Japan Market Tremor Bruises Bonds as Yen Soars

The stimulative tide of easy money is in retreat around the world as central banks fight high inflation, and no one is immune.

The Bank of Japan jolted global markets Tuesday by tightening the loosest monetary policy among the major central banks, reinforcing hawkish commentary last week from the Federal Reserve and the European Central Bank.

The bank framed its decision to allow the yield on the 10-year Japanese government bond to rise up to 0.5%, from 0.25% previously, as one needed to "facilitate the transmission of monetary easing effects."

Markets weren't buying it. The Japanese yen gained about 4% against the U.S. dollar and the euro, while the yield on the 10-year U.S. Treasury bond rose 12 basis points to 3.70%.

Japan's central bank has targeted a 10-year yield of zero since 2016 under a policy known as yield curve control, in an effort to achieve stable inflation of 2% after decades of stubborn deflation. In 2021, it formalized an effective range of plus or minus 0.25% from that target. Tuesday's change doubled the range to plus or minus 0.5%.

Low domestic rates and yields, along with ample capital, have made Japan a major source of the carry trade, the practice of borrowing cheaply in a low interest rate currency to invest proceeds in foreign markets with higher returns. The scale of this trade after years of expansionary monetary policy in Japan and elsewhere has fed chronic concerns about the market effects of a policy reversal.

Japanese investors own $3 billion in overseas stocks and bonds, with more than half of that invested in the U.S., according to Bloomberg. "Allowing rates to rise could see a tsunami of offshore Japan money flooding back home," Asymmetric Advisers strategist Amir Anvarzadeh told the news service.

Bank of Japan made the change just as its policy boosted its ownership of government bonds above 50%. The bank's growing stockpile of government bonds and its control of yields have sapped the bond market's liquidity. "The functioning of bond markets has deteriorated," the BoJ noted in explaining Tuesday's decision.

At the same time, the BoJ increased its quarterly allocation to government bond purchases to 9 trillion yen ($68.5 billion), from 7.3 trillion, to defend the upper limit of its targeted range while deterring speculators who have recently bet it would have to abandon yield curve control.

Speculators are betting the bank will have to change course more decisively with Japan's inflation now at 3.5%, even as economic growth falters. The recent pickup in inflation has proven unpopular with Japanese voters, and Bank of Japan Governor Haruhiko Kuroda had to apologize this summer after saying consumers have grown tolerant of price increases.

Kuroda is slated to step down in March, and anticipation of his departure has fueled speculation that Japan will soon abandon his signature policy. "This is a step toward an exit, whatever the BoJ calls it,” Masamichi Adachi, chief Japan economist at UBS Securities and a former BoJ official, told Bloomberg after Tuesday's decision. “This opens the door to a chance of a rate hike in 2023 under a new governorship."

"This is a victory for foreign investors and a defeat for the BoJ,” wrote Mizuho Securities chief market economist Yasunari Ueno in a research note. “The fact the BOJ suddenly changed its policy will strengthen market speculation that an abrupt end for [yield curve control] could suddenly materialize out of the blue.”