JPY, JGB, QQE, YCC – OMG?

• As the US Fed and European central banks raise rates to fight inflation1, the Bank of Japan (BOJ) is sticking firm to its policy in the face of growing market pressures.

• Heuristics are being challenged as the proverbial “safe-haven” Japanese Yen (JPY) is near a 24-year low2 and its devaluation is a looming negative market catalyst.

• Understanding (in)direct exposure to Japan is important as the repercussions could be widespread.

Challenging What We Know

In complex domains, like financial markets, heuristics (“rules of thumb”) are generally useful summary tools for understanding phenomena. However, when used without nuance, especially during market inflection points, they can catch investors off-guard.

A heuristic that is currently being challenged is the Yen as a “safe-haven” asset, as it has devalued 16% YTD vs. USD³ while global markets digest new normals and the Russia-Ukraine conflict is still ongoing. The above chart shows this is not “typical” during high-stress periods in the market.

So what’s different this time and why should we care?

Japan Primer

Since 2016, in a continued effort to stimulate the economy, the BOJ extended its quantitative and qualitative monetary easing (QQE) initiative with a framework called yield curve control (YCC). With YCC the BOJ committed to buying Japanese government bonds (JGBs) to keep yields low (i.e., pinned), and doing so until a stable 2% inflation target was hit.⁴

Currently, Japan’s economic output is still below pre-pandemic levels⁵ but inflation has trended above 2% the past few months⁶. A devalued Yen plus inflation above target should be a heuristic ideal for the BOJ, no? It’s a mixed bag – but perhaps a net-negative, as the inflation is supply (“bad”; energy & material imports) vs. demand-sided (“good”), which can be seen in the chart of deconstructed CPIs below.

So, the BOJ and governor Kuroda are in a precarious situation: stick with a divergent policy vs. global peers and risk devaluing the JPY to untenable levels, or raise rates and risk domestic growth and the balance sheet of the world’s top creditor nation?⁷

Why It Matters

The impact of BOJ actions and a volatile JPY reverberate through the interconnected global market.

• Japan is the largest holder of US Treasuries⁸ and could (continue to) sell and not be a marginal buyer of Treasuries going forward, due to rising FX hedging costs, uncertainty of US policy & inflation path, and other relative global opportunities (e.g., Europe).
  
  
• Abandoning YCC policy would shudder losses across Japanese institutions and retail investors. Concurrently, a rapidly rising JPY could unravel carry trades – a source of global liquidity.
  
  
• Geopolitically, China may view continued JPY devaluation as a threat to its relative competitiveness, especially if China sees a prolonged slowdown from the pandemic.

Whether the BOJ sticks to YCC and/or the JPY reverses course, the near-term outlook is one of elevated risks where our Multi-Asset Research Team will be wary of heuristics.

Important Disclosures & Definitions

1 Board of Governors of the Federal Reserve System, Policy Tools, as of 07/31/2022

2 Bloomberg, as of 07/31/2022, with respect to JPY per USD

3 Bloomberg, as of 07/31/2022, calculated with USD base

4 Bank of Japan, Monetary Policy, as of 07/31/2022

5 Moody’s Analytics Economic Indicators, Japan – Real Gross Domestic Product, as of 03/31/2022, latest information available

6 Official Statistics of Japan, e-Stat, as of 06/30/2022

7 Reuters, “Helped by Weak Yen, Japan Remains Top Creditor Nation with Record Net External Assets”, 05/26/2022

8 US Treasury, Major Foreign Holders of Treasury Securities, as of 05/31/2022, latest information available

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

One may not invest directly in an index.

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