Changes in bond yields will raise long-term interest rates and support appreciation of the yen
As the Bank of Japan (BOJ) has maintained remarkably loose monetary policy for nearly a decade, even small shifts in the central bank’s policy will have an impact on the country’s business landscape. In the short term, interest rates for loans with short time horizons are expected to remain unchanged, as the BOJ will keep its overnight lending rate fixed at -0.1%. Firms should, however, prepare for greater volatility in exchange rates, as extreme uncertainty over the actions of the BOJ will create disturbances in financial markets. Risks are tilted to the upside, as any increases in long-term yield rates will boost the value of the yen. These disruptions are expected to spill over into the Japanese stock market, which will dampen investor confidence and adversely impact firms’ ability to raise equity capital and their appetite for new investments.
Over the long term, interest rates for loans with longer time horizons (such as mortgages, facilities investment, or construction loans) are expected to rise, as their interest rates are linked with yields for Japanese government bonds (JGBs). As a result, private investment for construction projects, new homes, or facilities will likely weaken.
The BOJ has implemented a policy of monetary easing since 2013 by keeping the overnight interest rate at -0.10% and targeting a 0.00% yield on 10-year JGBs. Under this policy, the BOJ allowed yields for 10-year JGBs to fluctuate between ±0.25%.
In December, the BOJ shocked markets by raising the yield limits for 10-year JGBs to ±0.50%, effectively raising long-term interest rates. The central bank maintains that the shift does not represent a departure from its current policy but is instead an adjustment that makes the policy more practical for the current high interest rate environment. However, most market participants no longer take BOJ statements at face value and now expect further changes in monetary policy, if not a complete exit from the central bank’s current position.
Additional policy adjustments later this year would not be surprising, because the BOJ is set to undergo a leadership change in April as Governor Haruhiko Kuroda—who has held the position for 10 years and was the mastermind behind the current policy—steps down. The upcoming change in leadership has led to further speculation in financial markets that a substantial change in policy is imminent.
Japan’s central bank finds itself caught between two difficult paths: stick with the current policy or abandon it altogether. Neither option is attractive for a variety of reasons. Sticking to the current policy is becoming less and less feasible in an environment of high global interest rates. Yield curve distortions are preventing the Japanese bond market from functioning smoothly, forcing the BOJ to spend huge amounts of money to hit its yield targets. The current policy also puts the yen at risk of further depreciation, as interest rate differentials between Japan and the rest of the world continue to widen.
However, completely abandoning the current policy and abruptly raising interest rates are not practical options either. Inflation in Japan is expected to be transitory, with price growth returning below 2% in 2024, and maintaining accommodative interest rates is rational over the medium term in a market with low growth and negligible inflation. Perhaps more importantly, abruptly abandoning yield curve controls would have destabilizing effects on Japanese financial markets. Dramatic increases in JGB yields would draw capital away from the Nikkei stock exchange and other financial markets, causing widespread disruptions. Moreover, they would severely constrain public finances due to the huge levels of debt held by the government. Such a move would curb Tokyo’s spending ability and create massive debt repayment pressure.
Thus, it is likely that the BOJ will proceed with a middle ground. We expect it to gradually loosen the yield rate target for 10-year JGBs, providing greater flexibility within the current policy framework and allowing distortions in the yield curve to correct themselves. Such a policy would also allow markets to adjust long-term interest rates as needed, in case of inflation surprises. While this could take many forms, the most likely scenario is that the central bank will either widen the yield band further or raise the 10-year target yield. No change in short-term interest rates is expected, as subdued growth rates and global economic risks will ensure that the BOJ proceeds with an accommodative policy.
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