It’s here.

In this piece, we uncover:

  1. The fundamental role the Bank of Japan plays within global asset markets

  2. The flaw within the Japanese economy

  3. USD'/JPY rates & the BoJ vs Hedge funds

The Power of The BoJ

Now, for those of you who may not understand why I would choose to write on this particular central bank; you need to read this.

The Bank of Japan single-handedly plays one of the most crucial roles within capital markets globally, and that starts within the bond market.

Figure 1: U.S debt categorised by country

Japan is the single largest holder of U.S debt in the world, holding roughly 17% of all U.S treasury bonds available, now let me put that into context for you. The U.S treasury market is roughly a $11.2 trillion dollar market place; so owning just under 1/5th of that market shows how important the Bank of Japan is to the U.S market.

Let’s take it a bit further and expand on how crucial the Bank of Japan is to both the U.S & global asset markets. Up until now, many of you, including me at a point, believed that U.S treasury yields were priced and dictated by the Federal Reserve’s monetary policy stance and major economic data released from the U.S. That’s not the full picture, the world of U.S treasuries revolves not only on U.S economic data and the Fed but on the large holders such as Japan and China who collectively own just under a 1/3 of the treasury market. If the treasury market was only impacted by the Federal Reserve and U.S data, we would have experienced much higher yields within the U.S as inflation took off throughout the year peaking at 9.1% in June.

Effectively, what I’m saying is the Bank of Japan has indirectly capped U.S treasury yields through its lose monetary policy program. Here’s why.

Yield Curve Control & Low Rates

Figure 2: Japanese Interest Rates

In 2016 the Bank of Japan initiated a policy known as Yield Curve Control, (YCC), this was implemented to keep borrowing costs at all-time lows in order to prop up an inflation-starved economy. If you’re thinking what is yield curve control here’s an explanation:

Yield curve control is the process where a central bank of a country aims to control both short-term and long-term policy interest rates. This creates a framework where the central bank can effectively cap borrowing costs regardless of what shape the economy is in, in order to stimulate inflation within the economy.

Japan’s Flaw…

Inflation has been a massive problem for the central bankers in Japan as factors such as; a low fertility rate, ageing working demographic and due to the expansionary policy of the Bank of Japan, interest rates have been extremely low. Leading to a continuous outflow of capital to the United States and other countries. Private households, pension funds, life insurance companies and many other institutions have bought US government bonds and U.S assets further decreasing the demand for the Yen.

Here’s how the Bank of Japan has indirectly capped U.S treasury yields. Through yield curve control the BoJ has capped 10y JGB’s (Japanese Government Bonds) at 0.25%. If JGB yields are pinned at 0.25% then Japanese investors are forced to seek yield overseas by purchasing U.S bonds as one of the only alternatives to realising positive gains on their investments. Through this process of Japanese investors looking overseas, particularly within the U.S for investments, the yield of U.S debt is less influenced by the factors mentioned above but is now simply perceived as a sound store of capital compared to domestic markets in Japan yielding close to nothing.

Let’s play the other hand. What would happen if the BoJ were to move away from yield curve control?

Absolute chaos, put it this way. U.S treasuries and global yields/credit spreads would be through the roof, cost of capital would be even more elevated meaning the S&P500 and Nasdaq especially would be hammered to the ground. The main reasons are, tech stocks survive off of low borrowing costs and most importantly higher yields mean tech stocks’ earnings in the future are worth less today.

Dollar Yen, Pushed To The Limit?

Figure 3: USD/JPY FX Rates

It’s safe to say we know the Bank of Japan has got deep pockets, but this depreciation in the Yen must hurt them, right?

YTD the Yen has lost close to 25%, as investors have shifted their focus toward the ever-widening interest rate differential between the BoJ and the Fed among other central banks also on the tightening cycle. If you are a central bank or a large financial institution, say a pension fund or asset management firm and you have FX exposure on your books, the last place you would want to hold that would be in a currency like the Yen where your yield is 0.1%. So for the market participants seeing the purchasing power of the Yen slide uncontrollably, you would probably bet on the Bank of Japan being forced to hike rates and abandon YCC, right?

Not so easy. Earlier in May this year, hedge funds had bet that the Bank of Japan would be forced to hike rates and even move away from YCC.

Figure 4: Hedge fund bets on BoJ rate hike

Take a look at the yellow region highlighted to the right. Traders began shorting JBG’s in hopes that rates would increase causing the price of existing bonds to decline in value. This trade was met with full force as the Bank of Japan purchased a record amount of JGBs in order to defend its yield curve control and monetary policy stance. This trade is heavily referenced as the widow maker because that’s what the BoJ turned those funds into.

Figure 5: BoJ Steps Up Bond Purchases at June Meeting

Of recent, we saw the BoJ intervene to stop the yen slide after the central bank kept its rates low, abiding by its dovish policy; this intervention was the first in 24 years for the bank where the BoJ sold dollars to purchase Yen. The question one has to ask is, how much suffering until the BoJ is forced to pivot? As the only central bank in the world to have rates extremely low, the exchange makes imports of goods costlier for the nation.

What a week, thanks for your attention all the way till now! Hope you’ve enjoyed the articles released this week. Always love to hear from you guys; I’ve got some cool things warming up for the MMH community — just give me some time.

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Until next time,