The path ahead for Japan’s monetary policy
While we do expect forward guidance to shift more neutral after Ueda takes the helm and eventually put an end to YCC, any form of normalization will likely be gradual
Marcella, Shogo, Jennifer, Adrian
- Following the widening of YCC band in December, Ueda’s recent nomination as the next Governor of the BoJ paves way for Japan’s continued policy normalization. Any policy tightening will be very gradual given the still weak economic recovery.
- Higher nominal rates of economic growth are constructive to the outlook for local equities, however, any strengthening in the yen will have to be monitored.
- On JGB, we recommend maintaining a short duration stance in anticipation of yield increases.
On February 14, Japanese Prime Minister nominated Kazuo Ueda to replace Haruhiko Kuroda as Governor of the Bank of Japan (BoJ) in April. This represents the first leadership change since Japan’s ultra-lose monetary policy was adopted.
2022 has been a year of synchronized rate hikes around the world but Japan has been an obvious exception. With the BoJ first adopting negative interest rates and the yield curve control (YCC) policy in 2016, the central bank is now facing pressures to normalize policy as inflation has jumped to a 41-year high and the ongoing intervention is distorting market pricing.
Exhibit 1: G4 central bank key policy rates
Who is Ueda and what does this nomination mean?
Ueda is a professor at the University of Tokyo, who served on the BoJ’s policy board from 1998 to 2005. According to the finance minister Shunichi Suzuki, Ueda was selected based on expectations he can help keep inflation on target, sustain economic momentum and positive wage growth. Previously, markets speculated that deputy governor Masayoshi Amamiya would land this job. Compared to Amamiya, Ueda may be viewed as a relative ‘outsider’ with less attachment to the architecture of the current policy. Thus, this nomination could bring policy changes sooner rather than later.
However, we expect any policy change to be very gradual. Real GDP for 4Q22 disappointed, growing only 0.6% annualized from 3Q22 versus a consensus expectation of 2%, indicating that the economy is likely not sturdy enough to sustain a 2% inflation just yet. Although tourism can continue to support consumption and services exports, a slowing global economy could drag on Japan’s production activities and goods exports. If the Yen strengthens from monetary tightening, exports could slow down even further.
Thus, while we do expect forward guidance to shift more neutral after Ueda takes the helm and eventually put an end to YCC, any form of normalization will likely be gradual to avoid unnecessary shocks to the economy and financial markets.
In the near term three things will shape the outlook for monetary policy in Japan:
- Lower House hearings (Feb 24th) and the Upper House hearings (Feb 27th) of Ueda and others at the Diet.
- Outcome of Spring wage negotiation, which will be out in March. This will be one of the most important input for the BoJ in determining whether there will be sustained price increases in the future.
- Development in the U.S. economy as well as U.S. yields.
What are the investment implications for…
In 2023, we expect a continued appreciation in the Yen, especially against the U.S. dollar. It has been our view for a while that the U.S. dollar is overvalued relative to other currencies, especially now that the Federal Reserve is nearing the end of its rate hikes and U.S. yields have likely peaked. As market expectations build for tighter policy in Japan, the Yen will strengthen and become a more attractive safe haven currency than the U.S. dollar. Furthermore, increasing inbound tourism and reducing trade deficits from lower foreign energy prices, should benefit the Yen. Lastly, once the BoJ tightens, attractive domestic yields could prompt Japanese investors to repatriate foreign assets, providing further support for the Yen.
Japanese Fixed Income?
We favor a short duration stance in Japanese Government Bonds (JGBs) as we expect that the BoJ will eventually remove YCC, causing yields to rise. The exact timing for policy changes remain highly uncertain but the BoJ may want to wait for a calmer market to implement changes. In addition to rising inflation, Bank of Japan’s massive holdings of JGBs (over 50% of total outstanding) is another reason adding to the urgency for the central bank to review and adjust its YCC program. Structurally, further rate normalization should result in less outbound fixed income investments and more repatriation from Japanese investors given more attractive yields domestically. However, locally we have seen some signs of foreign bond buying returning after U.S. treasury yields peaked late last year. Having said that, given the high hedging costs for purchasing foreign bonds, we expect still resilient domestic buying in long end as JGB yields rise further.
In the short term, tighter monetary policy and stronger Yen could be a headwind for Japanese companies’ earnings and performance. Moreover, Japan’s cyclical equity market will be sensitive to weaker developed market growth, and it will also take time for Japan’s economic activity to fully recover. But the good news is, corporate fundamentals are holding up, as we’re seeing robust profits, strong balance sheets and improving corporate governance. On the macro side, as the economic re-opening tailwind continues playing out as Japan bids deflation farewell, corporates can regain higher pricing power, causing profit margins and valuations to improve in the medium term. Within Japanese equities, our preferences lie in companies with more domestic exposure, such as small and mid-cap stocks. Not only are their valuations more attractive, amidst a global growth slowdown, Japan’s domestic demand will also be more resilient than elsewhere in the world, thus, small and mid-caps stocks’ higher domestic exposure would be beneficial.