Investors were caught off guard yesterday after the Bank of Japan (BoJ) broke decades of monetary tradition.
The central bank's decision to widen the acceptable band on the country's risk-free rate was met with blood in equity markets. In response, Japan's Nikkei 225 Index fell a considerable 2.5%. Meanwhile, our local S&P/ASX 200 Index (ASX: XJO) shaved off 1.5%.
You might be wondering why this decision created such a panic. The short answer is: it creates more questions than answers. Let's delve into what that means exactly.
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Final nail in the ultra-low-rate coffin
Japan's central bank is one of only a handful that has implemented negative interest rates at some point over its existence. In 2016, the BoJ targeted a negative 0.1% rate to try and curb decades of deflation, evident by the country's stagnant — at times falling — gross domestic product (GDP).
However, Japan proved yesterday that even its economy is experiencing levels of inflation that can no longer be ignored. In its statement, the BoJ revealed it would widen its target band on the 10-year bond to plus or minus 0.5%, up from 0.25%.
The decision comes at a time when many investors and economists are deliberating over whether more rate rises are to come in Australia and the United States. Earlier this month, Philip Lowe made the call to jack the Aussie cash rate up to 3.1%.
Yesterday's BoJ decision could be interpreted as further rate rises to come. In fact, Exante Data founder and CEO, Jens Nordvig, went as far as saying:
Japan is a big investor in all kinds of markets, especially fixed-income markets around the world. We can see when there's a shift in Japan, we've decided to have all yields globally shift up today from Europe to the United States. So it's a big deal. And it's not just today, right? This is a signal that they're going in a certain direction, there are going to be almost guaranteed more steps in 2023 from the Bank of Japan.
Further interest rate increases are not the words investors in share markets want to hear right now. As Nordvig points out, that would mean less liquidity available to invest, potentially depressing prices more.
Why is the Bank of Japan doing this?
The 'why' for loosening the target band on Japan's 10-year yield depends on who you ask. According to the BoJ governor Haruhiko Kuroda the reason is to create a better functioning market, stating:
Today's step is aimed at improving market functions, thereby helping enhance the effect of our monetary easing… It's therefore not an interest rate hike.
However, with an inflation rate of 3.7% and central banks around the world hiking at a record pace — one could argue the conditions demanded policy tightening.
The Japanese Yen to the US dollar has eroded in value throughout the year, as shown above. Rising rates in other countries made foreign treasuries more appealing than holding Yen.
Given the country has a negative trade balance, Japan would effectively be importing more inflation to its country via its depreciated currency.
