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Market participants are swift to add pressure on the Bank of Japan to tighten monetary policy again. After quelling speculation for the most part of last year, the BOJ finally widened the 10Y YCC band, setting the cap at 0.5%. Despite running multiple rounds of unscheduled bond buying, the market sees further tightening ahead with 10Y yields breaching the cap several times and the USDJPY on a firm downtrend. We think it is reasonable to expect the BOJ to shift, but the extent and timing remains tricky. The risk of another shift this week is non-negligible. To be sure, many investors probably got scarred the DM tightening experience last year. Forward guidance was not meaningful and the pace of tightening got ratcheted up as the year went by. If the BOJ (the laggard in the cycle) shifts, an extrapolation would see the BOJ abandon YCC at some point this year. The key issue then lies with whether CPI close to 4% (another data point due on 20 Jan) and PPI touching 10.2% YoY in December is sufficient justification for policy catch up. Much might also depend on the spring wage negotiations and the stance of the next central bank governor.
There are a few measures to gauge where 10Y JGB yields might head to if YCC gets scrapped. The clearest way would be look at the JGB-swap spread. This spread widened out to around 50bps recently while the norm appears to be closer to 20bps. By this measure, if JGB yields were not artificially capped by the BOJ, 10Y yields might be much closer to 0.75%. An interpolation between the 9Y and 15Y tenor JGB throws up a similar figure. The last method would be to look at implied real yields. 10Y implied real yields have climbed to about -0.25%, up from a trough of -0.78% in mid-2022. The median real 10Y yield since 2015 is around -0.38%. Current 10Y yield setting look to be slightly on the tighter side. The picture is broadly the same when we consider actual CPI over the same period. The real yield median is about -0.32%. With realized CPI approaching 4%, real 10Y JGB is pushing deeper into negative territory. We see 10Y JGB yields rising over the coming months as we do not think the 0.5% cap is tenable. An overshoot is likely if the BOJ decides to play catch up (either shifting YCC to the 5Y tenor or even abandoning YCC completely). Overall, this steepening in JGB curve should also put steepening pressures on DM curves in general.
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