In its latest monetary policy statement released on December 20, the Bank of Japan (BOJ) stated that it will continue to retain the benchmark interest rate at a historical low of -0.1%, and maintain the 10-year government bond yield target near 0%. Meanwhile, the Japanese central bank decided to significantly increase its monthly bond purchases to JPY 9 trillion (approximately USD 67.5 billion) from the currently planned JPY 7.3 trillion. What surprised the market is that the BOJ revised its yield curve control (YCC) policy, which will allow the 10-year government bond yield ceiling to rise to 0.5% from the previous 0.25%. The bank said the move would enhance the sustainability of its monetary easing policy.

This unexpected decision signifies that the quantitative easing policy that the BOJ has been insisting on before has begun to adjust and move towards policy normalization. The change also jolted the market. With the announcement of the policy, the exchange rate of the JPY against the USD rose sharply by nearly 3%, and once rose to a nearly five-month high of JPY 133.12 per USD. The Bloomberg Dollar Spot Index fell 0.7%; while the 10-year Japan yield soared 21 basis points to 0.467%, the highest since 2015. The move also triggered a sharp drop in the Japanese stock market, with the Nikkei 225 index falling 2.46% to the close of the day. U.S. bonds also fell sharply, and the 10-year U.S. bond yield once rose to 3.62% in a short period of time; the three major U.S. stock index futures also plunged.

The rising of the upper limit of YCC by the BOJ this time is not without prior signs. Japan has been sticking to this policy, even if it caused the yen to depreciate against the dollar to the point of JPY 150 to USD 1. With the Federal Reserve's interest rate hike slowing down and the dollar index falling, the yen has returned to below 140, and the external pressure on the BOJ's YCC has actually eased. The BOJ and Japanese policy officials have also repeatedly stressed that they will stick to their quantitative easing policy until there is a clear improvement in inflation. At the same time, the outside world has long believed that the Japanese central bank should not change its policy until the end of the 10-year term of its governor Haruhiko Kuroda. Therefore, its policy tweak at this time is sudden. The reason, according to the researchers at ANBOUND, is that this is mainly due to the pressure on Japan's domestic economy and inflation, as well as the dilemma between curbing inflation and stimulating the economy. Although the BOJ still maintains the benchmark negative interest rate, the increase of the upper limit of the YCC means that the market interest rate of the JPY has been allowed to increase. This shows that Japan has begun to follow the pace of major European and American economies, releasing a signal of its policy shift.

Since the beginning of this year, when the Fed started to tighten its policy, while Japan still insisted on its quantitative easing policy, the widening interest rate differential between the U.S. and Japan caused the JPY to fall to a low level of more than 20 years against the USD at one point. However, the depreciation of the JPY did not effectively boost the Japanese economy. Instead, it has increased imported inflation. A weaker JPY makes imported goods such as energy and raw materials more expensive. Data show that Japan's core consumer price index (CPI) hit a 40-year high in October, up 3.6% year-on-year, far exceeding the Japanese central bank's 2% target. As of October, Japan's inflation rate has exceeded 2% for seven consecutive months. Moreover, Japan's inflation situation has not spontaneously cooled down as the BOJ expected. The latest survey by Reuters showed that Japan's core CPI rose by 3.7% year-on-year in November. In addition, the JPY continues to be in a weak position and has a chain reaction in business operations and labor. From the start of the year, the JPY has depreciated by about 30% against the USD, falling into the range of JPY 150 to USD 1 for the first time since Japan's bubble economy in 1990. For a while, the situation of the world's third-largest economy sparked concern. To prevent further depreciation of the JPY, the Japanese government began to intervene in the foreign exchange market in September. Recently, the Japanese currency has recovered slightly against the USD. A weaker yen means that wages settled in that currency are becoming less attractive to foreign workers. Previously, during the devaluation of the JPY, market investors believed that the BOJ needed to abandon or adjust the YCC policy to maintain the stability of the yen.

Although the Japanese economy is still growing, and its year-on-year GDP growth rate in the third quarter reached 1.9%, if the BOJ abandons the quantitative easing policy that has been in place for many years, it is bound to have a more profound impact on the Japanese economy. Because the interest rate increase is not conducive to corporate profits and internal consumption demand, the risk of Japan's debt problem, especially the government debt problem, will increase after raising interest rates. According to IMF data, under years of easing policies, the ratio of Japanese government debt to GDP rose to 263% in 2021, the highest among developed economies. As interest rates rise, additional interest payments further add to the financial burden. If Japan raises the benchmark interest rate, it is likely that the rare growth momentum will be halted, and return to the past sluggish state.

For the international market, the unexpected move of the BOJ has caused the market's reaction. This change not only means that after the narrowing of the interest rate gap between the JPY and USD, capital will return to Japan; but the more important impact is that during the period of negative interest rates, the BOJ's long-term adherence to the yield curve control has indirectly increased the lower borrowing costs globally. This also forms the basis for a certain asset valuation. Today, changes in this basis will inevitably affect the re-adjustment of valuations of capital parties that rely on JPY capital for global allocation. Earlier, some analysts warned that if the BOJ suddenly shifted away from the YCC policy, the role of the Japanese government bond market as the last heavyweight anchor for further surges in global bond yields would change, and it may trigger turmoil in the global bond market and other markets. When this happens, its impact on the global market will not be weaker than that of the turmoil in the British bond market. Therefore, this change by the BOJ will not only cause fluctuations in the Japanese stock market and debt but also bring a new wave of shocks to the markets of developed countries such as Europe and the U.S. This round of capital turbulence and volatility will also continue to backfire on Japan's domestic capital market, exacerbating its economic and financial turmoil.

Final analysis conclusion:

While maintaining the benchmark interest rate unchanged, the Bank of Japan adjusted its yield curve control policy and raised the upper limit, mainly due to the pressure on the country's economy and inflation, in facing the dilemma of curbing inflation and stimulating the economy. This shows that Japan has begun to follow the pace of major European and American economies, releasing a signal of its policy shift. However, the unexpected change in the policy that has persisted for many years is bound to trigger a new round of turmoil in Japan's domestic and international capital markets.