Bank of Japan decision

What happened?
The Bank of Japan decided to maintain its current policy rates and monetary policy framework at its Monetary Policy Meeting on January 17-18. The BOJ also made an operational adjustment aimed at promoting smooth formation of the yield curve. Specifically, the BOJ enhanced its Funds-Supplying Operations against Pooled Collateral by offering financial institutions funds with low-interest rates for the maturity up to 10 years. This new operation, which appears to be intended to lower bond yields as it encourages financial institutions to purchase government bonds, will start from January 23.
After the BOJ widened the permissible fluctuation range of 10-year bond yield from ±0.25% to ±0.5%, the market speculation of a further BOJ policy change toward a tightening direction, such as revising its YCC (yield curve control) policy at this meeting, has risen. The speculation increased after Yomiuri newspaper reported on January 12 that the BOJ would examine the side effects associated with accommodative monetary policy and modify its policy if necessary. But it turned out that the BOJ did not make any material changes to its monetary policy, which seems to reflect the downward revision to its economic outlook (BOJ’s GDP growth forecast for FY2022 was lowered from 1.9% in October 2022 to 1.7%, while the forecast for FY2024 was revised down from 1.5% to 1.1%). The forecast of BOJ core-core CPI (CPI excluding fresh food and energy) for FY 2024 remains unchanged at 1.6%, which is still considerably below BOJ’s 2% target. It appears that the BOJ could not tolerate policy adjustments towards tightening, amid intensifying downward pressures on Japan’s economic outlook.
How have markets reacted?
After the announcement of the decision by the BOJ, the financial market has come to realize that YCC policy is likely to be maintained during Governor Kuroda's term of office until early April. In the bond market, 10-year JGB yield declined to 0.4% from around 0.5% after the announcement. 8-year and 9-year JGB yields, which were both distortively high at 0.6% in the previous day (January 17), went down to 0.49% and 0.51%, respectively.
In the FX market, the JPY exchange rate depreciated about 1.8% against USD after the announcement today from mid-128 yen to around 131 yen. Keep in mind that the JPX exchange rate appreciated from the mid-132 yen after the publication of the aforementioned Yomiuri newspaper article on January 12, and so its reaction to the actual BOJ decision brings it back down, closer to its pre-article level.
In the stock market, the Nikkei225 index rose 2.5% on January 18 as yen's depreciation against the dollar boosted export-related stocks, while real estate-related stocks and stocks with relatively large borrowings benefited from the continuation of BOJ's easing stance.
What is our outlook on the situation?
The BOJ’s future policy is likely to be guided by both developments in economic fundamentals, such as economic growth and inflation, and degree of market distortion caused by the accommodative monetary policy. Looking from an economic fundamentals perspective, the important factor is negative impacts of slower growth in the US and Europe on Japan’s economy. Although Japan’s domestic demand is expected to remain resilient due to a continued economic reopening, there is a risk that a worsening external environment stagnates domestic economic activity. In order for Japan to achieve a stable 2% inflation rate in the medium term, Japan needs to see relatively significant wage increases over the next two years. In this regard, the BOJ is likely to continue its accommodative policy to support wage hikes. From a market function perspective, there still is the possibility that the distorting pressures increase again in anticipation of future policy changes by the BOJ, even though today’s policy decision has somewhat reduced the distortion of the yield curve,
Considering these factors, our view is that the BOJ is unlikely to make a material shift towards tightening during 2023, unless serious market distortions occur, although the BOJ may need to change its forward guidance on interest rates to include the sentence that indicates that the monetary policy direction is “data-dependent.” However, in 2024 when the US and European economies are expected to start recovering, Japan’s economic growth and wage growth are likely to improve, which may lead to an initial hike in both short-term and long-term policy rates by the BOJ. In the medium term, once the 10-year JGB yield approaches a neutral level, the BOJ may opt to abolish 10-year yield control. This action probably needs to be accompanied by an increase in JGB purchases to mitigate an unexpected, sharp rise in JGB yield.
What is our resulting investment view?
Since the beginning of January, expectations that the BOJ will shift to a tightening policy had risen, causing the upward shift of the yield curve and yen appreciation. However, as the BOJ showed its willingness to continue monetary easing at today’s policy meeting, the underlying strength of the Japanese economy against the backdrop of firm domestic demand is likely to attract attention. The Kishida administration's relatively large-scale fiscal stimulus package and the recent brisk capital investment by companies are expected to support Japan’s market. Despite the risks associated with an unexpected policy change by the BOJ, we expect a rebound in Japanese equity prices in the short term, which should be followed by performance comparable to that of US equities.
What are the risks to our view?
One risk is that domestic demand exceeds expectations and there is an earlier-than-expected achievement of the BOJ’S 2% inflation target, prompting BOJ TO shift toward tightening earlier than expected. Another risk is that market distortions increase significantly, in which case the BOJ would have to quickly implement de facto tightening measures through changes and revisions to the YCC framework. Continued attention should be paid to Japan's inflation and inflation expectations, developments in domestic and external demand, trends in US long-term interest rates, developments in the yield curve of government bonds, and the possibility of a change in policy stance under the new BOJ Governor.