What Happens When the BoJ Kills its Yield Curve Control?

17 Apr 2023

Yield Curve Control (YCC) has kept interest rates on ten-year Japanese government bonds within a narrow range close to zero percent since 2016. The Bank of Japan (BOJ) employs YCC to target short-term interest rates at -0.1% and to maintain the 10-year government bond yield within 0.5% above or below zero.

In 2016, Japan was grappling with over a decade of sluggish growth and the issue of deflation, where prices of goods decline. To avoid purchasing huge amounts of the bond market, Yield Curve Control (YCC) was introduced to maintain interest rates at their existing levels.

But now, Japanese annual inflation has reached 3.3% as of February, which suggests that Yield Curve Control (YCC) may no longer be needed. The Bank of Japan (BoJ) has faced criticism for distorting markets with the YCC while inflation has exceeded its 2% target. As a result, the BoJ is considering phasing out YCC, which could have significant consequences for US and Japanese bonds and the USD/JPY exchange rate.

So, what will happen when the Boj decides to Kill its YCC?

Japanese investors have been disappointed for the past seven years in the returns on domestic bonds since interest rates have been fixed close to zero. This has prompted many to consider investing in US bonds which have become highly appealing, resulting in trillions of Yen being invested in them. A relaxation of the YCC by the Bank of Japan on the 10-year rate could potentially make Japanese government bonds more appealing to domestic investors. This could result in a significant amount of money repatriating to Japan and have a major impact on global markets.

There are two potential outcomes if Japanese investors repatriate their funds and invest more in Japanese bonds. Firstly, the interest rates for US bonds may increase, leading to tighter financial conditions and a slowdown in US economic activity. Secondly, there may be a weakening of the US dollar, especially the USD/JPY, as investors sell their USD to buy JPY for repatriation.

The USD/JPY is currently in the range bound between around 138.00 and 129.500. But a downside potential to a level like 116.00, which has not seen since early 2022 if a knee-jerk reaction eventuates. Ultimately, how drastic these outcomes turn out will depend on the selling pressure and timing of Japanese investors in reaction to a relaxation of the YCC.

But how likely is it that the BoJ will loosen its control of the yield curve?

Japan's new central bank Governor, Kazuo Ueda, has suggested that the policies of his dovish predecessor, Haruhiko Kuroda, will eventually be phased out. However, the BOJ is likely to avoid changing its policies until it is certain that inflation will reach and maintain its 2% target. Next week, On April 27-28, Ueda will preside over his first BOJ policy meeting, during which the board will release new quarterly growth and inflation forecasts that will be scrutinized for indications of how soon the central bank anticipates inflation will reach its target sustainably. Speaking last week, on April 10th, Ueda emphasized the need for the BOJ to make proactive decisions regarding the timing of policy normalization. He warned that delaying the adjustment could lead to disruptive consequences.