Japan 2023: what comes next for the Yen, JGBs and the global bond markets

Today, the BOJ surprised the financial markets by announcing they were expanding the YCC band on the 10 Year JGBs to ± 50 bps, around 0% from the prior ±25 bps. At the same time, the BOJ announced further monetary easing with more JGB buying. This leads us to believe that the BOJ was concerned about financial stability in the illiquid holiday period, as the JGB market has been deteriorating this year, with the BOJ having to increase its overall holding of the JGB market to 50%. A higher band allows other market participants to step in and ease the BOJ’s burden.

The result was sharp movements across asset classes post this announcement:

• the Yen appreciated 3.2% to the USD;
• the 10-year JGB went up sharply to over 40 bps vs 25 bps prior;
• the yields, still negative for short-term bonds, are now positive for the 2-year upwards (with no backwardation);
• the Nikkei 225 dropped over 3% but with wide dispersion in underlying stocks (bank stocks like Mitsubishi UFJ and Dai-ichi Life were up around 6% and 9%, while auto shares were down heavily);
• global bond yields went up sharply.

What remains to be seen is if this is the start of a new trend or a false breakout.

The countertrend argument is that nothing has changed yet: the press release was still dovish as the target yield has been kept unchanged at -0.1% for short-term and 0% for long-term bonds, so any interest rate hike in the near term is unlikely. Kuroda also noted an expansion of monetary easing remains a possibility. The BOJ is looking for sustained 2% inflation with corresponding wage increases.

The new trend argues that a policy shift is near, as inflation is expected to remain above 2% in 2023, and the chances of wage increases are rising, as foreign workers started to return home when their wages were reduced with the weakening Yen. Now the government and the BOJ are preparing to raise interest rates after Governor Kuroda’s term expires in April 2023. Even Kuroda hinted that it was time to start the discussion on the pace of rate increases.

There are many reasons to believe that the BOJ will start rate hikes in Q2 2023, but the only question is how much and how quickly. Their JGB holdings are substantial at this stage, market participants are baulking at buying more JGBs due to the low returns, so initial rates may rise sooner than later, followed by a gradual increase given the high level of debt/GDP in Japan (Fitch estimates the 2023 Japanese government deficit to achieve 7.2% of GDP).

Possible outcomes and trades for 2023: The BOJ could shift ST rates from -0.1% to 0% and LT rates from 0% to 0.1%, with a 50 bps band. Rising participant levels could impact JGB flows that correspondingly leave international markets, so I consider shorting mid-curve JGBs opportunistically and shorting bonds of the larger EU nations (Germany, France). The long Yen (alongside ECB hiking) would imply USD easing, which would help US multinationals in the FX impact on their financials.