The Bank of Japan takes off the yield bumpers

The Bank of Japan (BOJ) has effectively removed the cap on bond yields, though it can still intervene to manage yield increases. Inflation data suggests wage-price rises are sustainable, and we expect the exit from negative interest rate policy (NIRP) and yield curve control (YCC) in 2024. We see muted global spillovers, as Japanese investors, including insurers, are only rotating gradually back to JGBs. The risk of a yield spike triggering a liquidity crunch as in UK pension funds is moderately low for now.

• The Bank of Japan has relaxed yield curve control further, rephrasing the 1% upper bound on 10yr Japanese government bond yields as a "reference" not a "rigid cap".
• We see a full exit from NIRP and YCC towards mid-2024. The spring wage negotiations are key to watch.
• Japanese life insurers plan to increase JGB purchases at higher yields, but are likely to do so only gradually.
• We view disruptive spillovers to global bond markets as a tail risk only, since high yield differentials with US/Europe limit repatriation flows back to Japan.
• The risk of a UK-style pension crisis is moderately low with limited use of leverage among Japanese institutional investors.

The BOJ at its October meeting further relaxed its YCC policy by rephrasing the 1% upper bound on the 10-year government bond (JGB) yield as a "reference" rather than a rigid cap. This frees the BOJ from its former pledge to defend a yield level with unlimited bond purchases, though it will likely still intervene to minimise disruptively large changes. The BOJ's decision was in line with our long-held view¹ that it will wait for more evidence of sustainable wage-price growth before full exit from NIRP and YCC policies, likely by mid-next year after seeing the results of the 2024 wage negotiations. JGBs yields are becoming attractive again to Japanese institutional investors, including insurers, but we expect their asset reallocation process to be gradual and not create abrupt spillovers to global bond markets. Sharply higher yields and yen appreciation could hit valuations of both foreign and domestic bond holdings, but we view the likelihood of a UK-style liquidity crisis as moderately low at present.

Strengthening inflation fundamentals support the case for monetary policy normalisation in Japan. Though goods inflation has already declined from a peak, service sector inflation is broadening in tandem with resilient economic growth (see Figure 1 top). Japan's largest labour union, Rengo, has said it will target a "5% or more" wage rise in the Spring 2024 negotiations, stronger than last year's wording ("around 5%").² A weak yen, and expected higher energy prices once government subsidies end next May, are contributing to higher inflation expectations. The BOJ also lifted its inflation (ex. fresh food) forecasts in this meeting for FY2023 and FY2024 by 90bps to 2.8%, as widely expected.

Japanese insurers have long awaited higher yields and intend to add to their long- and ultra-long-duration JGB holdings.³ But they are not yet buying on a large scale due to expectations of even higher yields as the BOJ's policy shifts. Due to the weak yen, insurers are paying high currency hedging costs on the large stock (c.30%) of foreign assets in their portfolios, eating into investment profitability in 2023. However, selling foreign assets now would also mean realising significant mark-to-market losses. Policy normalisation in Japan adds upward pressure to global yields, but we think the magnitude of spillovers will be muted. The near-term economic resilience in the US had widened the yield differential between the 10Y US Treasury (UST) and JGB to around 400bps, the largest since 2002 (see Figure 1 bottom). For now, Japanese investors may still be inclined to add to their UST holdings rather than repatriating back home.

Figure 1: Japan inflation metrics; 10-year Japan and US government bond yields

Rising Japanese yields may bring flashbacks to the liquidity shock to UK pension funds in September 2022. This risk is moderately low at present, we believe. First, the potential yield increases in JGBs would probably smaller than those of UK gilts in 2022. We estimate the fair value of the 10Y JGB yield to be 1.0%-1.2% without YCC⁴. The BOJ is unlikely to keep increasing short-term policy rates as the BoE did, as we expect global growth to slow and Japanese inflation to moderate further next year. Japan's institutional investors generally use few leveraged transactions such as interest rate swaps and repos, given different accounting standards to the UK, and better funding adequency.⁵ Still, ahead of the introduction of economic value-based solvency margin ratio (ESR) regulation in 2025, life insurers have begun to use more leveraged transactions to reduce asset-liability duration gaps. The potential broadening of this trend to more interest rate-sensitive investments is a risk to be closely monitored.

The BOJ still retains the option to use large-scale JGB purchases to bring down yields. Giving up the rigid 1% cap risks yields rising so high as to raise financial stability concerns. But the BOJ's previous widening of YCC range have tended to "attract" yields up to (and occasionally beyond) the cap, as BOJ interventions are not triggered intraband.⁶ We think that on average, the benchmark 10-year yield may overshoot fair value temporarily in 2024, but eventually settle closer to 1.2% by year-end as other central banks begin to loosen policy again.