(Bloomberg) – Investors are bracing for Wednesday’s Bank of Japan monetary policy decision, which has the potential to unleash shocks in local and global markets.
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While economists are almost unanimously expecting the BOJ to maintain its policy stance, their conviction has waned since the central bank surprisingly raised the bond yield ceiling in December.
The tension in financial markets is such that even an unchanged decision could trigger a sharp reaction – Japan’s 10-year bond yield has repeatedly breached the BOJ’s 0.5% ceiling in recent days, and implied volatility is showing FX markets is at its highest since the pandemic.
Should the BOJ give in to market pressures and abandon its yield curve control policy altogether, bonds would likely crash, sending rates higher and accelerating a yen rally, strategists say. The moves after the December decision – which sent US Treasuries lower and touched everything from US stock futures to the Australian dollar and gold – show that the impact could extend beyond Japanese markets even if the BOJ does makes minor changes in course.
The yen has been recovering since October, hitting the strongest levels since May on bets that an eventual end to the so-called YCC will narrow Japan’s yield differential with other major economies. More gains could be imminent as the dollar-yen currency pair recently formed a cross pattern.
Yen volatility has increased even further. The implied volatility of the USD/JPY pair for one-week at-the-money options has risen to the highest level since the global pandemic began in March 2020.
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The Japanese bond market has struggled against the yield cap since its inception in 2016, with the challenge intensifying in recent days. The BOJ surprised markets last month by doubling the width of its YCC band, claiming it did so to improve the functioning of the market. In the end it did almost the opposite. Traders quickly pushed yields through the cap of the new cap.
The bond bear challenge has prompted the BOJ to ramp up its daily bond purchases to a number of records, draining further liquidity from the market it sought to improve.
A downside to record bond buying is the growing threat of another breakout in popular bond and futures basis trading. The BOJ has lent a record amount of bonds on its balance sheet to try to narrow the gap between cash bond and futures prices.
NOTE: Ernest Tsang is Market Producer for Bloomberg TV. The above observations are his own and are not intended as investment advice. For more market analysis, see the MLIV blog.
–Assisted by Cormac Mullen.
(Adds context around BOJ decision in third paragraph)
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