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Bank of Japan surprises markets with change in yield control policy

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The Bank of Japan surprised markets on Tuesday with an unexpected change to its controversial yield curve control policy, triggering sharp swings in currency, bond and equity markets.

Traders described the move as potentially marking the long-awaited “pivot” from the BoJ, which is the latest of the world’s major central banks to stick to a ultra-loose diet avoid raising interest rates to fight global inflation.

“We view this decision as a major surprise, as we expected any widening of the tolerable band to be carried out under the new leadership of the BoJ from spring next year, in line with the market,” said Naohiko Baba, chief economist for Japan at Goldman Sachs.

At a press conference, however, BoJ Governor Haruhiko Kuroda denied that the latest adjustment amounted to a tightening of monetary policy, stressing that the central bank would not abandon its yield target.

Japan’s increasingly extreme status has contributed to a huge drop in the yen this year as markets priced in the gap with the US Federal Reserve’s rate hike.

The central bank said it would allow 10-year bond yields to fluctuate plus or minus 0.5%, down from the previous 0.25%. He kept overnight interest rates at minus 0.1%.

Line chart of 10-year yield (%) showing Japanese bond yields soaring

Kuroda had previously said that any change in yield curve control (YCC) would effectively equate to an increase in interest rates. But on Tuesday, he said the adjustment was aimed at addressing heightened volatility in global financial markets and improving the functioning of the bond market to “enhance the sustainability of monetary easing”.

“This action is not a rate hike,” Kuroda said. “Adjusting the YCC does not signal the end of the YCC or an exit strategy.”

Core inflation in Japan – which excludes food price volatility – exceeded the BoJ’s 2% target for the seventh consecutive month, hitting a 40-year high of 3.6% in October.

But Kuroda has long argued that any tightening would be premature without solid wage growth, which is why most economists expected the BoJ to stay the course until he steps down in April. On Tuesday, the BoJ maintained its outlook for inflation to slow next year and warned of “extremely high uncertainties” for the economy.

“It may be an act of generosity on Kuroda’s part to reduce the burden of the next BoJ governor, but it’s a dangerous move and market participants feel cheated,” said Masamichi Adachi, economist chief for Japan at UBS. “US yields are now falling, but if they start rising again, the BoJ could once again be forced to raise rates.”

The BoJ’s efforts to defend its YCC targets have contributed to a sustained reduction in market liquidity and what some analysts have called a “dysfunction” in the market. Japanese government bonds market. The central bank now owns more than half of outstanding bonds, up from 11.5% when Kuroda became governor in March 2013.

Line chart of the daily change in Japanese 10-year government bond yield showing the BoJ awakening the bond market from its slumber

Kyohei Morita, chief economist for Japan at Nomura Securities, said the BoJ’s move was probably best seen as a policy adjustment rather than a full pivot. “The BoJ probably wants to help reduce the negative side effects of yield curve control policy,” he said, noting that the bank’s outsized ownership of the Japanese government bond market meant that liquidity had evaporated.

“They want to reactivate this market, even at the cost of yen appreciation,” Morita said.

The yen briefly jumped nearly 3% to around ¥133 against the US dollar, while the Topix stock index fell 2.5% and the 10-year bond yield hit 0.46%, its highest level since 2015. In recent weeks, the Japanese currency has rebounded from a 32-year low as policymakers in the United States and Europe have begun to scale back their interest rate hikes .

The BoJ’s decision on Tuesday also ricocheted across other major markets. The yield on the US 10-year Treasury rose 0.08 percentage points to 3.66%, while the equivalent yield on the UK gilt rose by the same margin to 3.58%. Yields rise when prices fall.

Mansoor Mohi-uddin, chief economist at Bank of Singapore, said the BoJ’s decision was significant as it signaled that the central bank was considering a broader exit from YCC, adding that it would be an important turning point for the yen.

“The BoJ’s decision to raise interest rates in December 1989 caused a dramatic change in Japanese markets,” Mohi-uddin said. Public servants today will be acutely aware of this history. This amplifies the importance of their signal for the markets today.

Benjamin Shatil, currency strategist at JPMorgan, said the BoJ’s move would now lead the market to start pricing in new policy moves, even if none were actually forthcoming.

“This momentum may kick off another cycle of higher Japanese yields, test the new or higher YCC target ceiling, and renew surges of yen strength,” Shatil said. “It also has ramifications for global markets, given the potential for continued reallocation of Japanese investors’ assets from foreign bonds to domestic bonds – now that they offer a more attractive higher yield.”