Japan surprises everyone, and bonds everywhere feel it

The Bank of Japan unexpectedly widened the permitted trading band for 10-year Japanese government bonds from ±0.25 to ±0.50 per cent, and bond markets around the world shook. The yen jumped nearly 4 per cent against the dollar within hours, and government bond yields from Berlin to Washington rose in sympathy. Haruhiko Kuroda's last months as governor were supposed to be a calm exercise in continuity. By changing a single setting in its Yield Curve Control (YCC) framework, Tokyo reminded everyone that it has been holding yields down far beyond Japan.

For years Japan's ultra-loose policy acted as a release valve for global liquidity. With yields at home pinned near zero, Japanese life insurers, pension funds and retail investors sent trillions of dollars into foreign bonds, a big source of demand for US Treasuries, French OATs and Australian government debt.

A band under strain

The Bank introduced yield-curve control in September 2016 and has loosened the band twice before, to ±0.2 per cent in 2018 and to ±0.25 per cent in March 2021. Each time it insisted it was not tightening policy. This year the strain was different. With yields rising everywhere else, the 10-year JGB sat pinned against its ceiling, the Bank had to buy vast quantities to hold it there, and on some days in the autumn the benchmark bond did not trade at all.

That breakdown in market functioning is the Bank's stated reason for acting. It also raised its planned monthly bond purchases and left its short-term rate at minus 0.1 per cent, to signal that the policy stance has not changed. Markets took the widening as the more telling of the two messages.

A currency under siege

The pressure on the band came through the exchange rate as much as the bond market. As American rates climbed and Japanese yields stayed capped, the yen fell to its weakest against the dollar in more than three decades this autumn. The finance ministry bought yen in September and again in October, spending heavily to slow a slide that its own central bank's policy was feeding.

A weak yen also made imports of fuel and food far dearer, and Japan has been running record trade deficits as a result. Core consumer inflation has risen above 3 per cent, well beyond the Bank's 2 per cent target, and a central bank importing inflation through its currency had fewer arguments left for keeping every setting unchanged.

Why Japanese money comes home

The sums behind that trade were already getting worse because currency hedging had become so expensive. With three-month dollar-yen hedging costs above 5 per cent, a Japanese investor buying a 10-year US Treasury was locking in a heavily negative return after hedging.

The wider band gives Japanese investors an alternative at home. They can now earn a rising yield on risk-free domestic debt without paying heavily to hedge currency risk. Bringing money back into yen assets has gone from an academic idea to a practical priority for their balance sheets.

The flows will not arrive all at once. Japan's big life insurers set their investment plans at the start of each fiscal year in April, and most will let foreign holdings run off as they mature rather than dump them. The effect is a missing buyer more than a forced seller, which is slower but lasts longer.

Who pays for the change

Japan is the largest foreign holder of US Treasuries, with more than $1 trillion, so Washington is the most exposed borrower in absolute terms. The sharper effect may fall on smaller markets where Japanese investors have been a large share of foreign demand, such as Australian government bonds and French OATs. Yen-funded carry trades, which borrow cheaply in Japan to buy higher-yielding assets abroad, also look less comfortable when the yen can jump several per cent in an afternoon.

Japanese banks are the obvious winners at home. A steeper domestic yield curve lets them earn more on lending than they pay on deposits, after years in which the Bank's policy squeezed that margin to almost nothing. Exporters are on the other side: carmakers and electronics firms that booked windfall profits from a cheap yen this year will see those gains shrink if the currency keeps recovering.

The government is exposed as well. Japan's public debt is the largest in the rich world relative to output, and the Bank now owns roughly half of the government bonds in issue. Every rise in the yield cap feeds slowly into the cost of refinancing that debt, which is why the Bank has moved in small steps and will probably keep doing so.

A higher floor for yields

The change probably marks the beginning of the end for negative interest rates worldwide. When the world's largest creditor nation starts to raise its own cost of capital, term premia elsewhere have to rise to stop money leaving.

There is a precedent for a single central bank's turn setting off a global repricing. In February 1994 an unexpected rise in rates by the Fed set off a bond rout that spread to Europe and Japan within weeks, because investors everywhere had built positions on the same assumption of cheap money. This time the assumption was that Japanese savers would always be available to buy foreign debt.

The case against is that the Bank has widened the band, not abandoned it, and may defend the new limit as hard as the old one. The next tests are the policy meeting in January, the government's choice of Kuroda's successor before his term ends in April, and the spring wage negotiations, which will show whether Japanese inflation is durable enough to justify a further retreat.

The BOJ said the move was only meant to help the bond market work better, but markets were right to see it as the first crack in YCC. As Tokyo moves towards scrapping its yield caps, foreign governments can no longer count on Japanese savers to fund their deficits, and they will probably have to pay permanently higher yields to borrow.