The Bank of Japan caught the markets off guard on 28 July by tweaking its yield curve control scheme, with which the central bank places a cap on the 10-year Japanese government bond yield.
Its nine-person policy board, with an 8-1 vote, decided to raise the yield curve control ceiling to 1% from 0.5%. The decision was a surprise as many in the markets did not expect the central bank to alter the scheme until later in the year.
In short, the decision in July appears to be a compromise. The central bank was faced with a dilemma: it needed to address a situation in which the yield curve control scheme was distorting capital market functions, while it still lacked the conviction that inflation had become strong enough to warrant a shift in monetary policy.
By artificially capping the 10-year Japanese government bond yield the Bank of Japan created a kink in the yield curve and distorted pricing in the credit market, thereby hampering the ability of firms to raise funds through the issuance of corporate bonds.
The latest yield curve control tweak, allowing the 10-year Japanese government bond yield to rise to 1.0%, theoretically enables corporate bonds to be issued at levels deemed more appropriate by the market. Under different circumstances, the Bank of Japan may have preferred loosening the yield curve control scheme only when it had a stronger conviction that domestic inflation would be sustainable.
For inflation to become a long-term phenomenon, wages in turn have to enjoy a sustained rate rise. The Bank of Japan, therefore, is likely to stick to an easy monetary policy until it sees enough evidence of such an occurrence.
Although, while they have been climbing steadily so far in 2023, the rate at which wages have been rising has still lagged behind inflation. It could be a different story in 2024, as labour shortages have shown no signs of abating. Annual springtime negotiations between unions and large corporations may therefore result in wages outpacing inflation early in 2024.
This scenario could finally convince the Bank of Japan that inflation will be sustainable in the long term, opening the door to take a more significant step such as scrapping the yield curve control scheme altogether.
Factors that could help shape the bigger inflation picture include corporate earnings results in autumn 2023, the overall size of bonuses paid out this winter and wage hike demands presented by the workers’ unions in early 2024.
The Bank of Japan is expected to focus almost exclusively on domestic factors as it plots a way out of monetary easing; rate hikes by other central banks are unlikely to force Governor Kazuo Ueda’s hand as some commentators suggest.
Japan equities could have ‘legs’ this time amid transition to secular growth
A noticeable aspect about the latest bull run in Japanese equities is that the surge has begun to catch the attention of niche, industry-specific publications in addition to the mainstream media. One such publication recently concluded that, unlike in the past, when excitement over the Japanese equities was usually followed by disappointment, the market’s current phase “has legs”.
Before we assess what could be different this time, it may be worth noting the characteristics that caused past disappointments which led many investors to overlook Japan entirely. Prior to the current phase, Japanese equities tended to track economic cycles.
Put another way, the market lacked secular changes and was saddled by deflationary sentiment, which made it difficult for equities to go on a sustained rise and gains tended to be followed by equal, or even greater, losses.
The turnaround began during the pandemic, when strong exports, mainly to the US, led to manufacturing capacity shifting from a surplus to a deficit. Manufacturers subsequently sought to boost capex and hire more workers, triggering a labour shortage.
The shortage was exacerbated as the economy fully re-opened after the pandemic, with the return of travel, tourism and leisure activities prompting a scramble for workers in the service industry. The current boost in capex and labour shortage are Japan’s first since the Global Financial Crisis, and have been accompanied by increased consumer demand.
For businesses, the cost of raising wages to hire more employees would be more than offset by the resulting increase in sales. We are witnessing a big shift from a deflationary mindset into an inflationary one.
The end of the deflationary mindset would be significant as it would spell a departure from the cyclical pattern to which the economy has been captive for so long. The current environment could also prompt companies to invest in new technology to cover for labour shortages and to invest in other facilities to increase efficiency and productivity.
Reversing the typical traits of a deflationary economy – labour surpluses, stagnant sales and lack of capex allowing machinery to sit idle and age – would be a sign that Japan has broken out of it. Investors who have so far overlooked Japan may not want to miss this transition from cyclical to secular growth.
Naoki Kamiyama is chief strategist at Nikko Asset Management. The views expressed above should not be taken as investment advice.