Summary

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  • Since April 2017, the Bank of Japan (BoJ) has reduced its government bond (JGB) buying. At the current pace, the BoJ could end the year with a net increase of its JGB holdings of about JPY60 trillion, significantly lower than the current indicative target of JPY80 trillion.
  • The most credible explanation for lower bond buying is the yield-curve control policy framework, introduced in September 2016. The BoJ, a “buy and hold” investor, has a more than 40 per cent market share in the JGB market and requires lower volumes of purchases to maintain the yield curve flat at about 0 per cent, since sell volumes are much lower today than at the beginning of Japan’s Quantitative Easing (QE) programme in 2013.
  • However, the BoJ cannot exit its ultra-loose monetary policy in the near term, as GDP growth still looks more policy-driven than self-sustained and inflation remains lacklustre.
  • The looser-for-longer policy stance reinforces our view that Japan equities are attractive, from a valuation and earnings perspective, as well as from a relative monetary policy stance compared to the US and the eurozone. Although we find them overvalued, we believe JGBs (currency hedged) can be attractive as a source of diversification for our global bond portfolios, in a context of gradually rising interest rates in other countries.


This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination.

The BoJ has slowed down the pace of JGB accumulation

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As markets continue to speculate on the likelihood that the ECB tapers its QE programme and the Fed unwinds its balance sheet in the next few months, the BoJ seems to have already started to reduce its purchase of JGB. As of 22 August 2017, the BoJ held JPY401.7 trillion of JGB, representing an increase of JPY41 trillion since the beginning of the year. In 2015 and 2016, increases at the same period amounted to JPY52.6 trillion and JPY53.3 trillion respectively (Figure 1).

Figure 1: BoJ YTD increase in JGB holding

Figure 1: BoJ YTD increase in JGB holding

Source: Bank of Japan as of 31 August 2017

This slowdown in JGB buying is the direct consequence of the yield-curve control policy framework introduced by the BoJ in September 2016. Until this date, the BoJ had a policy target of buying JPY80 trillion per year, with a view to lower and flatten the yield curve. In other words, yields were the adjustment variable. The yield-curve control follows a different logic, whereby the level of yields is pre-determined (at about 0 per cent for both the short and the long ends of the yield curve) and the amount of JGB purchases required to achieve this target becomes the adjustment variable.

Despite lower volumes of buying, liquidity indicators have remained remarkably favourable, particularly bid-ask spreads on JGB futures and cash markets. This is primarily explained by the fact that the BoJ, which is a “buy and hold” type of investor, already holds around 40 per cent of the overall JGB market, up from less than 10 per cent in 2012. As the central bank accumulated government debt, the amount of JGBs available on the secondary market was reduced in a meaningful way. Financial institutions have thus gradually reduced their exposure to JGB, and trading volumes by non-monetary authority financial institutions have constantly declined since the election of Shinzo Abe in 2012 (Figure 2). With lower volumes of JGB trading, the BoJ needs to buy less to stabilise the yield curve.

Figure 2: JGB monthly sales (ex-bond dealers)

Figure 2: JGB monthly sales (ex-bond dealers)

Source: Japan Securities Dealers Association as of 31 August 2017

Japan still needs policy support to reach inflation targets

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Keeping the indicative JGB buying target at JPY80 trillion per year may become increasingly difficult to attain and, at some point, the BoJ may have to announce a reduction in the target, possibly before the end of the year, or at least before the end of BoJ Governor Kuroda’s term in April 2018. Importantly, such a policy move would be a technical adjustment and should not be seen as a tightening. Economic conditions remain relatively fragile, with most of the recent improvement looking more policy-driven than self-sustained.

Despite a very tight labour market, inflation and regular wages (ex-bonuses) remain too low, and the prospect of a possible VAT rate hike in October 2019 could adversely impact economic growth and inflation. The latest core and headline consumer inflation data (as of July 2017) have shown a complete stagnation on a year-to-date basis (Figure 3), despite six consecutive quarters of above-potential GDP growth. As for other central banks in advanced economies, the apparently looser relationship between unemployment and inflation is a risk, in the sense that it makes the calibration of interest rates and asset purchases more difficult. To prevent policy mistakes, central banks have no alternative but to move very gradually.

Figure 3: Japan’s inflation has not picked up yet

Figure 3: Japan’s inflation has not picked up yet

Source: Japan Bureau of Statistics as of 31 August 2017

Although the annual JGB-buying target is only indicative under the yield-curve control framework, if the BoJ announced a reduction, it would have to explain its decision extensively, as markets would be likely to perceive it as a form of tightening. This would be particularly true if, at the same time, the ECB initiated its QE tapering and the Fed reduced the size of its balance sheet. In order to mitigate possible negative reactions, the BoJ could, for example, increase its annual amount of equity ETF purchase (currently set at JPY6 trillion), although there are obvious limitations to such a policy, as it could give the central bank control of certain listed firms.

Investment implications

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Given the lack of progress in terms of inflation, and the uncertainty surrounding the sustainability of the recent pickup in GDP growth, the BoJ is likely to keep its ultra-loose monetary policy stance even after US and Eurozone central banks start the normalisation of their monetary policies. Everything else being equal, we think Japan equities should benefit from this “goldilocks” configuration. Apart from attractive relative valuations and risk premia, the attractiveness of Japanese stocks rests on several dimensions, from an improved earnings outlook (Figure 4) to ample cash holdings (fuelling expectations of increased distribution to shareholders), and the ongoing buying of ETFs by the BoJ.

Figure 4: Japan and US earnings per share

Figure 4: Japan and US earnings per share

Source: Datastream Worldscope as of 31 August 2017

Meanwhile, JGBs are overvalued, in our view, whilst the BoJ’s commitment to peg 10-year yields close to zero could be re-evaluated. However, within our global bond portfolios, we see JGBs (currency hedged) as a possible way for us to reduce drawdowns stemming from increasing rates elsewhere without reducing carry. For the time being, the BoJ looks committed to keeping long rates close to zero, which translates into lower volatility and a narrower return distribution than bonds in other advanced economies.

Disclaimer

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