The Bank of Japan—A new era is underway

On Tuesday, March 19, the Bank of Japan (BoJ) formally ended its negative interest rate policy, in effect since 2016, and raised its policy rate for the first time since 2007. This is obviously a historic shift as the BoJ is finally overcoming deflation and a new era is underway. Key changes to the BoJ’s monetary policy framework include:

• The end of the BoJ’s yield curve control (YCC) program, which was used to target and manage 10-year Japanese government bonds (JGB) yields
• The end of its negative interest rate policy
• Lifting the overnight policy rate from -0.1% to around 0% to 0.1%
• Guiding short-term interest rates as a primary policy tool
• Discontinuing purchases of exchange-traded funds (ETFs) and real estate investment trusts (REITs)
• Abolishing the commitment to expand the monetary base (i.e., quantitative easing)
   

Details of the BoJ’s announcement were well telegraphed in the run up to its meeting. While the BoJ justified its decision by indicating that the price stability target of 2% is in sight and would be achieved in a sustainable and stable manner, the actual decision to change its monetary policy course was somewhat triggered by the recent spring wage negotiations among large corporations, resulting in wage increases of over 5%, the sharpest rise in more than 30 years.

At the same time, the BoJ stated that given the current outlook for economic activity and prices in Japan, it anticipates that accommodative financial conditions will be maintained for the time being. In addition, the BoJ will continue to purchase the same amount of JGBs as before, about JPY6 trillion per month, also for the time being.

As a whole, the BoJ’s messages are a bit complicated: It ended its long-standing negative interest rate policy based on the view that its 2% inflation target is now achievable, while the central bank will also maintain monetary easing as the economic and inflation outlooks are not yet strong enough.

In terms of immediate market reaction, JGB yields declined across the yield curve by 1 to 3 basis points (bps), Japan’s equity market rallied and the Japanese yen depreciated despite the historic policy change. This was because markets were already pricing in the policy change and the BoJ’s talking points suggested an ongoing accommodative stance.

We think that the next steps will be additional policy rate hikes, given rising wages stemming from labor shortages and inflation trends above the policy target. That stated, we do expect the pace of future rate hikes to be gradual and exercised with caution, as there is considerable uncertainty about the spillover mechanism of an interest rate hike on the real economy and its impact on the financial system. Indeed, the Japanese economy might not be strong enough to withstand higher rates after large-scale monetary easing for more than a decade.

Our view continues to be that Japan’s improving economic outlook, elevated inflation and expected policy rate hike should continue to put an upward pressure on JGB yields. As a result, we currently favor maintaining a short duration position. Importantly, we believe the restoration of market functions for JGBs due to the normalization of monetary policy should increase the potential for active management to earn excess returns through duration and yield curve positioning.