Policy divergence between the Bank of Japan (BOJ) and its G10 counterparts continues to widen, resulting in heightened pressure in Japan’s FX and bond markets. The European Central Bank delivered an outsized 75bps rate hike on 8 September. The Federal Reserve is also expected to hike 75bps on 22 September. In contrast, the BOJ is expected to maintain its Yield Curve Control (YCC) on 22 September, anchoring the 10-year Japanese Government Bond (JGB) yield at 0.25%. 

The yen has depreciated by 25% against the USD in the past six months, hitting the weakest level seen since August 1998. The YCC policy has stretched by the markets, with the 10Y JGB yield advanced towards the BOJ’s upper limit of 0.25%. In response, the BOJ boosted bond purchases during the regular operations on 7 and 14 September. It also reportedly conducted a FX rate check with financial institutions on 14 September. Meanwhile, top government officials stepped up verbal interventions on the yen. Chief Cabinet Secretary Hirokazu Matsuno, Finance Minister Shunichi Suzuki and currency chief Masato Kanda all have said that they won’t rule out any options on FX response.

BOJ’s 2% inflation goal and policy mandate

The BOJ has an explicit 2% inflation goal under its current policy framework. It pledges to continue expanding monetary base until CPI growth “exceeds 2% and stays above the target in a stable manner”. This strong commitment is aimed at addressing the longstanding deflation mindset in Japan and creating a virtuous cycle of rising prices and rising demand. To achieve the 2% inflation goal, the BOJ introduced a series of bold easing measures over the past nine years, including Quantitative and Qualitative easing in April 2013, Negative Interest Rate Policy in January 2016, and Yield Curve Control (YCC) in September 2016.

At present, most indicators still show that underlying inflation is below the 2% target:

1) CPI: Headline and core CPI rose to around 3% YoY as of August. But the core-core CPI, which excludes both energy and fresh food prices, stood at the mid-1% level. The BOJ currently sees the rise in headline and core CPI as a temporary phenomenon. It projects core CPI to ease to 1.4% in FY2023 from 2.3% in FY2022.

2) GDP deflator: The broader prices measure – GDP deflator – remained in the negative territory, at -0.3% YoY as of 2Q. The rapid rise in energy import prices caused a loss in Japan’s terms of trade. This weighed on national incomes and thus the underlying prices outlook.

3) Output gap: The BOJ’s latest estimate showed that the economy’s output gap remained slightly negative, at -1.2% of GDP. This also suggests that spare capacity existed in the economy and the underlying prices momentum remained weak.

4) Inflation expectations: The BOJ conducts inflation expectation surveys on a regular basis to access the medium- and long-term prices outlook. The latest surveys showed that Japanese enterprises expect inflation to rise 2.4% in the next one year and 1.9% in the next five years; consumers expect inflation to rise 5% in both the 1Y and 5Y horizons. The latter, however, tends to consistently overestimate the actual inflation by a wide margin, as suggested by the past experiences.

5) Wage growth: Wage growth is another important variable closely tracked by the BOJ to access the overall prices outlook. In this regard, growth of total nominal wages in all industries picked up to nearly 2% YoY as of July. Base wages, which exclude bonus and other one-time components, still advanced at the 1% rate.

Central scenario

Under our central case scenario, we think the BOJ will maintain the existing YCC policy framework in the rest of this year. It may consider some policy finetuning in response to market pressures, e.g., widening the 10Y yield target band by 10bps. Substantial policy adjustments will still require convincing signs of a virtuous economic recovery, or a review of the BOJ’s 2% inflation goal and policy mandate. This may only happen after the BOJ leadership changes in mid-2023, at the earliest.

The government will likely further expand fiscal measures to counteract the adverse imapct of a weak yen on household living costs. Prime Minister Fumio Kishida’s cabinet approved a JPY2.7tn supplementary budget in May, to provide subsidies for oil wholesalers and give cash handouts to low-income families. This month, he announced to extend the existing fuel price subsidies and offer another JPY50,000 financial support to low-income families. His cabinet is likely to unveil a more comprehensive stimulus package in October, and submit a second supplementary budget for parliamentary approval before the year end.

The authorities will also likely accelerate the pace of post-Covid border reopening, to boost the number of tourist arrivals, expedite the recovery in services exports, and alleviate the pressure on the yen. From 7 September, Japan has started to allow the entry of non-guided foreign package tours, and raise the daily arrival cap to 50,000 from 20,000. PM Kishida is reportedly to announce further reopening measures in the coming days, including lifting the ban on foreign individual tourists and scrapping the daily arrival limit.

Stress scenario 1

Under a stress case scenario, excessive yen weakness may trigger a shift in BOJ policy. A sharp and continuous depreciation of the yen may take the headline, core and core-core CPI broadly above 2% YoY. As inflation overshoots the target, the BOJ may allow interest rates to gradually go up, such as shifting the existing yield target from the 10Y to 5Y segment, or raising the 10Y yield target directly by 25-50bps.

Economic impact will be mixed. Higher interest rates will increase corporate and household financing costs and slow domestic demand. But this could be partly offset by the positive impact of a weak yen on exports. Higher bond yields will increase the government’s debt repayment burdens. But a weak yen could boost Japanese companies’ export earnings, providing some support for the government’s tax revenues.

The probability of this stress scenario is now on the rise, but still modest. Border reopening and lower energy prices will likely lend some support to Japan’s current account, alleviating the pressure on the yen. A 50% recovery in tourist arrivals is estimated to generate tourism receipts worth JPY200bn/month. A $10 decline in oil prices is estimated to reduce energy trade deficit by JPY140bn/month. Meanwhile, the weak yen also encourages Japanese investors to sell part of their overseas portfolio assets and convert them into the higher proceeds denominated in local currency. As the world’s largest creditor country, Japan holds net international assets worth JPY449tn. The Government Pension Investment Fund (GPIF) alone has JPY98tn in foreign bonds and equities (as of March). A 1% repatriation by GPIF will represent funds inflow of about JPY1tn.

Furthermore, overshoot in CPI numbers, if mainly driven by exchange rate movements, could still be seen as a temporary phenomenon by the BOJ. The yen needs to depreciate sharply every year to generate 2% inflation on a sustainable basis. For the BOJ to make a substantial policy change, it would still require evidence of a stable 2% inflation outlook, such as a rise in the long-term inflation expectations and upward momentum in base wage growth.

Stress scenario 2

Under a higher-level stress scenario, massive foreign selling of JGBs may put consistent upward pressure on bond yields, resulting in a reform of the existing policy framework. The BOJ may abandon YCC, allowing yields to go up more significantly. 10Y yield could converge with the 30Y yield, reaching about 1%.

Rapid yield increase will hurt economic growth and weaken the public debt dynamics. Japan’s public debt ratio rose further after the Covid pandemic (263% of GDP in 2021 vs 236% in 2019), because primary deficit widened and nominal GDP growth contracted. A 100bps rise in effective interest rates will lead to a further rise in public debt ratio – unless primary deficit ratio can be reduced by 2ppt or nominal GDP growth can be boosted by 1ppt.

The probability of this stress scenario is comparatively low. Foreign investors currently hold only 8% of the total outstanding JGBs. After years of aggressive bond buying, the BOJ is now the largest holder of JGBs, owning as much as 50%. Japanese banks, insurance firms, pension funds and other institutional investors are also the primary JGB holders, owning the remaining 40%. Domestic financial institutions are unlikely to follow foreign investors to massively sell JGBs, considering the need for them to hold liquid assets to meet regulatory and risk management requirements.

JPY Rates: Not in the hands of the market

We maintain that it is extremely difficult for the market to push the Bank of Japan (BOJ) into tweaking YCC. Thus far this year, the BOJ has been the notably exception within the G10 space. 10Y JGB yields remain firmly capped at 0.25%, the upper bound of YCC. Market participants did try to force the BOJ to adjust in June. Back then, global yields were surging and

10Y US yields hit a peak of 3.50% that has held so far. There was a lot selling pressure of 10Y JGB futures. Similar stresses were seen in the 10Y JGB and surrounding tenors.

However, the critical issue lies not with whether the BOJ can cap yields. By buying unlimited amounts of JGB (this buying picked up in recent months), the BOJ can easily push off speculators. Moreover, there has only been verbal intervention as the USD/JPY heads higher. Interestingly, despite JPY weakness, 10Y breakeven is still comfortably below 1%. The current levels of implied negative yields do not seem to be affected the BOJ. Moreover, with an extended period of deflation over the past few decades, CPI above 2% for some time does not seem to be threatening. If verbal intervention and reopening are sufficient to slow the pace of yen depreciation, there are no obvious avenues for the market to force a BOJ tweak.

Large JPY misalignment creates policy tension

Measured on a real effective exchange rate basis, the JPY is at a large 2.5 standard deviations below its historical average since 2000. Our DEER model, which not only incorporates price differentials like the REER, but also productivity and terms of trade differentials, shows that the JPY has tumbled to a record under-valuation. 

Part of the JPY’s widening misalignment from our DEER fair value is due to the stagflation environment this year. Given high volatility in global rates, deviations from currency fair values have become larger and more prevalent globally, though the JPY is a more extreme case. Across 8 major DM currencies, the mean absolute deviation from our DEER fair values has now soared to its highest since 2012, which is a striking change after a previous trend of steady convergence. In particular, the JPY’s undershoot of its long-term fair value reflects short investor positioning for a continued expansionary policy stance by the BoJ, in contrast to rate hikes for other central banks.

Notwithstanding policy divergence, the JPY misalignment from fair value is now exceedingly large by historical standards. Thus, it is unsurprising to see an escalation in policy rhetoric by officials, as well a highly unusual FX rate check by the BoJ, to temper speculative JPY shorts.  Clearly, further JPY declines and elevated volatility will be viewed as highly undesirable by policymakers from here on.

A second source of tension relates to external trading partners, who may view the weak JPY as a headwind to trade competitiveness. Based on export similarity, Korea stands out as an economy that could be adversely affected by JPY depreciation. Risks of competitiveness-induced depreciation across Asia will be a worry, though the strong USD could provide an offset in today’s environment.

JPY market volatility – more weakness before a sharp pullback

This year, the Japanese yen’s 20% YTD depreciation was the worst since 1979 and 1982. Like today, the yen was under immense pressure from the Fed’s relentlessly tight monetary policy to bring US inflation under control. The yen’s worst collapse within a year was -22.6% YTD in November 1979. An equivalent depreciation in 2022 would lift USD/JPY to 148.70. However, USD/JPY did not peak in December 1979 but in April 1980, which would translate into a higher 155 level today.

USD/JPY’s plunge in 1980 was traced to a hard landing in the US economy from jumbo hikes; real GDP contracted -8% QoQ saar in 2Q80 and prompted massive Fed cuts. However, USD/JPY recovered in 1981 after the economy rebounded by 8.1% in 1Q81, with the   Fed returning to control inflation with higher rates. The fall in USD/JPY 4Q82 was due to the Fed finally subduing inflation and Reaganomics bringing about one of America’s longest post-war economic expansions.  

We cannot rule out nterventions to stabilize the yen because of the sharp depreciation this year. When Japan last intervened to support the yen in 1998, it punished speculators only in the short term. It could not reverse the tribulations of America’s Strong USD policy and the Asian Financial Crisis. It took external forces – the collapse of hedge fund Long-Term Capital Management and the Fed’s three rate cuts to stabilize global financial markets after that – for USD/JPY to peak around 148 in August and fall below 114 by the end of 1998.

Overall, 1979, 1982, and 1998 suggest scope for USD/JPY, regardless of intervention, to test the 147.66 high in August 1998. Without a hard landing in the US prompting Fed cuts, we cannot rule out USD/JPY pushing above 150. However, once the jumbo hikes this year start hitting the US and Western economies hard, the risk of the yen reprising its haven role will increase dramatically.

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Chang Wei Liang

FX & Credit Strategist, Global

[email protected]

Eugene Leow

Senior Rates Strategist - G3 & Asia

[email protected]

Ma Tieying 

Senior Economist - Japan, South Korea, & Taiwan 

[email protected]

Philip Wee

Senior FX Strategist - G3 & Asia

[email protected]