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Why the BOJ’s Policy Was Such a Surprise Change

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So, the yen advanced over 300 pips, and the Tokyo stock exchange kinda crashed. The move was so big that Japanese bond futures tripped a circuit breaker and had to be suspended for a while. There are a plethora of articles talking about how this move has global implications. Just yesterday, everyone thought that BOJ meeting would be another “meh”. What happened?

Understanding the BOJ

First, there was unanimity among economists polled by Bloomberg ahead of the meeting that the BOJ wouldn’t change its policy at this meeting. As we talked about yesterday, there was a potential that the BOJ would adjust its yield curve control policy. And it did – just sooner than expected.

This is the thing about the BOJ: It likes to surprise markets. Other central banks prefer to telegraph moves, to prepare the markets, and reduce the potential chaos. The BOJ believes policy can be more effective, and generate a stronger response if markets are surprised. That’s possibly an explanation for why they went ahead with this policy tweak now, and didn’t provide any warning it was coming.

What does it mean?

Back in 2016, the BOJ implemented a policy called “yield curve control”. That means that if the yields in bonds rise above, or fall below a certain range, the BOJ would step in and buy (or sell) to get bonds back in that range. This is called the “yield control band”. The middle of the band is where they want the yield to remain at. In the case of the 10-year, benchmark, bond, that is 0%.

Up until yesterday, the band was 25bps. That meant that the market could move up or down 25bps from 0%. If it moved beyond that, the BOJ would step in and buy (or sell) bonds, to force the yield back into the range. The trick is that because the threat from the BOJ was so big, the market didn’t dare move significantly beyond the rage. That way, the BOJ could keep bond yields, and maintain the interest rate paid on bonds, within a specific range without having to buy as much.

What did the BOJ do?

They didn’t change their yield control target; it’s still at 0% for the 10-year bond. What they did is widened the band, allowing yields to move up to 50bps away from 0%. Since all the pressure is to the upside, because of the higher inflation rate, this effectively means that the BOJ raised the cap on Japanese government bond yields. In practice, this means that Japanese debt can pay higher interest rates.

It’s not a change in the official interest rate, even though Kuroda kind of implied that in the past. But it has a similar effect, by raising borrowing costs in yen. It has global implications, because of carry trading. Many investors borrowed in yen so they could buy other currencies with higher interest rates, such as dollars (American, Australian, Canadian), Euros and emerging market equities. Now, the cost for borrowing has increased for those operations, which could incentivize some of the capital to return to Japan.

The end result supports the yen in a way similar to an interest rate hike. The yield curve control policy remains in effect, and the BOJ even promised to buy more bonds to reinforce the edges of the band they allowed. Kuroda argued that the purpose was to improve liquidity in the bond market; but many investors are seeing it as the first step towards policy normalization. Some are even suggesting that the BOJ could raise rates some time next year.

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