Preparing For Japan Central Bank Shift

Transcript

Inflation in Japan has been on the rise – it’s driven by a weaker currency and higher energy prices. That’s now feeding into higher wages.

A sustained rise in inflation underpinned by wage growth is exactly what the Bank of Japan has been trying to achieve. And now we’re preparing for a policy shift.

1) An end to Japan yield curve control

That would mean volatility, in our view.

The Bank of Japan relaxed its cap on 10-year yields late last year, surprising markets and jolting yields. We think it could abandon the cap – and that may signal more action like shrinking its balance sheet and raising rates.

A policy shift could come even before a new governor takes over the central bank in April. We see a policy shift reverberating globally, driving up yields and reducing risk appetite.

2) More compensation to hold bonds

This fits into a larger trend by major central banks to boost yields instead of depressing them, leading to tougher global financial conditions. That’s why we see investors demanding more compensation to hold long-term government bonds.

3) Risks to Japan equities

We see this and the sensitivity of Japan’s economy to the global growth slowdown posing risks to Japan equities.

We turn tactically underweight Japan equities – the same as developed market peers.

We prefer short-term government bonds and credit for income.

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Japan’s economy is starting to look like its developed market (DM) peers at least in one way: Inflation is beginning to take root after having been long missing in action for decades. Yet, the Bank of Japan’s ultra-loose monetary policy remains, including a cap on bond yields that requires sizable bond purchases. We think a policy change could come at any moment – scrapping the cap risks pushing global yields higher and reducing risk appetite. We cut Japanese stocks to underweight.

Inflation comes to Japan

Notes: The chart shows core CPI inflation, excluding food, non-alcoholic beverages and energy (Western core). The earnings line is based on the three-month moving average.

Inflation – long missing in Japan – has reached four-decade highs on a weaker yen and higher energy prices. Crucially, that’s now feeding into higher wages. See the chart. We think that paves the way for the BOJ to roll back policies that by its own measures may have achieved their goal: to foster a sustained rise in inflation toward its 2% target that is underpinned by wage growth. The BOJ’s monetary easing went further than other major central banks with relentless bond buying to cap yields and large-cap stock purchases. Governor Haruhiko Kuroda has led the effort as one part of former Prime Minister Shinzo Abe’s fight against deflation, dubbed “Abenomics.” With wages rising by the most in decades, the BOJ can start winding down these policies. Yet, doing so is unlikely to be easy without stirring market volatility. We see any Japanese yield spike from scrapping yield curve control as a global risk that could drive other yields higher and hit risk appetite.

Speculation is rising on what a BOJ leadership change in April will mean for policy. Kuroda’s last meeting as governor will be March 10. But we think who succeeds is less important than the fundamental issue: a nearing shift in policy. Regardless of who takes over, we think the wage and inflation dynamics at play mean the current policy stance has likely run its course. Policy changes could come in different forms. The BOJ could widen the band on its 10-year bond yield target again – market pricing not impacted by the cap is already up to 0.5% higher than that limit. We also think the BOJ could abandon its yield curve control at any moment. That would push yields higher and stoke interest rate volatility. It would put the BOJ on track to stop bond purchases – it owns over half of outstanding Japanese government bonds – potentially let its balance sheet shrink as bonds mature and push up policy rates.

Global ripple effects

We see global implications of a BOJ policy shift. A gravitational pull among developed market bond yields increases the risk of a global spillover, in our view – especially if Japanese investors cut their large foreign bond holdings. We see the jolt from a BOJ policy shift as another driver of higher term premium, or the compensation investors demand for holding long-term government bonds. We think the risk of further rises in global yields could dampen global risk sentiment. The policy change could put the BOJ on course with a larger trend by major central banks to boost yields rather than depress them. The BOJ would then join the quantitative tightening push, with the Federal Reserve doing so now and European Central Bank soon.

These risks prompt us to downgrade Japanese stocks to underweight. Monetary policy uncertainty and the sensitivity of Japan’s economy to the slowdown in other major economies spur the change. Declining earnings growth estimates already reflect some risks from slowing growth – we expect Japan’s export sector to suffer. But we do see the positive undercurrents of corporate reform, a result of one of the economic initiatives in Abenomics known as the “third arrow.” Japan has become a more shareholder-friendly market, in our view, with companies boosting share buybacks and dividends. We prefer unhedged Japanese equity exposures for foreign investors given the policy risks – and we also favor sectors that stand to benefit from automation, digitalization and tourism.

Bottom Line

We see a BOJ policy shift driving the risk for higher global yields. That reinforces why yield is back – and why we tactically prefer short-term government bonds and credit for income. We downgrade Japanese stocks on policy uncertainty and a worsening economic environment. We prefer emerging market stocks on a relative basis to DM equities.

Market Backdrop

Global stocks fell last week and U.S. Treasury yields rose across the curve as markets partly priced out Fed rate cuts later in the year. We think the risk asset pause shows we’re at a critical crossroads. The messages from Fed officials last week were more clearly about not being done in fighting inflation. Fed Chair Jerome Powell last week stressed the inflation fight will “take quite a bit of time.” We think policy rates could stay higher for longer than the market expects.