review of monetary policy, slated for Apr-Oct 2024.
Nevertheless, there remains a 30% chance that the BOJ may consider modifying its YCC policy at the forthcoming meeting. This could involve widening the 10Y yield band or shifting the yield target from the 10Y to the 5Y segment. At present, market conditions do not strongly require YCC modification, with the 10Y JGB yield experiencing only a marginal upward movement of 6bps in the first three weeks of July, still staying below the upper end of the BOJ's ±0.5% band. Additionally, the JPY has appreciated by about 2% against the USD this month, partly driven by growing expectations for the peak of the Fed's rate hike cycle.
On the other hand, the current low market pressures also offer the BOJ an opportunity to discreetly modify its policy. When market participants do not strongly anticipate BOJ policy changes, the central bank gains an advantage in avoiding overshooting in long-term yields. Hence, a policy move at the upcoming meeting cannot be entirely ruled out from this perspective.
JPY: Watching risks of a YCC tweak
Given our expectations that the BoJ should not be mulling any exit from YCC or negative rates at its upcoming meeting, we see little scope for a dramatic move in USD/JPY post-meeting. For one, markets have priced in an outcome where the BoJ does not introduce any meaningful change. Last Friday, a major financial news media reported that BOJ officials see little urgent need to address the side effects of the YCC program in the coming meeting. Markets were quick to respond by re-entering JPY shorts in favor of carry trades. USD/JPY has since rebounded above 140 and is consolidating in a 140-143 range. A BOJ that is on hold this Friday should be par for the course for most market participants.
But even if the wider BOJ policy stance is unchanged, tweaks to the YCC parameters are still plausible. To pre-empt any negative impact on JGB bond market functioning from YCC, a move to widen the YCC trading band (current: +/- 50bps) around the 0% target cannot be ruled out. After all, enacting a tweak when there are no overt pressures is better than implementing at a time where pressures are acute and when any tweak could be quite disruptive.
Could such YCC parameter tweaks, if they happen, lead to a surprise strengthening in the JPY? If the YCC trading band is widened or if the YCC target is moved to a shorter-tenor bond, there is a likelihood for the 10Y JGB yield to trade above its current 0.50% bound. This is because inflation pressures are building in Japan, and a higher inflation compensation premium could be priced. Thus, a policy tweak has scope to push the JPY higher through higher JGB yields. Over the longer-term though, the impact on JPY may fade if the BOJ is right on inflation remaining below target given little change in price-setting behavior, resulting in yields reverting lower.
On a shorter time horizon, the previous YCC tweak in December 2022 saw a strengthening in the JPY in its aftermath, with USD/JPY falling from around 137 to 132 levels. The sharp move partly reflects greater uncertainty over BOJ’s policy stance, but it is also indicative of how stretched the JPY is from its fair value, and how sensitive it has become to small policy shifts, given that large rate differentials have made in a favored funding currency for carry trades.
As such, we expect the short-term impact on JPY to be sharply positive in the event of an unexpected YCC tweak. Widening of the YCC trading band to +/-75bps around 0% could result in a surge in the JPY, with USD/JPY possibly easing towards 135. Changing the tenor of the YCC target to a shorter 5Y bond signifies a degree of withdrawal of stimulus and could lift the JPY even more, as the policy anchor across the yield curve will become more limited.
On the flip side, if there are no policy tweaks, USD/JPY could rally back to 143, though risks of intervention from the Ministry of Finance (MOF) are likely to cap further gains. Back in Sep-Oct 2022, Japan had intervened in currency markets after voicing repeated concerns on currency volatility. With USD/JPY trading closer to levels that had precipitated intervention previously, Vice Minister Kanda, the top currency official responsible for JPY intervention, had also recently reiterated that excessive currency moves are undesirable. We think official rhetoric could step up more in frequency and intensity if JPY weakens too much, and downside risks should be correspondingly limited.
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