The Bank of Japan’s (BoJ) Halloween announcement wasn’t quite the shocker everyone was expecting. Despite increasing pressure to raise interest rates, the BoJ has held firm to its ultra-loose policy for the last seven years, keeping Japan’s benchmark interest rate at -0.1%. On October 31st, they decided to tweak their cap on ten-year government-bond yields, changing the 1% ceiling to a reference instead of a rule. Even still, these yields are at 0.95%, higher than they’ve been in over a decade.
After the announcement, the yen dropped to its lowest point in decades at ¥151 to the dollar. Inflation, which has been at historically low levels, is expected to increase, with the BoJ raising its forecasts for underlying “core” inflation over the next three years. Analysts are predicting that the central bank will finally end its yield-curve-control policy and raise interest rates by April 2023.
The impact of Japan’s prolonged ultra-low interest rates and ongoing effort to suppress bond yields has been significant. With low rates at home, Japanese investors have sought higher returns through foreign assets, resulting in Japan’s overseas investments generating $269 billion more in income than foreign investors made in Japan last year. This foreign yield chasm has consequences for Japanese investors holding foreign bonds and global issuers who benefit from Japanese investment.
Japan’s largest financial institutions are heavily invested overseas, and the cost of hedging overseas investments is high due to the large gap between short-term interest rates in different currencies. There is now a guaranteed loss for Japanese investors buying long-term bonds in dollars and hedging their exposure, leading life insurers to dump $87 billion in foreign bonds last year.
The large gap between short-term interest rates means Japanese investors have limited options, leading to increased risk-taking. And if and when the BoJ does end yield-curve control, rising yields on long-term Japanese bonds may lead local investors to repatriate their funds. This move could have implications for the funding of Western firms and governments, which are used to Japanese investment in their bonds.
Despite the potential impact on the financial industry, the exact ramifications of these changes will only become clear in the months to come. What is already certain is that someone is bound to feel the effects.
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