Previewing This Week's Most Interesting Central Bank Decision (No, Not The Fed)

While most attention over the next week will be focused on the fascinating slow-motion-train-wreck developments in the US political arena over the next week, let's please think of the central banks, which are used to being the key source of public fascination. And while the Fed's November 1-2 meeting will come and go, with Yellen paralyzed with fear and certain to change nothing just 6 days before the election, a far more interesting central bank meeting due later this week, is that of the BOJ which addresses the market on November 1, and which over the past few months has set the global bond market on edge with its attempts to steepen the JGB yield curve which in turn led to the VaR-shocked early September stock selloff, inspiring other central banks to contemplate tapering long-end purchases resulting in a the biggest global debt selloff since the Fed's 2013 taper tantrum.

This is what to expect from the BOJ according to Goldman Sachs:

We expect the Bank of Japan (BOJ) to maintain current monetary policy at its October 31-November 1 Monetary Policy Meeting. Here, we look at this and other points in a Q&A format.

Q1: Will the BOJ ease further at the next monetary policy meeting?

A1: We expect the BOJ to maintain the status quo.

We expect the BOJ to opt to maintain current monetary policy, keeping the short-term policy rate at -0.1% and the long-term (10-year) yield target at around 0%. Our impression from the BOJ’s “comprehensive assessment” in September and the adoption of an “inflation-overshooting commitment” is that the BOJ’s bias toward maintaining the status quo has strengthened, as we discuss in more detail in Q4.

On top of it, we see very little chance of the BOJ embarking on additional easing at the next monetary policy meeting (MPM), given the following four factors. (1) We expect core CPI inflation, which is tied to the inflation-overshooting commitment, to rise in coming months due to slowing in the pace of year-on-year energy price declines. (2) The Japanese government has formulated a second FY2016 supplementary budget, which is likely to buoy the economy through FY2017. (3) Although the BOJ has set a 10-year JGB yield target of around 0%, little improvement is evident in the JGB yield in the 1-5-year zone, which is an important factor for banks earnings. (4) Market expectations for a near-term rate hike have risen in the US and with this the yen has come off high levels in the forex market.

Q2: What changes do you expect in the Outlook Report?

A2: We expect the BOJ to lower its FY2017 inflation outlook and push back the target date for achieving its 2% inflation target. However, we see the importance of the Outlook Report diminishing in terms of forecasting monetary policy.

We expect the BOJ to lower its inflation outlook to around 0% for FY2016 (from +0.1% as of July outlook report), around +1.3% for FY2017 (from +1.7%), and around +1.7% for FY2018 (from +1.9%; see Exhibits 1-2). We also see a possibility of a slight downward revision to the BOJ’s real GDP forecast, to around +0.9% for FY2016 (from +1.0%) given data thus far, but we expect almost no changes in other areas. We think the BOJ will push back the deadline for its 2% inflation target, which has been within FY2017 (i.e., before the end of March 2018), by around six months at least.

In its comprehensive monetary policy assessment, we believe the BOJ has already drawn lines of defense, saying “a further rise in inflation expectations through the adaptive mechanism is uncertain and may take time” (bolding added by us). Moreover, it has already extended its timeframe from a short battle to a prolonged one by introducing an inflation-overshooting commitment. We believe that the connection between the inflation outlook in the Outlook Report and monetary policy actions will diminish going forward (see Q4).

Exhibit 1: The BOJ’s economic and inflation outlook

Source: BOJ, JCER


Exhibit 2: Revisions to the BOJ’s inflation outlook

Source: BOJ, JCER

Q3: What do you think about the JGB market conditions under the yield curve control?

A3: JGB market functionality has already deteriorated and we expect it to continue to deteriorate under the yield curve control, as long as the BOJ continues with the current monetary policy.

Bond market functionality has been deteriorating even prior to the introduction of yield curve control in late September. In the BOJ’s bond market survey, the DI for bond market functionality deteriorated to -46 in August 2016, as compared to -25 in February 2015, when the survey first started (see Exhibit 3)[1]. Deterioration in the DI was particularly noticeable after the adoption of the negative rate policy.

With the addition of 10-year JGB yield control on top of the negative interest rate policy, we expect long-term rates to become more “fixed” and market functionality to decline even further. Already, on October 19, an entire day went by with no transactions made in newly issued 10-year JGBs (according to the Japan Bond Trading Co.). This is the first time in 13 months, since September 24, 2015, that no transactions have been made for an entire day.

We believe that the BOJ is also concerned about impairment of JGB market functionality, in that it may potentially cause large stress in the market when the BOJ decides to raise its policy rates in the future. We see little way to get around this issue, however, as long as the BOJ maintains current monetary policy.

Exhibit 3: DI on Bond market functionality

Source: BOJ


Q4: What is the outlook for BOJ's monetary policy beyond the next MPM?

A4: We expect the BOJ to maintain status quo for now, barring a surge in the yen’s value, although there is uncertainty about the effectiveness of further rate cuts in correcting yen appreciation.

At its September monetary policy meeting, the BOJ announced a comprehensive assessment and also decided to adopt a new monetary easing framework that it refers to as “Quantitative and Qualitative Monetary Easing with Yield Curve Control.” In light of this, we see a high likelihood that the BOJ will continue to preserve further monetary easing as a future option barring any major market shocks, such as a surge in the yen’s value.

Our view is based on two main factors: (1) The BOJ’s latest set of policies represents a major shift in direction to prepare for a prolonged battle, in which it will only respond to significantly negative exogenous shocks, and the bias toward maintaining the status quo appears to have grown stronger. (2) It will take more time for the BOJ’s new framework to take hold among the BOJ and bond market participants.

The BOJ’s additional monetary easing options center on taking short rates further into negative territory insofar as the BOJ regards this as an effective means of correcting yen appreciation. In its comprehensive assessment, the BOJ said that the flip-side of the positive effects of the negative interest rate policy is growing pressure on financial institutions’ profits. It went on to say that the impact can vary depending on the duration of the policy. With the BOJ explicitly extending its timeframe and saying that the side-effects of the negative interest rate policy will depend on how long the policy is maintained, we think that the number of monetary easing policy measures that the BOJ is left with has diminished. This will serve to strengthen the bias toward maintaining the status quo, in our view.

In addition, our analysis indicates that if the BOJ were to take interest rates deeper into negative territory, it would likely need to lower the 10-year yield target by at least the same degree as the rate cut (see Japan Economics Analyst: To what degree can the BOJ control the 10-year JGB yield? October 17, 2016). Our understanding is that the BOJ’s aim is to avoid lowering 10-year yields, as much as possible, in order to minimize the adverse impact on financial institutions’ earnings. However, it may not be possible to simultaneously achieve both this objective and that of strengthening the negative interest rate policy. This risk, too, could strengthen the bias towards maintaining status quo.

In a speech on August 27, BOJ Governor Haruhiko Kuroda said that the adoption of a negative interest rate policy provides central banks with more leeway in coping with a variety of adverse shocks[2]. In line with this remark, we expect the BOJ to position further rate cuts as a backstop measure for dealing with negative exogenous shocks, such as a surge in the yen’s value. However, with the number of measures the BOJ is left with in this prolonged battle having diminished, it would not likely be able to make a move if the yen were merely to breach the ¥100/US$ level. We should note, however, uncertainty about the effectiveness of further rate cuts in correcting yen appreciation on such occasions.