BoJ did more than you think for the yen - Nomura

Bilal Hafeez, Research Analyst at Nomura, suggests that just when the market was thinking that the BoJ could not surprise, it delivered a new policy tool – a yield curve target and as a result we are likely to see more pronounced yen weakness in the months ahead.

Key Quotes

“From now on, the BoJ will ensure the 10y JGB yield will remain around 0%. It will achieve this through varying its JGB purchases and offering fixed rate JGB purchases when needed. This has strengthened the yen, but investors are likely underestimating the consequences of the policy change.

There may also be some doubt that the BoJ can control the curve. Undoubtedly, there are risks of it negatively affecting the functioning of the bond market. But what helps the BoJ is that much of the JGB market is held by domestic investors, which means that it is less internationalised and so easier to manage. We also have the precedents from the US. In the 1940s, the Fed capped 10y yields at 2.5% in part to ensure the government could easily issue debt and finance its war efforts. It lasted from 1941 to 1951. Then in the 1960s, the Fed successfully flattened the yield curve through Operation Twist. Again, it was able to maintain this from 1961 to 1965 until inflation rose.

By guaranteeing the steepness of the curve, the policy should be very supportive for the financial sector, which in turn supports the stock market. Financial institutions can engage in roll-down trades on the yield curve with much less risk than before. The yen has a strongly negative correlation with Japanese stocks, so over time recovering risk appetite should weigh on the yen.

Perhaps more important, with the central bank essentially setting yields, it dramatically alters the economics of engaging in yen carry trades – borrowing in yen and investing in high-interest currencies and assets. We know from studies that FX carry trades that target the short-end of the curve have tended to be profitable over time. Part of the reason is that the volatility of that part of curve is controlled by the central bank. However, the longer the tenor of the FX carry trade, the less profitable the strategy.

Indeed, studies have shown the so-called uncovered interest parity condition, that is, the theory that spot should converge to the FX forward rate and so prevent profits from being made on FX carry trades, tends to be more closely met at the long-end of the curve. That is, holding a 5y AUD/JPY carry trade to maturity tends not to be profitable, whereas holding a 3m carry AUD/JPY trade does tend to be profitable. However, by extending control of interest rates out to 10 years, the BoJ has made it more likely that even longer-tenor JPY carry trades may start to become profitable; not least because the rates risk is much lower than before. We should therefore start to see more pronounced yen weakness in the months ahead.”