The yen has been behaving pretty well lately, keeping mostly below the 160 handle against the dollar that has become something of a line for Japanese financial authorities. That’s despite a series of data points coming out from the US that has left the greenback stronger and the market expecting now just one rate cut out of the Fed.
That might help alleviate some of the pressure on the BOJ, which had been in a difficult spot through most of the year. It also might be a sign that the intervention in the markets weeks ago has had the desired effect. If the markets are inclined to respect the lines set by financial authorities, then the BOJ can get back to the businesses of balancing out Japan’s precarious fiscal situation.
Righting a Very Stubborn Ship
Financial markets hate instability, particularly about fundamental assumptions like interest rates. If the central bank keeps interest rates at a particular level for a long time, the more the market will be unwilling to accept a change. With more than a decade of negative rates, banks and other financial institutions have made financial decisions on that basis. This massive accumulation of bonds means that they are especially vulnerable to rate hikes pushing their holdings into negative.
The length of time that rates have been low is important, because the benchmark interest rate is the 10 year Japanese Government Bond (JGB). If rates have been negative for ten year, that means it has exceeded the maturity time of the reference bond. Most financial institutions keep the reference bond as a hedge against the volatility of short-term interest rates. But that situation is flipped on its head in Japan, which is why the BOJ was practically forced to keep buying bonds even as it was raising rates.
Time to Restart Normalization
Bond buying is quantitative easing, and has the opposite effect of raising rates. If the BOJ were to normalize monetary policy, it would naturally have to stop the bond buying. That move, however, comes at a substantial risk. Even more, potentially, than raising rates, which can always be backstopped by the BOJ simply buying bonds from any institution that was at risk.
Therefore, the speculation in the lead up to the next BOJ meeting that the central bank might end its unlimited bond buying program, but still keep buying some bonds, is significant. Just how much JBGs the BOJ will keep buying could be pivotal to the market, and there is potential that it could shake up the entire Japanese financial industry. That would be, ironically, very negative for the yen.
What to Look Out For
Analysts project that the BOJ will pare back its bond buying to about 5-6 trillion yen a year. That figure is in the same ballpark as what the BOJ has been doing under its “unlimited” program. In other words, not much change in practice, but the psychological effect of putting a limit would help move the market towards a position where the BOJ could start trimming back further.
Of course, the BOJ could just keep buying without limits, which would likely be interpreted as dovish for the yen. On the flip side, a smaller than expected buying program could end up supporting the yen. It might even be enough to finally push the currency pair into a downward trend.