Background: what happened in December 2022

At the Bank of Japan (BoJ) meeting in December, the BoJ shocked the market by unexpectedly shifting its YCC band on the ten-year Japanese Government Bond (JGB) from +/- 25bp on either side of zero, to +/- 50bp on either side of zero. It explained the move as improving market functioning.

The shift triggered a 5% drop in USD/JPY from 137.30ish to a low of 130.56. The Nikkei fell over 1000 points (-4.6%) from just above 27,000 to 26,055. Elsewhere the yield on the U.S ten-year bond yield jumped 10bp.

The market has interpreted the BoJ’s shift in December as a first step towards policy normalisation. An end to an era of ultra-easy monetary policy settings in response to Japanese inflation at a four-decade high.

Three possible changes the BoJ can make tomorrow

• Option 1 (45%). Leave policy unchanged, and reiterate comments that the band's widening in December was aimed at easing bond market distortions. Furthermore, leave any other changes until current Governor Kuroda’s term expires on the 8th of April
• Option 2 (45%). Make a further tweak to YCC by widening the band to +/- 75bp on either side of zero or +/- 100bp on either side of zero and argue that this will improve market functionality
• Option 3 (10% or less). Completely abandon Yield Curve Control.

What is the potential for another shock this week?

Option 1.

Most economists think that the BoJ will maintain its current policy settings and allow Kuroda to see out the last few months of his term. This period would also allow the BoJ to assess the outcome of “shunto” wage negotiations. It would likely trigger a ~3% short covering rally in USD/JPY and the Nikkei for the reasons outlined in Option 2.

Option 2.

Following a media report last week (Jan 12) in the local press (Yomiuri Shimbun), speculation has increased that the BoJ will make another adjustment to its Yield Curve Control (YCC) at Wednesday’s meeting.

After the article appeared, USD/JPY has fallen 4% (from just above 132.00 to its overnight low of 127.46.) Nikkei futures have fallen almost 1000 points from a high of 26530 on the 12th of January to a low yesterday at 25,675. In the bond market, the BOJ bought over JPY 10 trillion worth of JGBS from the market at the end of last week as the yield on the ten year JGB pushed up to 0.57%. As of yesterday, it was back trading at 0.50%.

Movements in markets since Jan 12 outlined above, suggest that Option 2. is mostly priced into FX and stock markets. It may trigger a minor ~1-2% short-covering rally in USD/JPY and the Nikkei.

Option 3.

Should the BoJ abandon YCC tomorrow, things will get messy. It would see the JPY explode higher along with JGB yields. Global yields would also increase due to a possible acceleration of Japanese investor’s unhedged foreign bond portfolios.

Overall, the Nikkei would be poleaxed, and global equity markets would also weaken.

USD/JPY daily chart