On 9 January 2018, the Bank of Japan (BoJ) reduced, i.e. ‘tapered’, its purchases of long-maturity bonds: it trimmed its buying of 10-year to 25-year Japanese government bonds (JGBs) from JPY 200 billion to JPY 190 billion, and of 25-year to 40-year JGBs from JPY 90 billion to JPY 80 billion.
There was only a muted reaction to this move from the JGB market, with the long-end yield rising by only 1bp to 2bp on the day. On the other hand, the Japanese yen was bought aggressively on the foreign exchange market, while global bond markets (for example, the market in US Treasuries), were impacted, too.
While some market participants might be concerned that this ‘tapering’ signals a significant monetary policy change by the BoJ, we do not agree.
Thanks to rising tax revenues and further technical reductions in refunding needs – the Ministry of Finance has been extending the average maturity of JGB issuance for years and the JGB refunding pressure is lessening – JGB issuance for fiscal 2018 is set to be considerably smaller than in fiscal 2017 (see Figure 1). The drop in issuance and fact that the BoJ holds about a half of all outstanding JGBs mean the volume of JGBs available to other buyers has dropped sharply.
Figure 1. JGB market issuance
Data as 12 January 2018. Note: 2018 value is a forecast.
Sources: Japan Ministry of Finance, BNP Paribas Asset Management.
So, quite aside from questions over monetary policy, the central bank actually needs to taper its quantitative easing simply because there are not enough JGBs available on the market.
Due to this shortage, we expect the BoJ to continue to taper during 2018. This does not reflect any ‘policy change’, such as a tweaking of the yield curve control (YCC) target, which is currently set at 0% for the 10-year JGB yield. In considering any actual monetary policy change, we would assess two factors.
The first is inflation. We think the BoJ’s current target of 2% is unrealistic, and we suspect the central bank itself agrees on this. On the other hand, we think the BoJ hopes to see inflation at 1% – preferably on an exenergy basis – before it raises the YCC target.
The second factor is the health of Japan’s financial system. Japanese small and medium-sized financial institutions are currently in critical shape with regard to earnings. Credit demand is weak and small banks are obliged to invest excess cash in the bond market. With a negative policy rate and a flat yield curve, they cannot make enough money from bond investments. At some point, the BoJ might be forced to raise the YCC target to prop up these small banks even if inflation is still too low.
With these factors in mind, here is what we expect to happen in 2018. The first major item on the agenda is the nomination (or re-nomination) of the BoJ’s governor for the next five years, as current Governor Kuroda’s term ends in April. The consensus view in Tokyo is that Kuroda will be reappointed. We agree that is possible, but we also think there is a chance that Kuroda will voluntarily step down.
Judging from his recent comments (for example, in his speech in Zurich on 13 November 2017), we think Kuroda has finally realised the seriously adverse side-effects of excessive monetary easing. If we are correct, Kuroda may either: 1) resign and leave policy adjustment to his successor; or 2) gradually change his current stance during his second
term by allowing the yield curve to bear-steepen.
The timing of a policy change would depend on the two factors mentioned above, i.e. inflation and the earnings environment for small banks. In our view, if there is any sort of meaningful rise in inflation in coming months, we may see – or at least financial markets may discount – an upward tweaking of the YCC target towards the end of 2018. If there is no inflation pick-up at all, and if BOJ thinks small banks can hang on for another year or two, central bank policy is, in our view, likely to remain unchanged throughout 2018.
The tail risk scenario would be the nomination of a strongly pro-growth dove as BoJ governor – one who would ignore the risk of turmoil in Japan’s financial system turmoil and aggressively accelerate monetary
The Japanese parliament session resumes on 22 January 2018, after which we may hear at any time about who is to be the new BoJ governor.