The end of monetary policy desynchronisation is looking possible. All major centrals banks (US Fed, ECB, BoE) have embarked on their respective inflation-fighting journey, and arguably they are all now at the tail-end of the process. If we bring the Bank of Japan (BoJ) into the equation, then monetary policy desynchronisation is certainly the case on the ground for now and it has grown wider with the BoJ staying put with its negative interest rate stance thus far. The BoJ however had recently tweaked its Yield Curve Control (YCC) with a reference ceiling of +1.0% for the 10-year Japanese Government Bond (JGB). This could be a prelude to the end of negative policy rate which we think could happen by the first half of 2024. To recap, the benchmark rate was at 10 bps before the current ultra-loose policy regime started back in 2016.

The Japanese Yen declined significantly since monetary policy tightening started elsewhere. Clearly this played a role in pushing the Yen lower with the USD/JPY had broken the 150 levels. Exhibit 1 shows the dynamic of USD/JPY which has been rising in tandem with widening of the 10-year US Treasury/JGB spread and over the same period, the US Fed had pushed the Fed Funds Rate higher by 525 bps while the benchmark rate in Japan stays at -0.1%. Higher import prices from the weakening Yen also partly contributed to inflation climbing, although it already came off its peak earlier this year. We think the US Fed is reaching its terminal rate given how some indicators pointing to slowdown ahead in the US economy with interest rate cut is seen along the horizon by mid of 2024. Such a significant decline in the Yen is a manifestation of investors positioning to benefit from huge positive carry and the prospect of a narrowing rate differential could trigger selling of USD/JPY i.e., the case for the Yen to rally in 2024 is growing.

Ending the ultra-loose policy will be a challenging task, not just for Japan. On normalising the short-term rates, Governor Kazuo Ueda had commented that “it is going to be a serious challenge for us”. The combination of a negative interest rate and YCC, which has been in place for so many years, implies a very high level of monetary accommodation. To understand its ramifications, we try to look at this from two perspectives. For a start, the magnitude of the Japanese Yen being used as a funding currency in carry trades (borrowing in a currency with low interest rate and investing in a high-yield currency) plays a crucial role as sudden appreciation of the Yen may force investors to close this position to avoid more losses and the process (closing position) is likely to expedite the Yen’s rally. The second question is will narrowing rate differentials significantly dictate Japanese investors to re-position their international portfolio and repatriate funds back to Japan. If it does and viewed together in the context of quantitative tightening in other major economies (lesser buyer in market), then there will be international spillovers from mark-to-market value perspective. Using the International Investment Position (IIP) as a proxy, portfolio investment abroad stood at around JPY616 trillion as of June 2023.

Source: AmInvest Research - 14 Nov 2023