Watch the yen as Bank of Japan decides whether to signal exit from negative interest rates

Economists see virtually no chance the BOJ will move rates when it concludes its two-day policy meeting. But investors are on the lookout for any sign the world is about to lose its last remaining anchor to the extraordinary, ultraloose monetary policy settings that dominated the global financial system following the global financial crisis and during the COVID-19 pandemic.

Bank of America economists Izumi Devalier, Shusuke Yamada, and Tomonobu Yamashita, in a note late last week, said that if, as they expect, the BOJ plans to end its negative interest-rate policy, or NIRP, early next year, it will likely offer a signal following Tuesday’s meeting either via its policy statement or in BOJ Gov. Kazuo Ueda’s post-meeting news conference.

If the signal comes in the statement, it could take the form of new language acknowledging further progress toward the bank’s 2% price stability target and a directive from Ueda ordering the staff to consider options for guiding short-term rates into positive territory.

A “weaker form of guidance” would see Ueda use his news conference to state that policy makers believed they were moving closer to sustained and stable 2% inflation and were making preparations to exit from NIRP, the economists wrote.

The Bank of Japan in October effectively abandoned its policy of keeping the yield on the 10-year Japanese government bond
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below 1%, saying the threshold would now serve as a “reference” point.

The BOJ sent shock waves through global markets in July when it loosened the cap, lifting it to 1% from 0.5%.

The BOJ had implemented yield-curve control, or YCC, in 2016, a policy that aims to keep government bond yields low while ensuring an upward-sloping yield curve. Under YCC, the BOJ buys whatever amount of JGBs is necessary to ensure the 10-year yield remains below its cap.

YCC was one of many extraordinary measures employed by the Bank of Japan in recent decades in an effort to battle deflationary prices. Inflation rose in the wake of Covid.

Changes to YCC have prompted or amplified selloffs in U.S. Treasurys and other government bonds, adding volatility to stocks and other assets. That’s because the prospect of higher yields in Japan could prompt the nation’s investors to repatriate money parked in assets overseas.

Japan’s maintenance of ultraloose monetary policy, meanwhile, contributed to a slide by the Japanese yen, which last year slumped to a more-than-40-year low versus the U.S. dollar
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and tested those levels again last month.

The prospect of tighter BOJ policy and expectations the Fed and other major central banks have finished raising rates and are likely to lower them in coming months has sparked a bounce for the yen.

The dollar has dropped 3.6% versus the Japanese currency so far in December, but remains up 9% so far this year.

Some analysts fear the yen’s rebound has gone too far, too fast.

“The market’s position regarding the yen couldn’t be clearer. Presently, long Japanese yen is the most obvious trade in the currency markets. It is almost too easy,” said Ipek Ozkardeskaya, senior analyst at Swissquote Bandank, in a Monday note.

“A hawkish signal from the BOJ has the potential to push the USDJPY below the 140 level, even with prevailing oversold conditions. Conversely, should the BOJ disappoint the market once more, any price rallies could draw the attention of top sellers,” she wrote.

Skeptics contend the BOJ is unlikely to signal any big changes. They argue the post-COVID spike in inflation, amplified by a sharp jump in energy prices, which took inflation to 4.4% in January, continues to fade.

Japan’s deflation woes are primarily the result of its aging and shrinking population, said Carl Weinberg, chief economist at High Frequency Economics, in a client note.

“Since most of those who die of old age are retired from the workforce, potential GDP is unaffected by their loss. Thus, slack is persistent and increasing. Deflation is the natural companion of Japan’s depopulation,” Weinberg said.

“We expect CPI to fall again within the next year,” he said.

Tokyo inflation, a closely watched leading indicator of price trends, fell to 2.6% year over year in November, down from 3.2% in October as food and energy inflation cooled.

The economy, meanwhile, contracted in the third quarter — falling an annualized 2.9% — and shows no sign of recovery this quarter, Weinberg said. He argued that even if Ueda thinks negative rates aren’t helping to support prices and can be normalized, the timing would be wrong as the economy begins to contract.

“We expect no change in policy or guidance at this week’s BOJ Board meeting,” he wrote, with inaction likely to trigger a yen reversal after its recent rally.