The Bank of Japan’s (BOJ) commitment to controlling bond rates with inflation over the BOJ’s objective is being put to the test by investors, who are fiercely attacking the yield curve control (YCC) of the bank.
In an endeavour to permanently reach 2% inflation, the BOJ’s super easy policy sets some short-term borrowing costs at -0.1% and the yield on 10-year government bonds at 0.5% either above or below zero.
Here are the workings of Japan’s YCC and some potential issues.
Although the market is currently challenging the BOJ’s target bond yield’s upside, the bank implemented YCC in 2016 to prevent interest rates from dropping too far.
In order to prevent an unwanted yen appreciation, the BOJ reduced short-term rates under zero in January 2016 after years of massive bond purchases failed to spark inflation. Financial institutions were outraged when the move destroyed rates throughout the curve and caused their returns on investment to vanish.
Eight months after adopting YCC, the BOJ increased its -0.1% short-term rate objective to a 0% aim for 10-year bond yields in an effort to push long-term rates back up.
The goal was to manipulate the yield curve’s form to lower short- to medium-term rates, which have an impact on corporate borrowers, without significantly lowering super-long yields and decreasing earnings for pension funds & life insurers.
The BOJ decided on a rate regime because quantitative easing, in which it purchased certain amounts of assets to drive down yields in an effort to boost inflation and economic activity, had reached its limit.
It was challenging to commit to purchasing bonds at a defined rate when the central bank had snatched up half the bond market. The BOJ was able to buy only what was required to reach its 0% yield goal thanks to YCC.
In order to prepare for the eventual termination of the ultra-easy policy, the bank has scaled back its bond purchases during periods of calm markets.
Bond rates started to trade in a narrow range as the BOJ was pushed by persistently low inflation to keep the YCC in place for a longer period of time than anticipated.
The BOJ stated in July 2018 that these negative effects could result in the 10-year yield moving 0.1% over or below zero. To revive a market its purchasing had paralysed, the bank expanded the band to 0.25% for either direction in March 2021.
In December, the BOJ increased the band to 0.5% either above or below zero in response to criticism from investors who were betting on a rate increase and increased bond purchases to defend the ceiling.
On Friday, investors exceeded the 0.5% threshold, raising speculation that the BOJ might need to adopt more harsh measures.
When inflation was weak and there was no chance of reaching the BOJ’s price objective, YCC performed well because investors could rest on a mountain of government debt that guaranteed secure yields.
However, investors have sold bonds as a result of inflation erasing those gains, pricing in the possibility of a rate hike in the near future.
To defend its yield cap, the BOJ has increased purchases, including by making offers to purchase an infinite number of bonds. Analysts have criticised this for distorting pricing and causing an unwanted yen collapse that increased the price of importing raw materials.
The BOJ wants to delay hiking rates until it is certain that inflation will sustainably achieve the bank’s 2% objective, supported by faster wage growth.
This is because the BOJ has historically faced political backlash for prematurely reducing stimulus.
However, the 10-year yield cap was breached by the market on Friday, forcing the BOJ to back down before a big bond purchase lowered the rate. This week, investors might keep shorting Japanese govt bonds in anticipation of an impending rate hike.
According to some analysts, if the market onslaught persists, the BOJ may raise or drop its long-term rate objective, further extend the range around its yield target, or both.