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Reflections #43 - Don't get tweak'd

While the Fed delivered what was expected and signaled a less one-sided look at the future path of interest rates (no forward guidance anymore), the focus shifts to the BoJ and whether it changes its YCC policy.

When looking at key economic numbers, the BoJ may have all the reasons to tighten its ultra-loose monetary policy as inflation is at the highest level it has been since 2014 and above the 2% target, inflation expectations and wage demands rising amidst low unemployment and robust activity - were it not for the bad memory of previous occassions when inflation temporarily rose just to collapse soon after.

Market expectations have been fluctuating with the media headlines - which one day suggest a change in YCC just to be followed on another day by reports of a low likelihood of a revision.

We do believe the chance of a policy tweak is high especially as more and more reports out of Japan show that inflation becomes entrenched leading to a likely significant upward revision of the BoJ's FY2023 (core) inflation forecast. A recent Bloomberg article suggested a revision to 2.5% from the previous projection of 1.8% in April.

What to expect?

Speculation has now shifted to a change of YCC to the 2 or 5yr tenors from the 10yr target. This would allow the yield curve to steepen and increase liquidity and functionality in the JGB market while keeping monetary policy still sufficiently easy.

We do think this is the most likely outcome, as the economic impact is rather limited as funding is mostly in the front-end for Japanese companies but it solves some of the negative side-effects in long JGBs trading.

Although this may not prove as a big step per se, it may result in an outsized reaction, given that investors were disappointed over and over again in the past.

  1. JGB long-end yields are likely to rise sharply, tightening the spread to US10Y. We would expect a move above 1% relatively quickly.

2. The JPY is likely to see a knee-jerk reaction higher with a move towards the trendline around 135 as the first target and a medium-term target of 127.

This is supported by our FX scorecard, in which the JPY stands out as one of the cheapest currencies across the FX universe.

First, on a REER basis only NOK and SEK look currently cheaper than JPY.

Second, our cross asset model shows JPY on the weak side with the undervaluation rising on a tightening US-JP10Y yield spread.

Third, the momentum in the trade deficit has turned positively with rising car exports pointing to a lower trade deficit and support for the yen.

Fourth, CFTC positioning shows speculators close to the shortest levels in the last 5 years.

Bottom line, we see a high chance of a BoJ policy tweak tomorrow. It may only be a small step for the BoJ but it may be a big step for the investor community. We expect the markets to have an asymmetric reaction to a policy change and think the JPY to be the biggest beneficiary in case it happens.


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