The Land of the Rising Sun

The Land of the Rising Sun

Japan has been getting exciting, lately. Inflation has been back on the rise, with core inflation looking sticky around 4.2%. At this point, Japanese inflation is higher than US inflation.

Some will note that Japan has had inflation concerns before and managed fine, but this time, the Bank of Japan (BOJ) modified their yield curve control (YCC) system. They abandoned their 0.5% peg on the 10Y JGB. Instead, they will allow a 0.5% band around the old peg and will defend 1%.

That’s a tightening, but since they didn’t formally raise the peg, they’re going to let the market do it, and that tends to take time. Thus, it’s a slower tightening, rather than anything quick and dramatic.

This action has been weakening the yen, as more supply is expected as they protect JGBs. We could also see other bond markets suffer as Japanese bonds become more competitive. Considering Japanese investors are estimated to have $1.84T in foreign assets, that shift could be pretty big.

Why should we care? Japan is the center of carry trades, where traders borrow in a low-yield currency then invest in assets of a higher-yielding currency. Japanese investors are also the largest overseas holders of US Treasuries. Right now, Japanese investors can get JGBs at 0.6% and USTs at a currency-adjusted 0.05%. Moving more into JGBs seems like a no-brainer. Again, this pressures world bond markets, which in turn make equity markets look more expensive.

The thing that’s interesting about this is that it’s kind of a slow burn. How quickly will JGBs take to hit the new ceiling? Right now, this move doesn’t seem too bad, but as we approach the 1% rate, we’re going to see more fireworks. The simplest concern for us, in my mind, is JGBs are now that much more attractive than USTs for Japanese capital. That should encourage USTs to drop (yields to rise,) which is hard on long duration risk assets, like stocks.

Japan has long set the floor for rates in the world, and they just raised that floor. In the longer term, this is likely to create a mess for Japan and a mess for world liquidity.