Yen weakness restrained by flexible YCC
- BOJ had made its YCC more flexible, changing the previous target range to a reference range.
- Markets are reading the move as policy gradualism, with JPY and implied volatility declining since.
- However, we view the move as one providing latitude for the BOJ to shift policy nimbly.
- Volatility of long-term JPY rates should rise, which in turn supports the JPY.
- Further USD/JPY rallies could thus be limited, especially if the Fed halts rate hikes.
A more flexible yield curve
Bank of Japan (BOJ) surprised markets last Friday by relaxing its 10Y yield target range of +/-0.5% around 0% to become a “reference” range while committing to a higher cap of 1.0% for the 10Y yield. The express purpose is to enhance the sustainability of policy easing by introducing more flexibility to how it implements yield curve control (YCC).
Shifting from a clear target range to a fuzzy one brings with it a cost to clarity and transparency, while conferring the benefit of allowing BOJ to “smooth” JGB yields when they are judged as excessively above the reference range. In short, the hard defense line of 0.5% has morphed into an elastic defense, which can rapidly change at the BOJ’s discretion depending on how economic data evolves.
We have previously written that rising inflation uncertainty warrants more flexibility to YCC but had expected a straight widening of the YCC trading band. A more “elastic” trading band around the reference range renders this YCC tweak more non-committal and partial than a straight band widening. Possible reasons for this could include a policy desire for gradualism or to curb market volatility in yields, which will certainly be higher under a straight band widening. It also underscores BOJ’s reservations on whether inflation will pick up durably, even as short-term inflation momentum surges.
Impact on the JPY
Post BOJ’s decision, the JPY had noticeably softened while the JGB 10Y yield now trades only slightly above 0.50%. Implied volatility for long-dated USD/JPY options has also fallen. Such market outcomes are in line with views that policy gradualism will prevail. Market participants may expect a limited change in yield levels and that bond purchases from the BOJ will continue, keeping yields well-behaved near the reference range.
We disagree that gradualism is the correct read. Rather, BOJ’s actions are better interpreted as preparing the ground for them to be able to shift “nimbly” in their policy parlance. The policy statement notes that firms’ wage- and price-setting behaviour are changing in Japan, and there are upward shifts to inflation expectations. In addition, BOJ’s research has also found that inflation passthrough from producer prices, exchange rates and wages can show non-linear behaviour, with a larger passthrough beyond a certain threshold (see Sasaki, Yamamoto, and Nakajima (2023)). Extreme JPY weakness could thus continue to stoke inflation going forward.
Suppose the above-target inflation turns out to be more sustained than what BOJ forecasts, having an elastic YCC framework allows BOJ to implement changes more quickly and with fewer risks of strains to bond market functioning. Ultimately, whether JGB yield volatility will materialize is now less reliant on BOJ’s biases and more sensitive to future inflation shocks. Shocks can be larger than usual, as our model indicates that Japan’s conditional volatility of inflation has stayed at high levels, despite mitigating measures such as energy subsidies.
What is the impact on the JPY amid more flexible YCC and rising volatility of JGB yields? We expect that the JPY exchange rate should appreciate when rate volatility rises. Benigno, Benigno, and Nisticò (2012) found that the USD real exchange rate tends to appreciate when there are volatility shocks to the US yield curve, proxied by the MOVE index. Our more recent GARCH-based volatility analysis, broadening to seven other major currencies on top of the USD, also found that the real exchange rates generally tend to appreciate when volatility rises across both short-term and long-term rates.
In conclusion, while markets may perceive BOJ’s flexible YCC as a preference for gradualism with no impact on the JPY, we view this as giving wider latitude for BOJ policy shifts in the future. This should bring higher volatility in long-term JGB rates, supporting the JPY. Thus, any USD/JPY rallies above 142 may prove difficult to sustain, especially if the Fed is to halt rate hikes. MOF’s rhetoric over JPY volatility, and the associated threat of intervention, is also likely to weigh. Going forward, BOJ’s unscheduled bond purchases will be important to determine how much control the BOJ is willing to relinquish, which could be more than many expect.
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