Why the Bank of Japan May Matter More Than the Fed for Now (October 29, 2023)

Expectations are rising for the BoJ to tighten policy and roil global markets.

By Lisa Beilfuss
October 29, 2023

Financial-media attention in the coming days will likely focus on the Federal Reserve’s meeting that ends Nov. 1. But what the Bank of Japan decides a day earlier may be more important.

The BoJ on Tuesday is expected to leave its short-term interest rate target at -0.1%. But there are rumblings of a sooner than expected move out of negative territory. Tokyo reported hotter-than-expected consumer price inflation for October, with headline CPI rising 3.3% from a year earlier versus a 2.8% consensus expectation, notes Peter Boockvar, chief investment officer at Bleakley Financial Group. Tokyo CPI leads the national number, he says, due November 24. Boockvar is betting that the BoJ will get rid of negative interest rates either this week or in December.  

What is more, there are growing expectations that the central bank will further adjust its yield curve control policy, or YCC. Under current policy, the bank guides the 10-year government bond yield around 0%, with an allowance band of 50 basis points in either direction and a hard cap of 1%.  

A rate hike and/or a YCC tweak by the BoJ would be bearish for global bonds at a time when U.S. Treasuries are already under pressure and yields are rising. “While we need to rethink even harder where the FOMC may be heading, it may be time to pay greater attention to growing pressures on the BOJ,” says economist Harald Malmgren. Tightening by Japan’s central bank “could potentially shock the entire world bond market,” he says.

Japan’s 10-year yield hit a new decade high last week, touching the 0.875% level–about double the level just three months ago. While there is still room before it tests the BoJ’s 1% upper limit, the relentless rise in Japan’s 10-year yield reflects resilience to the six rounds of bond-buying operations by the BoJ since July 2023 and is prompting hawkish bets for further policy normalization, says IG strategist Yeap Jun Rong. 

Leaving the ceiling for the 10-year yield unchanged could force the BoJ to buy more government debt and expand its already massive balance sheet, worth roughly $5 trillion or 120% of Japan’s gross domestic product. 

That is as the Japanese yen again weakened past the key 150 level against the dollar–trading near its lowest level since August 1990, tumbling more than 10% this year, and making it the worst currency among its G-10 peers, Deutsche Bank analysts note. In addition to potentially triggering intervention by Japanese authorities, the currency depreciation puts pressure on the BoJ to consider tightening monetary policy, they say.   

All of this matters in part because of the yen’s role as a carry-trade funding currency. With rates in Japan so low for so long, investors have long borrowed yen to buy assets denominated in higher-yielding currencies. The BoJ’s surprise move late last year to start relaxing YCC meant the yen lost some carry-trade luster, but it still plays a big role in global financial markets.

Bob Michele, global head of fixed income at JP Morgan Asset Management, warned last month that tighter BoJ policy could unwind the carry trade and spark a decade-long patriation of Japanese capital parked in foreign assets, triggering global volatility. He flagged the 150 level in the yen versus the dollar, warning that the central bank could be forced to hike rates sooner than expected if the yen weakens beyond 150. 

“I worry as the yield curve normalizes and rates go up, you could see a decade or longer of repatriation,” he said on CNBC. “This is the one risk I worry about.”

Former hedge-fund manager James Lavish explains how this all comes back to haunt the U.S. bond market. Yield-hungry Japanese investors have been selling Japanese Government Bonds, or JGBs, and then the yen received for them in order to buy U.S. dollars to buy Treasuries. Meanwhile, the U.S. has its own problems with a growing deficit, a mountain of debt, and worries from investors who are pushing the yield of that debt higher to be compensated for long-term inflation risks. 

Japan is the largest non-U.S. owner of Treasuries. And the BoJ is either allowing the Treasuries they hold to mature off their books or outright selling them and using the dollars to buy and stabilize the yen, says Lavish. 

While expectations are rising for the BoJ to tighten policy as early as this week, some in Japan are betting the bank won’t move so quickly. 

As one Japanese trader told Praxis, “they aren't going anywhere, or changing anything, and nor should they,” referring to the BoJ and chiding foreign investors and commentators for misunderstanding the bank’s view of its currency. The “BoJ and [Ministry of Finance] don't gaf about the yen. It can go to 250 for all they care, as long as it goes slowly.”

The person adds that the ongoing slowdown in the central bank’s ETF buying program gives “them more fire power to conduct and maintain YCC,” where the BoJ slowly allows a higher 10-year yield cap. 

Moreover, Japan’s Nikkei newspaper reported last week that four of Japan's biggest life insurance companies are planning to increase foreign bond holdings with no currency hedge in the coming months. Those Japanese life insurers–among the world’s most closely watched bond investors–are judging that the benefit of lower hedging costs currently outweigh the risk of a spike in the yen, the kind of move one might expect from a hawkish central bank announcement. In other words, they are betting the yen will hold steady versus the dollar.  

Betting the yen holds steady versus the dollar could be as much or more about the Fed than the BoJ. A BoJ that doesn’t tighten policy in the coming week may signal that the world’s biggest creditor nation doesn’t expect the Fed to be as hawkish as Fed officials themselves suggest, meaning they expect relief is coming for Japan’s domestic markets. 

What the BoJ decides to do this week may for now may matter more than what the Fed says–not only because of the direct implications on U.S. markets, but because of what Japan might signal about the path of U.S. monetary policy.