Japanese market outlook following the change in yield curve control policy

What happened?
The Bank of Japan decided to allow 10-year bond yield to rise effectively up to 1.0% under the YCC (Yield Curve Control) policy1, although the upper limit of the 10-year bond yield, which has been set at 0.5% was nominally left unchanged. The BOJ’s decision came as a surprise to the markets .
According to the BOJ, the decision aims to enhance the sustainability of monetary easing by flexibly responding to both upside and downside risks amid high uncertainty about economic and inflation developments.
This means that the decision was not aimed at either easing or tightening its monetary policy.
The BOJ's statement indicated a concern that the effects of monetary easing will become stronger through a decline in real interest rates, if upward movements in inflation continues while strictly capping long term interest rates could affect the functioning of bond markets.
In fact, over the past month or so, Japan’s 10-year breakeven inflation rate has risen from just under 1% to around 1.2% leading to a decline the real 10-year bond yield, which has unintentionally strengthened the effects of monetary easing.
The BOJ maintained its core CPI inflation (all items less fresh food and energy) outlook for FY 2024 at 1.7% and FY 2025 at 1.8% in its latest Outlook Report released last week.2
This indicates that the BOJ still does not envisage the achievement of 2% inflation target and the accommodative monetary policy is likely is be maintained.
How have markets reacted?
Preceding the announcement by the BOJ, a leak article published by the Nihon Keizai Shimbun in the early hours of July 28 indicated that the Bank of Japan would allow the 10-year bond yield interest rate to rise above 0.5%.
So the 10-year JGB yield has risen from 0.44% on 27 July to around 0.5% just before the announcement while, in the foreign exchange market, the yen appreciated from around 140 yen to the dollar on 27 July to the low 139 yen level, reflecting the narrowing of the Japan US interest rate differential.3
In the stock market, where the appreciation of the yen and rising interest rates became a concern, the Nikkei 225 fell from 32,892 yen on the previous day's closing price to 32,454 yen before the announcement on the 28 July.3
After the actual announcement by the BOJ, which revealed that it set the new upper bound for the 10-year bond yield at 1% the financial markets swayed further as 10-year bond yield rose further to 0.556% while the dollar yen rate fluctuated but came back to a 139 yen/USD level (as of 15:00 on 28 July, JST).3
Nikkei 225 initially declined after the announcement but rose later to 32,759 yen as banks, which benefit from a rise in long term bond yield, supported the stock market.3
What is our outlook on the situation?
The BOJ’s Governor Ueda mentioned that he did not anticipate the 10-year bond yield to rise to 1% since the 1% level is just considered to be an upper limit.4
In fact, the BOJ is expected to continue to control the yield curve (and control 10 year bond yield) by adjusting the bond purchase operations and conducting fixed rate purchase operations.
It is worth noting that there is a possibility that investment in US bonds by Japanese institutional investors could shrink if the Japanese long term bond yield rises further, putting some upward pressures on long term US bond yield.
As for the future monetary policy of the BOJ, I expect that meaningful wage increases in the spring collective negotiation between companies and labor unions in 2024 will lead the BOJ to raise both short and long term policy rates at its April 2024 policy meeting.
After that process, the BOJ may have the opportunity to abolish the YCC policy at the timing of further monetary tightening.
What is our resulting investment view?
The Japanese economy is currently maintaining its strength, and it is unlikely that the limited rise in Japanese long term bond yield and yen appreciation will undermine this strength.
With continued strength of Japanese economy relative to the US and Europe, I expect the performance of Japan equities to outperform that of other advanced economies in 2H 2023.
What are the risks to our view?
Looking ahead, the movement of the 10-year bond yield will be important for the Japanese financial markets in the short term.
If the 10-year bond yield rises toward the new de facto upper limit of 1%, the dollar-yen rate will move further toward yen appreciation. The damage to corporate performance due to the yen's appreciation and rising interest rates should be factored in the stock prices.
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Footnotes
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1
Source: Bank of Japan, as of July 28, 2023
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2
Source: Bank of Japan, as of July 28, 2023
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3
Source: Bloomberg, as of July 28, 2023
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4
Source: asia.nikkei.com, as of July 28, 2023