Business / Financial Markets

Bank of Japan chief Kuroda's pain threshold put to test as yen rallies and yields slump

by Toru Fujioka and Chikafumi Hodo

Bloomberg

Global financial turmoil is turning up the heat on the Bank of Japan, raising the question of how much pain it can take before it is forced to act.

The BOJ faces two market-driven problems as the U.S.-China trade war escalates — a strengthening yen and sliding government bond yields. Its options for responding are limited, both in number and in effectiveness, and would come with unwelcome side effects.

But if the U.S. and China don’t pull back, the yen is likely to get even stronger, threatening BOJ Gov. Haruhiko Kuroda’s quest to return inflation to normal levels. And 10-year Japanese government bond yields could slide beyond the BOJ’s targeted trading range, calling into question its control of yields and inflicting more pain on banks, which could respond by pulling back on lending.

“Market developments are posing very severe challenges for the BOJ,” said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance Co. in Tokyo. “Among global central banks, the BOJ has the most limited scope for further easing. It’s like they’re trying to squeeze water from a dry towel.”

‘Something big’

The BOJ may have to “do something big” to stop the yen’s rise, but it will want to see the Federal Reserve’s stance more clearly before acting, said Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group. “Chances for additional easing in September are rising rapidly.”

Shirakawa doubts the BOJ’s ability to halt the slide in yields, and said the 10-year could go as low as minus 0.3 percent if U.S. Treasury yields fall further.

Even before the recent market turmoil, a majority of BOJ watchers said the central bank’s next policy move would be to add stimulus, primarily because Fed rate cuts would strengthen the yen, weakening inflation by lowering import prices and cutting into corporate profits.

Now the Fed is seen as likely to cut rates again, with some investors expecting a half percentage point move at its next meeting in September, which ends a day before the BOJ’s does.

The European Central Bank also looks set to add stimulus, indicating it could cut rates as early as next month.

The BOJ is low on firepower after six years of extraordinary monetary stimulus, and it’s not clear that it could be effective in stopping the moves in the yen or bond yields.

The Finance Ministry would make the call on any direct intervention in currency markets, but that would almost certainly draw a rebuke, at least, from U.S. President Donald Trump at a time when the U.S. and Japan are in trade negotiations of their own.

A ministry official said Tuesday that Japan will continue to watch the market with a sense of urgency, echoing language used a day earlier by the ministry’s currency market chief Yoshiki Takeuchi. That language indicates an elevated level of concern.

‘Powerless’

The BOJ knows it is “powerless” to halt the 10-year yield’s slide as long as it’s fueled by overseas conditions, and it will probably be prompted to act on yields only if the 10-year falls to about minus 0.25 percent, said Mari Iwashita, chief market economist at Daiwa Securities Co. in Tokyo.

The 10-year bond yield ended trading at minus 0.20 percent on Wednesday, following Tuesday’s trading when it touched a three-year low of minus 0.21 percent. The BOJ sets its bond target range at about 0.2 percentage points from either side of zero. Kuroda has said the band shouldn’t be interpreted too strictly.

The yen swung to a loss Tuesday after the People’s Bank of China guided the yuan stronger, easing fears of a currency war.

On Wednesday, the yen was trading between ¥105.94 and ¥106.45 against the dollar during the day. Many economists say the yen at 100 versus the dollar would force the BOJ to act.

The BOJ is likely more concerned about the yen than 10-year yields, which it could probably tolerate at around minus 0.3 percent, said Akio Kato, general manager of strategic research and investment at Mitsubishi UFJ Kokusai Asset Management Co. in Tokyo.

The yen at 103 to 104 against the dollar could force the BOJ’s hand, Kato said, but its options will be limited. It would be difficult for Japan to intervene directly in the currency market, given global trade tensions, he said. The BOJ could buy more shares in exchange-traded funds, which would support share prices and, indirectly, underpin sentiment about the economic outlook, thereby supporting the dollar versus the yen, he said.

One problem with letting bond yields slide is the reversal rate theory, Kato said. The theory is that extremely low rates at some point actually suppress bank lending. It’s a potential problem Kuroda himself has flagged in the past, though he said last month that rates aren’t at that level.

A summary of opinions from the BOJ’s policy meeting last week showed the board members debating the merits and risks of additional action. Afterward, Kuroda said the central bank was “more positive” about adding monetary stimulus. Global markets may let him prove it