Deutsche is owrried about it:
The topic of today’s CoTD is the BoJ who meet on Friday. Nothing much is expected from them but let’s look at the wider context. As of last night, so far in 2022, 10yr yields in the US, Germany, France, the UK and Italy were up +196bps,+193bps, +219bps, +162bps and +300bps, respectively. Meanwhile 10yr JGBs are up just +19bps, and having traded in a very narrow 5bps range since the middle of March just below the BoJ’s 0.25% target. This target is becoming more expensive to defend as the global yield sell-off has escalated.I ndeed the Yen has fallen nearly -20% since March as they are becoming the last man standing on QE. However, there is absolutely no sign that the BoJ is about to change course but as a tail risk, it’s the first thing I look at every morning when I wake up to write the Early Morning Reid. Although the house view is that the BoJ won’t change tact until H2 2023, at various points this year there were no signs the ECB or the Fed were prepared to be anywhere near as aggressive as they now look set to be. Both have aggressively backtracked on their own forward guidance. This leaves the BoJ as the outlier and having to spend a phenomenal amount defending their target. So if you’re looking for something to reset global yields even higher, or a not too outlandish tail-risk event, then this is one to track over the next few months.
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Actually, I think this is more likely to be the high for yields globally if it were to happen. The final poetic capitulation of the end of the Japanese “widowmaker” trade.
UBS mulls how the BOJ could finesse it to avert chaos:
We outline a scenario in which YCC adjustment turns the yen around
USDJPY is up 15% since March, 30% from 2020 and 80% versus the pre-Abenomics alltime low of 75.35. The yen’s real effective exchange rate has slumped to 50+ year lows as a result, or 40% below where it was when spot printed 147.66 towards the end of the Asian Financial Crisis (Figure 1). The latest moves clearly reflect widening rate differentials as central banks abroad have shifted post-COVID to normalize policy (Figure 2). This drove yen selling by foreign speculators, who over the past 18 months went from record long to max short (Figure 3). What’s sustaining the broader dollar bid now is uncertainty about how much more the Fed will do (Figure 4). It’s true that the yen also has been under pressure from rising energy pricers, supply chain bottlenecks and the country’s closure to foreign tourists. But substantial income from foreign investments, shrinking FDI outflows and diminished appetite for foreign securities have kept Japan’s current account and broad basic balance in surplus (Figures 5-9).
The BoJ’s role has been mainly passive and indirect as yet. It views rising inflation expectations as cost-push driven and thereby unsustainable without a pickup in wages, which will only come with a recovery in services activity (Figure 10). But against a backdrop of capitulation from every other G10 central bank which had pledged to keep rates low for longer, the market is starting to doubt even Japan’s capacity to stand pat.
Thus, the BoJ had to buy JPY5 trillion in fixed rate tenders over the past three days and increase its regular bids, especially in the back-end of the curve. This puts its balance sheet back on track to expand at record pace after almost zero growth—in fact overall shrinkage—last year (Figures 11 & 12). That’s awkward as the Bank already owns 48% of term government paper and puts it at odds with peers which are pivoting to quantitive tightening. It’s likely to spur further yen weakness, fuelling contention within the government and resulting in public outcry (see here, here and here). The governor, who has been summoned to the Diet with increasing frequency, stresses rapid yen depreciation is bad for the economy. Key bureaucrats gathered to discuss the matter and issued a joint statement of concern last Friday.
The question then is whether the BoJ should capitulate and change policy imminently.
Some former officials had envisaged amendment as soon as the July Outlook meeting while others implicitly fingered October. Both may be too late, as the market is starting to sense (Figures 13-15). The ultimate danger would be domestic investors losing faith and selling vast quantities of artificially expensive JGBs to buy already discounted foreign bonds. This would put USDJPY on track for at least 150. We expect intervention would be futile given the widening de facto policy gap. Debt monetization concerns could ensue.
Happily, Mr Kuroda is well placed to navigate such difficult terrain. Credibility comes from his unwavering commitment to the inflation target as well as and the high degree of tactical flexibility he has demonstrated over the past nine years. He has experience dealing with excessive FX moves from his stint as vice minister for international finance from 1999-2003. And he has a core framework in YCC that was always meant to be adjusted periodically as the economy and markets evolved.
While our economists forecast no shift this year, what could one envisage if they are wrong? The overnight rate might be lifted to or slightly above zero from -10bp, signalling progress in escaping deflation. At the same time, the 10Y JGB trading band would most likely be widened considerably from its current +/-25bp; +/-75bp would probably be a good start and provide some breathing space. That would imply a considerably smaller VaR shock than the infamous 100bp move that ensued in somewhat similar circumstances during 2003. The currency spillover would be bigger in our view, though, and sustained since it would give the green light to under-hedged domestic institutions like the GIPF to cover some of their huge FX risk. We flag opportunities to position accordingly via longer-dated options that are relatively cheap and less skewed (Figure 16). A 6m 115 one-touch costs approximately 12.5% of notional, for example. Alternatively, a one-year 1.25 digital put with a 137 knock-out is 14% versus more than twice that for the vanilla.
The market will not be able to break the BOJ unless inflation surges much higher:
And I wonder if that pace of the correction underway won’t mean a safe heaven bid into JPY before long.
But add it to the list of possible cycle-ending accidents:
- Italian debt crisis;
- crypto Lehman;
- Chinese property collapse;
- Japanese bond bust;
- EM debt crisis;
- American stock market crash.