A new monetary regime in Japan?

Cross Asset Strategy

Recent growth and inflation numbers, the majority of which have surprised on the upside, have been the key drivers of market movements. The data has materially shifted market expectations for how much the Federal Reserve will have to hike rates. Investors now expect policymakers to reach a rate of 5.3% (with just one cut thereafter), compared to 4.8% (with two cuts by year-end) just two weeks ago. In our view, this all increases the odds that the Fed will keep hiking and remain in restrictive territory for longer. These stronger numbers have shifted the market narrative towards one of soft landing (or even no landing), suggesting the U.S. economy can withstand rates at current and even eventually higher levels. We are not buyers of the soft/no landing narrative. We still think rates are still high enough to keep growth below trend, importantly, eventually leading to a recession, lower inflation, and lower bond yields. Bolstering this view is the fact that the housing market is as unaffordable relative to median incomes as it has been since 1990. Bank lending standards are tight (which hampers capex and manufacturing activity) and non-mortgage consumer interest payments are rising. On that last point, credit card interest rates are above 20%! The path back down to 2% inflation is going to be bumpy, but we think the Fed’s path that is reflected in the rates market will likely be enough to eventually work.

Strategy Question: A new monetary regime in Japan?

In our experience Japanese markets are too often overlooked. Despite being one of the world’s largest economies with deep, liquid capital markets, years of negative yields and range-bound equity markets have conditioned many investors to instead focus on the faster growing markets of the U.S. or China. However, with many changes on the horizon including a new Bank of Japan Governor and potential shifts to monetary policy, now is an important time for global investors to pay attention to Japan’s monetary regime shift. This is primarily because the BoJ’s shift will have important implications for capital flows and the Yen as Japanese investors continue to rotate investments from foreign assets back to domestic debt. In other words, given the size of Japanese capital flows, shifts in monetary policy can have sustained spillovers into global liquidity conditions.

Will the new BOJ Governor signal a shift in policy?

The nomination of Mr. Kazuo Ueda as the next Bank of Japan governor was a surprise to many in the market and investors are now trying to get a handle on future policy shifts by parsing past actions and statements.

Currently working in academia, Professor Ueda used to serve as a BOJ board member from 1998 to 2005 and is a frequent panelist in BOJ economic policy workshops. Earning his PhD at MIT under Stanley Fischer (former Vice Chair of the Federal Reserve and dissertation advisor to former Fed Chair Ben Bernanke), Ueda is widely regarded as a pragmatist. In recent statements Ueda expressed concern on rising inflation and believed it is necessary to conduct a thorough review of the current easing framework, taking a potential exit strategy into account. However, he also expressed concerns over a quick tightening of policies, as it may negatively impact the economy and hinder the BOJ goal of raising interest rates by a sufficient amount over the longer run. This suggests to us that Ueda will likely make policy decisions in a balanced manner, and keep policy moves well-paced.

Another focus area is Ueda’s attitude towards the Yield Curve Control (YCC) framework, which is one of the unorthodox monetary tools utilized by the BOJ. Ueda has publicly expressed concerns over the side effects of YCC, such as market disruptions and encouraging large-scale speculation. In terms of moves to change the framework, he once raised shortening the target maturity of yield control to five years, but later ruled out this possibility. He stated in a Nikkei interview last July that YCC should not be open to minor tweaking¹, which to us raises the likelihood that any eventual change on this front would likely be a major expansion of the +/- 50bps trading band for the 10-year JGB, if not a full abandonment of the policy.

Japan’s macro landscape: inflation at 25 year high

While the personal views of policymakers matter, monetary policies ultimately reflect the realities in the economy. Development in Japan’s inflation dynamics are the key to watch. Core inflation has come in above the BOJ’s 2% target since April last year. While it does not imply an imminent response from the central bank, in our view it does mean a weaker case for continued massive easing.

It’s also important to understand the drivers. The current rise in inflation is largely driven by the negative supply shock from an increase in food and energy prices globally (i.e. “imported inflation”). Over recent months it is becoming increasingly clear that the peak of commodity prices has arrived and disruptions in the global supply chain will likely continue to fade. However, we are seeing more signs of “homemade” inflation at the same time. As shown in the chart below, wage inflation has considerably strengthened. Most now expect that the rate of wage increases decided by the ongoing spring wage negotiation (the Shunto labor talks) will be meaningfully higher than last year. Koji Nakamura, head of the Monetary Affairs Department, recently noted that cost-push inflation has not optically led to any drop in aggregate demand and could create momentum for wage growth to accelerate. This may give way to higher core inflation for an extended period of time. Nonetheless, any slowdown in global growth would add another level of complexity to this outlook.

Policy normalization likely slow and steady, an imminent hawkish shift is unlikely

In light of the new appointment and evolving inflation dynamics, we see high odds of BOJ policy normalization to start at some point this year. We think there is a chance we could see the YCC band being expanded to 1%, or an exit of the framework as early as this summer. However, we’d note that there is still a very long way to go before the BoJ’s monetary policy is fully normalized. Besides Ueda’s balanced perspectives, the fact that the Kishida administration reportedly initially offered the position to Amimaya – the most dovish candidate on the market’s radar – could be taken as a sign that a rushed hawkish shift in policies is not favored.

From here, we are closely watching a few upcoming events. Diet hearings on Ueda’s appointment, and those of the two deputy governors scheduled for February 24 and 27, are an opportunity for the market to further assess the upcoming governor’s views toward key economic issues and incumbent Governor Kuroda’s policy legacy. We could also see Kuroda tweaking forward guidance at his last Monetary Policy Meeting (MPM) on March 18-19, as Covid special operations are set to end in March. In addition, we could also get the first batch of results from the ongoing wage negotiation in mid March, and better assess the outlook for wage inflation.

Investment opportunities and market implications

From a foreign exchange (FX) perspective, our assessment of BOJ’s policy path forward is in line with our 2023 outlook for USDJPY to end the year around 120, assuming that U.S. rates eventually come down and the 10-year JGB yields are ultimately allowed to go higher. Despite a lack of near-term catalysts before the Federal Reserve confirms the end to its hiking cycle, our medium-term expectation continues to be that the USD can trade weaker over the course of the year as U.S. growth and yields “catch down” to low-yielding G10 currencies, including the JPY. We encourage investors to explore derivative strategies with loss limited features to express the bullish view on JPY against the USD over the next 6-12 months.

Over the shorter term, with the direction of USD admittedly harder to call, we can focus more on USD-neutral expressions. As shown in the chart below, valuation of the JPY is still the most attractive among G10 currencies based on multiple factors. We particularly like long JPY strategies against risk-sensitive currencies with vulnerable growth and relatively dovish central banks, i.e. GBP, NOK, and CAD.

From an equity perspective, given the high percentage of company earnings from exports, Japanese equities collectively are likely to face headwinds from a weaker USDJPY. This is reflected in our 2023 year-end outlook for the TOPIX of 1,980-2,030, offering limited upside from current levels. That said, we believe attractive investment opportunities do exist for domestic companies geared towards Japan’s re-opening to international travelers, and financials that could benefit from Japan’s gradual exit from the extremely accommodative monetary policy.

Over the longer term, as Japan’s near-decade of zero, and then negative, rates enters its final chapter, the outflow of Japanese capital will also likely slow. This could have important implications for global liquidity. If and when the BoJ tolerates a further rise in yields, a reorientation in Japanese portfolio flows away from foreign assets and back to domestic debt could have important implications for those markets where exposure is highest. While Japan is the largest single foreign holder of US Treasuries, given the sheer size of the market a pull-back in Japanese flows would likely not be that impactful, but rather could be more visible in Australia and Europe, where exposure is highest as a share of the total market.

¹Central Banking, as of Feb 15, 2023. https://www.centralbanking.com/central-banks/monetary-policy/7954502/can-new-boj-governor-ueda-maintain-his-neutral-position

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Index definitions

TOPIX, also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange.