Yen to pause before embarking on a leg higher

January 31, 2023 09:48
Photo: Reuters

The Bank of Japan (BoJ) surprised markets on Wednesday by keeping its Yield Curve Control (YCC) policy unchanged. The BoJ’s decision temporarily pushed Japanese government bond (JGB) yields lower and the USD-JPY pair back above 130. After the unexpected widening of its cap on the 10-year government bond yield to 0.5% from 0.25% at its December meeting, investors have been testing the Bank’s resolve in defending it, forcing the BoJ to spend about 34tn yen (5½% of GDP) on bond purchases. While the pace of buying is not tenable, we view Wednesday’s BoJ decision as a signal to the market: It will manage its way out of YCC at the pace it deems necessary and will not be forced to change its stance prematurely. Economic data, and not market pressure, will determine the timing of its exit.

We remain convinced that the BoJ will end both YCC and its negative interest rate policy (NIRP) later this year. Since we first made this call in early November, economic data, anecdotal evidence and the BoJ’s own macroeconomic forecasts have largely supported our view. Core inflation moved to 2.8% in November, its highest level since the early 1990s and wages (including bonuses) had grown at close to 3% in 2022. Japan’s largest federation of trade unions recently said it will ask for a 5% rise in base pay in the annual February/March round of wage negotiations for 2023, known as shunto. This is unusual, as the union used to demand significantly less, and reflects the emerging political consensus for higher wages, as well as a relatively benign economic outlook. In fact, the owner of the Japanese fashion chain Uniqlo already announced that it will raise annual salaries by up to 40% in 2023. The BoJ expects the economy to grow above its trend rate over the coming two years, and a strong rebound of the Chinese economy would make this prediction even more likely to happen. In short, we think that inflationary pressures in Japan will probably be more sustained than is generally believed.

So when could the BoJ’s pivot unfold? After years of deflation, the Japanese authorities don’t want to take any chances. Before making any major move, they will first want to see the shunto negotiations indeed delivering stronger wage gains, then they will wait for evidence that companies are passing on some of their cost increases to customers. This suggests that the earliest point in time the BoJ could abandon YCC and NIRP would be in the second quarter of this year under the leadership of a new governor.

For the Japanese yen, this means its recent rally is likely to stall for some time. Hence we expect the USD-JPY pair to be range bound at around 130 in the near term. Yet uncertainties with respect to the timing of the BoJ’s further policy steps are set to remain elevated and will likely peak around the last days of BoJ Governor Kuroda’s term. This suggests that the yen will continue to be exposed to an unusually high volatility over the coming months.

In the medium term, the yen’s dynamics are set to remain closely aligned to relative yield moves. In particular the US dollar’s yield advantage against the yen should come under further pressure, which should provide ample support to the yen. Given that the US cycle has slowed substantially as of late, the market increasingly expects the Fed to pivot sooner, which is weighing on UST yields. At the same time, upward pressure on JGB yields should be quick to resume as the market awaits further adjustments of the BoJ’s monetary policy stance. In anticipation of these, we expect the yen to embark on another leg higher once shunto negotiations conclude, which should bring the USD-JPY pair closer towards 120.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin