Expectations of an early termination of negative interest rates are dwindling

There is a growing view in the financial market that the Bank of Japan (BOJ) will not immediately seek to revise its policies under the new Governor Ueda. That view is putting pressure on the yen to depreciate in the foreign exchange market, and is also contributing greatly to a rise in stock prices.

Yields on two-year government bonds, which very much tend to reflect the outlook for policy interest rates (short-term interest rates) in the bond market, rose sharply after the BOJ suddenly announced last December that it would be raising the yield volatility range for its Yield Curve Control (YCC), and at year’s end they had surpassed 0%. This showed that the market had factored in the possibility of an early hike in policy interest rates (short-term interest rates).

While the yields on two-year government bonds rose to as high as +0.04% during their peak from the end of last year to the beginning of this year, they have recently dropped down to about -0.07%, the level seen around last October. Expectations that negative interest rates will soon be terminated have ultimately dwindled.

It will likely be some time before the BOJ sets out in earnest to terminate negative interest rates, or to make any other framework revisions to the unprecedented easing that it has maintained for the past 10 years. I personally believe at this time that we will not see this happen until the latter half of next year at the earliest.

However, there is a chance that YCC—which is rife with problems—could undergo changes sometime this year that are quite separate from a full-scale revision to the monetary easing framework, such as another expansion of the volatility range or even the elimination of that range under the pretext of extending last December’s flexibility measures. As a result, long-term government bond yields might rise slightly.

The biggest problem isn’t market distortions, but rather being forced to purchase massive amounts of government bonds

When the BOJ expanded the volatility range of YCC last December, the reason it gave was that it was responding to a distortion in the yield curve. At present, these yield curve distortions have been eliminated, and from that standpoint no further flexibility measures would seem to be necessary.

However, the real problem was likely the fact that the BOJ was forced to make massive purchases of government bonds in order to prevent 10-year interest rates from exceeding the upper limit of the volatility range. That means less fluidity in the government bond market, and raises the risk of heightened volatility. It also ends up needlessly bloating the BOJ’s balance sheet.

Given that one of the aims behind the decision in September 2016 to introduce YCC was conceivably to restrain the purchasing of government bonds, this is a serious matter. The BOJ now seems to be inclined to curb the amount of its government bond purchases soon, through measures such as expanding the YCC volatility range again or even abolishing that range altogether.

YCC’s fatal flaw

Incidentally, YCC also has a fatal flaw besides the fact that it required such massive purchases of government bonds. For example, let’s consider a case involving the US in which long-term yields are rising amid strong economic activity and an uptick in inflation. On such occasion, the effects of the US economy’s solidity and rising inflation would extend to the Japanese economy, leading inflation to rise in Japan as well. Not only that, the growing gap between yields in the US and Japan will cause the yen to depreciate, and that too will urge inflation higher in Japan.

Normally, this is a situation in which the BOJ would be pressed to implement monetary tightening policies. Yet if rising long-term yields in the US elevate the risk that 10-year government bond interest rates in Japan could exceed their target value, then the BOJ will be compelled to expand their government bond purchasing in order to halt the rise in yields. This would amount to enhance monetary easing, quite the reverse from monetary tightening.

If speculation that enhanced easing measures will lead Japan’s inflation rate to rise even further were to spread to the government bond market, then long-term yields would only end up rising more. Then the BOJ would be forced to further increase their purchases of government bonds. In other words, it would lead to a vicious cycle.

Conversely, if US economic growth were to slow down and inflation were to fall, then the BOJ would be compelled to enact monetary tightening measures.

Thus, the fact that the BOJ has been forced to implement monetary policies totally at odds with those that were originally necessary is a fatal structural problem of YCC. In this respect, a revision or even a major reform of YCC would seem to be the BOJ’s top priority under the new administration.

Implementing these measures would rapidly transform YCC into a mere shell of what it was. Still, we should suppose that the abolition of YCC won’t be carried out straight away. When the BOJ does eliminate negative interest rates, which will be the greatest turning point in the normalization of monetary policy, there is a risk that a shift in the outlook for short-term yields—the starting point of the yield curve—could lead to a significant rise in long-term yields. Should that occur, then the BOJ would likely end up maintaining (even if only formally) YCC as a framework for controlling long-term government bond yields, so as to justify measures for curbing the rise in yields through fixed-rate purchase operations and so forth.

One might suppose that the elimination of negative interest rates, and the subsequent abolition of YCC, will both be postponed until the latter half of 2024 or even beyond.

• Takahide Kiuchi

  Executive Economist