Analysts Are Trying to Persuade Traders That the Bank of Japan's Plan Will Fail

(Bloomberg) -- When you try to say "Don't fight the Fed" in Japanese, something gets lost in translation.

In a quest to vanquish deflation, the Bank of Japan has unleashed billions in asset purchases including everything from sovereign debt to exchange-traded funds and moved its policy rate into negative territory. Nothing has worked.

Now, the central bank is testing out a new approach: targeting the yield curve, with a promise to keep 10-year yields around zero and avoid excessive flattening, which hurts banks' profitability.

Market participants have so far capitulated to one part of the Bank of Japan's plan, explicitly stated on Wednesday, to anchor its 10-year bond yield at zero. "We are happy to acknowledge that the market thinks the BoJ will be credible when it comes to meeting its yield curve control target," write Credit Suisse Group AG strategists led by Shahbab Jalinoos. "This is clearly shown by the collapse of longer-dated swaption vols in the aftermath of the announcement."

Source: Credit Suisse

But analysts have cast doubt on the BOJ's hope that the yield-curve target and other monetary policy efforts announced at the meeting will arouse animal spirits and reflate the economy. Swapping out a broken hammer for a screwdriver, they say, doesn't look like the right way to nail in inflationary forces.

As such, traders are still fighting the central bank on other fronts — chiefly, in foreign exchange. The yen has strengthened since the BOJ meeting, much as it did after its move to a negative interest rate regime in January. Analysts contend a stronger yen represents an existential threat to Japan's bid to banish deflation by depressing domestic demand and crimping exports.

The dramatic shift in the central bank's policy framework has been met by a familiar tide of skepticism. It was marketed as a way to increase the central bank's flexibility and moderate downward pressure on bank profitability, while expanding stimulus efforts. But a bevy of analysts say the policy shift won't deliver a material increase in easing, and some argue the yield-curve target could effectively tighten monetary policy, setting the stage for a even stronger yen.

Japan's currency — which has appreciated by 19 percent against the dollar year-to-date — recovered its losses during Thursday's trading session; the fifth consecutive meeting that the yen advanced at the end of the trading day. The currency touched 100.10 against the dollar in overnight trading, its highest level in a month. 

Faced with these competing forces, analysts have lined up to question whether the central bank's attempt to keep yield curve in check will have its desired effect.

In a bearish note on Wednesday, George Saravelos, strategist at Deutsche Bank AG, says the Bank of Japan's new policy framework signals the end-game for the central bank's bid to reflate the economy. He argues the move to explicitly anchor long-end nominal yields higher in the interests of financial stability means it has effectively given up on its bid to aggressively drive down real borrowing costs. He forecasts 94 yen to the dollar by year-end.

If inflation expectations fall further due to an external shock, Saravelos warns, not allowing the 10-year to fall below zero effectively means that financial conditions are becoming tighter and more restrictive of growth.

Analysts at Macquarie Bank Ltd, led by Peter Eadon-Clarke, add that Japan's rising current-account surplus is placing upward pressure on the currency and will, therefore, bedevil the BOJ’s "campaign against deflation and entrenched deflationary expectations." 

While rates strategists at Bank of America Corp believe that the yen will weaken notably next year, they foresee more upward pressure on the yen this autumn, citing confusing over how the BOJ's policy shift will work in practice. The analysts, led by Shuichi Ohsaki, wrote in a note yesterday that "The newly introduced 10-year yield target and quantitative target cannot coexist in a clean form."

Credit Suisse's brutal assessment of the move maintains that the shift represents a volte-face from its cited bid two years ago to flatten the yield curve to stimulate the economy and, as such, makes a mockery of its credibility. "We fear the market has trained itself to be very accepting of the BoJ's more meager offerings and that is why it still tries to beef up the story around the efficacy of BoJ policy in terms of weakening the JPY,"  concludes Jalinoos' team.

While central banks set the policy rate, the term premium — the compensation investors demand for duration risk — depends on a slew of factors, including the state of the economy, and financial-sector risk appetite.

Faith in the Bank of Japan's ability to exert control over the slope of the yield curve is, therefore, misguided, according to CrossBorder Capital Ltd, a London-based research firm, citing its lack of control over market forces if sentiment shifts. In a research note published by on Thursday, the firm writes the BOJ is embarking on a dangerous project by explicitly targeting a zero percent yield curve target for the 10-year note.

"In short, the new BoJ policy will distort the term structure, could strengthen the Yen and will likely underscore the need for even more fiscal support," they write.

If upward pressure on the 10-year note kicks in, and the BOJ makes good on its commitment to intervene, real term premia will in fact rise, since 20-year and 30-year yields will be pushed up as a result. In other words, the yield curve will be kinked: effectively flat up to 10 years but sharply steepening thereafter. The research firm concludes that central banks can't fix the shape of the yield curve "rather like squeezing a balloon full of air in one place [it] simply pushes out the balloon somewhere else." 

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