The Bank of Japan’s Ability to Surprise - Part II

Investment Views
31 July 2023Print article
David MitchinsonFund Manager
James SalterFund Manager

For part I, please click here.

Mr Ueda has a habit of being somewhat opaque at times. Over the last ten years it has not been clear whether he was an outright believer in Quantitative and Qualitative Monetary Easing (QQE)/Yield curve control (YCC) or somewhat more sceptical about the longer-term impact on the functioning of the bond market. What have we learnt from today’s meeting? Well, in our view that he has somewhat tarnished his messaging at a very early stage in his tenure. Dovish or hawkish? We really don’t know.

Negative interest rates will continue at -0.1%. The Bank of Japan (BOJ) decided to conduct yield curve control “with greater flexibility”. The target is to keep Japanese government bond (JGB) yields around zero percent whilst allowing them to fluctuate +/- 0.5%. The biggest change today was in the language referring to “greater flexibility” regarding the upper and lower bounds of the range, and that it has raised the rate for fixed rate purchase operations every day from 0.5% to 1.0%. The level immediately before the meeting for fixed rate operations was 0.5%. Effectively, the BOJ have raised the ceiling for YCC to 1.0% but pretended not to have. The BOJ define rate hiking as raising the short-term policy rate, including ending its negative interest rate policy.

The rationale for today’s change is that inflation expectations are rising. The BOJ admitted that the consumer price index (CPI) inflation gauge was higher than their projection in April 2023. Wage growth has risen, and changes have been witnessed in firm’s wage and price setting behaviour. Interestingly, they mention that this new flexibility will enable a better functioning bond market. At Zennor we have long held the view that the QQE experiment globally persisted too long. The BOJ is no exception, and the risks continue to be that inflation is becoming more entrenched. The BOJ have correctly pointed to import related price hikes being transitory but have underestimated the domestic driven inflation corollary in our view.

Many companies we speak to are raising prices and the labour market remains super-tight. Recent Shunto wage negotiations came in at +3.6%. Today, Tokyo CPI ex-fresh food and energy was +4% YoY.

We have also talked about our view that the Japanese Yen is very undervalued. We do not know the full extent of the carry trade globally but continue to feel that this could ultimately lead to repatriation and could in a worst case be a “black swan” event for the US bond market. It is worth noting the BOJ still see inflation as lacking a strong footing, and they would argue that we still need to see evidence next year that wage rises are sustainable.

There is no doubt that this is the second step in a tortuous process of exiting QQE. Given the experience of the Reserve Bank of Australia in 2021, one could argue that Mr Ueda has opted for an approach that is well flagged and digested by market participants. My colleague, David Mitchinson is convinced that PPP on the Japanese Yen is at least Y125/$1. Our portfolios remain domestically focussed. Non-Japanese currency sales are only 28% versus a figure of around 45% for the market. If the Yen were to weaken the portfolio should benefit through its weighting in financials and domestic focussed names. Wrongly, we have avoided technology, and this has been costly, but valuations are rich, and the market seems too optimistic about the visibility of recovery in the second half onwards.

In their outlook strategy today, the BOJ talked of risks on prices “skewed to the upside”. This is NOT imported inflation but domestically generated, consumption led demand inflation. Wage growth will continue into a second year in our view. The output gap is rising, and David has reported today that where he is staying in Japan (Hakuba) things are booming. Finally, looking at the Tankan manufacturing sentiment index it is mentioned that “there is a definitive change in wage setting and price behaviour and in labour-management wage negotiations”.

James Salter & David Mitchinson

31st July 2023