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Bank of Japan Adopts Flexible Approach to Yield Curve Control with Implications for the Japanese Yen

Forex 7 minutes to read
Redmond-400x400
Redmond Wong

Chief China Strategist

Summary:  The Bank of Japan (BoJ) maintained its yield curve control (YCC) target for 10-year Japanese Government Bonds with a range of plus and minus 50 basis points around zero at the July monetary policy meeting. However, it introduced a more flexible approach, allowing deviations from the target range and setting a 1% cap on the maximum rise in the 10-year JGB yield. The BoJ retains discretion for bond buying between 0.5% and 1%. Market confusion ensued, but the BoJ's gradual departure from the YCC policy indicates potential implications for the Japanese Yen's strength and USDJPY exchange rate.


Bank of Japan's July Monetary Policy Meeting

In a highly anticipated monetary policy meeting, the Bank of Japan (BoJ) decided to maintain its yield curve control (YCC) target, keeping it in a range of plus and minus 50 basis points (0.5 percentage points) from zero percent on the 10-year Japanese Government Bonds (JGBs). However, what caught the attention of market participants was the central bank's announcement of a significant shift in its approach, signaling greater flexibility and introducing the possibility of tolerating deviations within an unspecified extent.

BoJ's Shift in Policy Approach

Gone are the days when the BoJ adhered strictly to rigid limits for the YCC target range. Instead, it has adjusted its policy that the upper and lower bounds of the YCC target range are now mere reference points. The central bank tweaked its long-held YCC policy to give itself newfound flexibility and leeway to maneuver its monetary policy in response to prevailing economic conditions.

BoJ's New Bond Buying Arrangement

One concrete step taken by the BoJ to demonstrate this shift away, particularly from the upper bound, is the introduction of a hard stop on the maximum rise in the 10-year JGB yield at a much higher level of 1%. The central bank will now offer to purchase 10-year JGBs at a rate of 1% every business day through fixed-rate purchase operations, effectively capping the maximum increase in the 10-year JGB yield at 1%.

Cross the River by Feeling the Stones

This move, however, gives the BoJ the discretion to intervene in bond buying between 0.5% and 1%, depending on its assessment of the then-prevailing economic landscape and market conditions. The BoJ apparently is cautious in exiting the YCC completely as it notes in its Statement on Monetary Policy that “sustainable and stable achievement of the price stability target of 2 percent, accompanied by wage increases, has not yet come in sight.” The BoJ says that it will continue to do quantitative easing (QE) “until the year-on-year rate of increase in the observed CPI (all items less fresh food) or core CPI exceeds 2 percent and stays above the target in a stable manner”.

In its Outlook for Economic Activity and Prices (July 2023), the median forecasts from the Policy Board Members on the CPI (all items less fresh food) for the fiscal year ending March 2024 was revised down to +1.9% from +2.0% (forecast made in the Outlook in April) and the forecast for the fiscal year 2025 stayed at +1.6% (Figure 1), both below the +2% target.


CPI
Figure 1. BoJ's Projections for Core CPI; Source: Outlook for Economic Activity and Prices (July 2023)

Forex Market Reaction

The initial reaction in the forex market was one of confusion about the message sent by an unchanged target range and the BoJ's discretion to maneuver long-term interest rates between 0.5% and 1%. It resulted in choppy swings of USDJPY between 141 and 138 within the first hour of trading after the policy announcement. Adding further to the confusion, BoJ Governor Ueda downplayed the significance of the changes and insisted that the policy shift was not a step toward the normalization of monetary policy.

Interpretation and Market Impact

Nonetheless, we believe that the BoJ's actions today signal a gradual departure from the YCC policy framework. While Governor Ueda's remarks calmed the forex market and brought the USDJPY back to 139.40, flat to its closing level last night in New York (Figure 2), the central bank appears to be taking a measured and controlled approach towards potentially abandoning the YCC policy.

JPY fluctuation
Figure 2. Initial movement of USDJPY after the BoJ policy announcement; Source: Bloomberg, Saxo

As the BoJ moves away from strict YCC target limits and embraces a more adaptable stance, the Japanese Yen could witness strengthening trends while traders and investors direct their focus onto the increasing likelihood of the beginning of a new policy direction towards completely exiting the YCC under Ueda. When this rethinking of the timetable of the BoJ normalizing policies picks up momentum, it may leave the path wide open for USDJPY to test the downside.

boj policy summary
Figure 3. Summary of BoJ's YCC policy; Source: Bank of Japan

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