The Bank of Japan will win next year's "Most Influential Central Bank" award

By now you’ve probably seen the headlines - the Bank of Japan increased the cap for where the 10 year JGB yield can trade from 25 bp to 50 bp on Tuesday. Usd/jpy spot dropped on the day of the announcement from 137 to 130, while JGB yields gapped up to 48 bp. It was a good day for the global macro portfolio, as short usd/jpy is one of the core positions I proposed a month ago and reiterated in my interview on Realvision. It’s the trade I’ve been beating the drum for the loudest.

Fidenza Macro @fidenzamacro

Short usdjpy will be the kingmaker of all trades over the next 12 months.

However even I did not expect BoJ Governor Kuroda to widen the 10 yr yield trading band so quickly. He has steadfastly promised to keep policy unchanged until the end of his tenor, which comes up in March. Every analyst and trader took him for his word and predicted that a change in monetary policy would come no earlier than Q2 2023. Now he is being criticized for lacking credibility and for “lying” to the public about his intentions. But seasoned global macro traders know that it is the job of a central banker to stick to the script right up until the point where the script changes. We learned this lesson when the Swiss National Bank pulled the rug on the 1.2000 eur/chf floor in 2015, and when Jerome Powell flipped from “not even thinking about thinking about raising rates” to 75 bp hikes per meeting a year ago.

Kuroda downplayed the significance of the decision, explaining that the move was “aimed at restoring the functioning of financial markets, and doesn’t mean tightening and an exit.” While it’s true that the market is indeed dysfunctional and this move addresses that dysfunction, I believe this decision is also the first step towards monetary policy normalization. In other words, this is just the beginning.

Japan’s core CPI just reached an 8-year high of 2.8% today, comfortably above the BoJ’s 2% target and showing no signs of stopping. Thanks to the BoJ’s ultra-loose, monetary policy, the yen weakened from 110 against the dollar to as low as 151, a 37% drop. This depreciation increases the price of food, energy, and goods imports, stoking a 3.8% increase in the total inflation measure that includes food and energy.

Periods of yen weakness have resulted in spikes in inflation with a 12 month lag. Source: Variant Perception

Rising inflation has resulted in discomfort at all levels of society and the government. The BoJ’s ultra-loose monetary policy setting has become unpopular and unsustainable, and I believe they will need to tighten policy even further to bring usd/jpy back to 2021 levels in order to stop inflation from accelerating further.

Investors got so used to yen depreciation that they haven’t bothered to convert all the foreign currency proceeds from selling their assets abroad back into yen! This means the broad investor community in Japan is running a massive yen short that will eventually need to be covered (aka repatriated).

Vanda research also confirms that asset managers and retail are mostly short yen. Only leveraged funds have made position adjustments in the direction of yen strength.

If you believe that the Fed is nearing the end of its hiking cycle and the BoJ is just beginning their tightening cycle, that means this trade is only getting started. Fundamentals, momentum, and positioning all point in favor of bearish USD/JPY positions.

BoJ policy normalization has larger implications beyond USD/JPY FX, and this is why they will be winning the award for next year’s “Most Influential Central Bank”. Japan investors happen to be the largest holders of US Treasuries and global fixed income. A decade of low yields and QE at home forced Japan’s pension funds, insurance companies, and banks to look outside of Japan for yield. Their relentless purchases of US and foreign debt have compressed term premium (the additional yield required to compensate bond holders for lending money to the Treasury for a long duration, above and beyond future rate expectations) to negative levels. The last two decades of the government bond market can be divided into two regimes: Pre-Kuroda, when term premium was a healthy 0 to 3%, vs the Kuroda era, when term premium was -1 to 0% and the BoJ was conducting QE or capping yields.

As the BoJ slowly brings domestic yields back to normal levels, the bar gets higher and higher for foreign bonds to be attractive enough for Japanese investors to buy. The buying support that was once there for global government bonds will recede and bring term premium back towards positive levels. This means higher long-term yields and steeper yield curves. This is why my other global macro bet, a 5-30 yr Treasury steepener, should do well. Fed rate cuts in response to a recession should drag 5y yields lower, while lack of institutional demand on the long end keeps 30y yields elevated.

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