Japans yield control faces biggest test to date as BOJ debates policy

Japan's yield control faces biggest test to date as BOJ debates policy

By Leika Kihara

TOKYO (Reuters) – Japans decades of ultra-low interest rates may reach a turning point on Wednesday, as the central bank debates the fate of its yield control policy, which is creaking under pressure as markets repeatedly break a limit set less than a month ago.

Any change to the Bank of Japan (BOJ) policy is likely to trigger sharp rises in the yen and long-term interest rates by fueling market expectations of a near-term end to ultra-loose monetary conditions.

But the market reaction could be even bigger if the BOJ makes no change to the policy, prompting investors to rush to unwind positions they have built on expectations of a shift.

While other central banks have aggressively raised interest rates to resist rising prices, the BOJ has kept long-term rates around zero, seeking stronger consumption and wage growth to accompany Japans unaccustomed inflation of the past year.

But with inflation exceeding its 2% target, the BOJ is facing its biggest test so far for its stimulatory policy, which is called yield curve control (YCC).

Introduced in 2016, YCC holds short-term rates at -0.1%, while its target for the 10-year government bond is 0% with a small tolerance band.

Under pressure from rising yields, the central bank last month shocked markets by doubling the tolerance to plus or minus 0.5 percentage point from the target, aiming to extend the life of YCC. The cap for the 10-year bond therefore became 0.5%.

The move backfired as investors took it as a prelude to further interest rate rises, unleashing heavy bond selling that broke the new cap for a third straight market day on Tuesday.

Some investors are betting that the BOJ will be forced to adjust, or even dismantle, YCC as early as this week on the view the central bank cannot sustain the massive volume of bond buying needed to defend the cap.

“The liquidity drain caused by the BOJ‘s bond buying is reaching abnormal levels,” said Chotaro Morita, chief bond strategist at SMBC Nikko Securities. “From the perspective of investors and securities firms, there’s a growing feeling the BOJ could give up maintaining its current policy scheme.”

At a two-day meeting that will end on Wednesday, the BOJ is likely debating whether further steps are needed to keep YCC going and iron out market distortions caused by its bond buying.

Waiting for wage rises

Before the 10-year yield breached the 0.50% cap on Friday, BOJ policymakers hoped to phase out stimulus only after Governor Haruhiko Kurodas successor took over in April and when recent wage rises had taken hold nationwide, sources have told Reuters.

But whether the BOJ can afford to wait that long is uncertain.

Instead of fixing market distortions with its heavy-handed defence of the 0.5% yield cap, the BOJ is aggravating them, critics say. Market expectations of an early rate hike have boosted yields broadly, with the eight-year moving higher than the 10-year yield.

In considering the BOJs options, some analysts bet it will further widen the band and allow the 10-year yield to rise as far as 0.75%. Others expect the central bank to raise the 10-year yield target above 0%, change it to one targeting a shorter-dated maturity, or abandon it altogether.

The BOJ is in a bind. Further cosmetic tweaks could simply ignite market expectations of a near-term rise in interest rates. But raising or removing the yield targets would run counter to the central banks narrative that it cannot overhaul or phase out YCC before stronger wage growth accompanies rising inflation, which has so far been driven mainly by import costs.

Some analysts see positive progress with price rises, and note that YCC has always been destined to end when inflation perked up and finally pulled Japan out of a deflationary mindset.

“It‘s true that inflation has been driven mostly by cost-push factors, but it’s also true that companies were able to pass on the higher cost to consumers because the economy was strong,” former top BOJ economist Seisaku Kameda told Reuters. “Thats an unprecedented change in Japan.”

In fresh quarterly projections due on Wednesday, the BOJ is likely to revise up its outlook for inflation, sources have told Reuters.

The BOJ is likely to announce its policy decision anytime between noon and 2 p.m. (0300-0500 GMT), followed by Kurodas news conference at 3:30 p.m. (0630 GMT).

(Reporting by Leika Kihara; Editing by Bradley Perrett)

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