20/10/2022
Updated on the 21st October 2022, Source: Yahoo Finance
Today (20th October), the Yen traded at 150 per US dollar, the highest level since 1990 (please see graph above). This 20-year record puts pressure on the Japanese Yield curve control policy (YCC). What is the YCC (Yield Curve Control) Policy? I know it seems like a very long time ago, but up to early 2021, most of the developed economies were facing what they considered to be “too low” inflation. To tackle this problem, several central banks adopted yield curve control. Yield curve control (YCC) involves targeting a longer-term interest rate by a central bank, then buying or selling as many bonds as necessary to hit that rate target. When the targets are extreme, this approach is aggressive and significantly different from the central banks’ typical way of managing economic growth and inflation, which is by setting a key short-term interest rate, such as the federal funds rate in the US. In 2016, the Bank of Japan adopted an extreme version of this strategy, through which the policy rate was reduced to -10 bps and the 10-year yield was fixed at 0%. The Bank of Japan promised to maintain YCC for as long as was necessary to achieve its 2% inflation target in a stable manner The recent deflation of the Yen against the dollar puts pressure on the sustainability of Japan’s YCC (yield curve contrail) policy in a world of generalized yield increases. In the words of Dr. Mohamed El-Erian (President of Queens College and former Pimco CEO): “Pronounced yen weakness results from the sustained implementation of YCC (yield curve control) in the context of higher global yields”. But why is Japan’s YCC problematic in today’s context? The YYC policy can be beneficial in a world of sustained economic growth or quantitative easing (QE). Indeed, YYC amplifies positive nominal growth shock as real interest rates do not rise in response to the shock, but rather fall. However, in an inflationary context, the 10-year yield fixed at 0% -fixed through Japan’s YCC- seems less appropriate. Over the world, the yields have risen in reaction to inflation, which is impossible under this regime. This situation forces the BoJ to conduct bond purchases – theoretically unlimited purchases – to maintain its yield curve control policy. On Tuesday, Japan reported that core inflation rose 2.8% from a year ago in August, the fastest growth in nearly eight years and the fifth consecutive month where inflation exceeded the BoJ’s target. What’s next? According to HSBC’s Senior Asia FX Strategist Joey Chew and analysts at Goldman Sachs, defending this policy would be the central bank’s priority instead of currency intervention, which would be decided by the Ministry of Finance, and carried out by the Bank of Japan. PS: I have received messages asking me to discuss Liz Truss’ resignation as England’s Prime minister. For the moment, the markets have not reacted strongly to the news. I think that, as we are, the markets are waiting to see what’s next. When we will have more information regarding economic consequences, I will write about it ;).