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- Growing global inflationary pressures have reached Japan.
- The BOJ's Yield Curve Control has outlived its usefulness.
- Abandoning the loose monetary policy, a la SNB, may trigger a massive revaluation of the yen.
USD/JPY at risk of collapse – while calling a top on the massive 1,400 pip rally has been hard, this cannot go forever. The Bank of Japan is alone among developed world central banks in promoting a loose monetary policy. Defending a 10-year yield of 0.25% could prove impossible, and if the BOJ abandons it, the yen could surge.
Why has the yen tumbled down?
Contrary to other developed economies, inflation remains mostly absent in Japan. When Kikkoman announced a 4% increase in prices of its world-renowned soya sauces, Japanese netizens raged. Deflation has been the country's problem for years, a mindset of falling prices has been dogging Japan since the 1990s and the government's efforts to change the national psyche have been in place since 2012 – but to little avail.
The BOJ has cut interest rates to negative territory (-0.10%), bought a massive amount of bonds, and also went further than other central banks with Yield Curve Control (YCC). Most central banks that bought bonds aimed to push liquidity into the system and also lower long-term borrowing costs. However, they did not have a target in mind. The BOJ went further by holding 10-year yields close to zero. When it was first announced in 2016, the band was either 10 basis points below or above 0%, and now it is 25 bps.
In the meantime, the world has changed. Inflation is rising in other places, most notably the US, where annual price rises hit 8.5% in March. That has prompted central banks to tighten their policy. They abandoned buying bonds, signaled interest rate increases and eventually announced hikes. The pace varies from country to country, but the direction of travel is clear – raising rates. That has pushed bond yields higher all over the world, with Japan standing out as the exception.
Nevertheless, the world is connected and when money flows out of markets and bonds almost everywhere, this ditching of government debt came also to Japan. That pushed the 10-year JGB yield toward the 0.25% limit, and the BOJ promptly intervened to defend its policy by buying more bonds.
In turn, this enchanted creation of the yen devalued the currency and pushed investors to buy assets abroad, further exacerbating the yen's decline.
How long can this go on?
At the beginning, officials in Tokyo must have been smiling inside – a weaker currency makes exports more attractive and gently pushes prices higher. However, the lower and the faster the yen falls, there are growing risks.
First, Japan's trading partners may see the BOJ's action as gaining an unfair competitive advantage, or a “beggar thy neighbor” policy. Japan's finance minister Shunichi Suzuki also talked about bilateral conversations with the US to tackle the situation.
Secondly, Japan could receive more than it wished for – a fast and uncontrolled depreciation of the yen could trigger high inflation and perhaps even panic that would further worsen the situation.
Third, it is amplifying the Japanese government's dependence on funding from the BOJ, crowding out regular investors and making Japan less competitive.
In general, the BOJ is going against the trend, which cannot last forever.
SNBomb, the sequel
There is a precedent for such efforts in the not-so-distant past. The Swiss National Bank fiercely defended its peg of the franc to the euro, enacted in September 2011. However, when the common currency suffered deviation and the European Central Bank was about to announce a bond-buying plan, the SNB abruptly abandoned its policy, sending EUR/CHF from 1.20 to below parity in an instant. That “SNBomb” was dropped on January 15, 2015, a day both forex traders and brokers – some went bankrupt – will never forget.
Will the BOJ pull an SNBomb? A continued effort to maintain yields at 0.25% does not make sense anymore, and the Tokyo-based instition may be forced to walk away. That would trigger a massive revaluation of the yen.
The exact response would depend on the abruptness of the move. If the BOJ maintains its policy in principle but expands the band to 0.50%, the yen would continue suffering. However, if it moves it to 1% or 2%, the currency would rise rapidly. A total ditching of the policy would send the yen surging.
USD/JPY levels to watch
Despite the recent correction, dollar/yen remains overbought according to the Relative Strength Index (RSI) on the daily chart. A “made in Japan SNBomb” would easily send it all the way to oversold territory.
Some support is at 128, the recent low, followed by 127.85, a temporary cap on the way up.
Further below, 125 is not only a psychologically significant level but also worked as a stepping stone on the way up in April, and was a swing high in March. If 125 fails to hold, the next cushion is at 124, a resistance line from early this month.
The next cushions are only 122.30, and then 121.20, which were in play early in April. A quick move can also imply a larger reveal to 119.50 and 118.10.
Perhaps a surge above 130 would mount pressure on the BOJ to act.
Final thoughts
Yield Curve Control, like any policy, works until it does not. In the BOJ's case, it seems unnecessary and counterproductive at this point. A parallel policy by the Reserve Bank of Australia was abandoned earlier on, and as mentioned, so did the SNB's EUR/CHF peg.
The longer the BOJ sticks to its guns, the larger the surge in the yen.
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