Japanese Yen: Bank Of Japan Versus Interest Rates

Japan has suffered from weak growth and inflation since the global financial crisis, and the Bank of Japan has frequently experimented with unorthodox monetary policies. In September 2016, the BoJ decided to directly target long-term interest rates. The so-called “yield curve control” (YCC) program fixed 10-year Japanese government bond (JGB) yields at 0%. If yields deviated from the BoJ’s target rate, the Bank bought JGBs (to push rates down) using its balance sheet, or issued new JGBs (to drive rates higher).

Following the implementation of yield curve control, the Japanese yen has been exceptionally sensitive to interest rates differentials. In particular, the yen tends to weaken when foreign 10-year government bond yields rise. When foreign yields fall, the yen tends to strengthen. For reference, a graph comparing USD/JPY and 10-year US Treasury bond yields is shown below:

YCC: once reliable, now not so much

Source: TradingView.com, USD/JPY in gray, 10-year UST yields in blue

As can be seen above, USD/JPY has predictably followed 10-year US treasury yields. As Japanese interest rates are fixed, investors tend to buy US dollars, in exchange for yen, when US interest rates are rising. The opposite is true when US interest rates are falling.

Starting in December 2017, this predictable relationship appears to have broken down. While US treasury yields have soared from around 2.4% at the start of 2018 to 2.7% today, USD/JPY has weakened (that is, the Japanese yen has strengthened). While yield curve control had a strong influence on the yen when economic conditions were weak, the ongoing economic boom is pushing markets to bet on tighter monetary policy.

An outline of recent GDP growth and inflation in Japan is shown for reference below.

Stronger GDP growth, but few signs of inflation

Source:Japan Cabinet Office

As can be seen in the graph above, year-over-year Japanese GDP growth has strengthened in 2017. Following several weak quarters in 2016, the last two readings suggest that the Japanese economy is now growing at 2.5% year-over-year. Looking at the latest data, forward-looking indicators suggest that the good times are set to continue. Last week, Nikkei manufacturing PMIs were at an 11-year high. Thanks to strong global growth, the Japanese economy is likely to do well in Q4 2017 and early 2018.