BoJ: No tapering but beware yen strength – RBS

Research Team at RBS, suggests that the Bank of Japan is facing the following two challenges in the run up to its next meeting on November 1.

Key Quotes

“First, Japan’s economic data continues to be weak signaling the central bank will have to push back again its forecasts of reaching 2% inflation when it publishes its latest Outlook Report at next month’s meeting.

Second, the BoJ has made targeting the yield curve central to its easing policies. But ten year yields have drifted down from its new target ‘around zero’ towards its 10bps short term deposit rate.

August’s data releases show Japan’s economic outlook remains weak. Retail sales fell 1.1% m/m. Household spending was down 4.6% y/y. The jobless rate ticked up from 3.0% to 3.1%. The BoJ’s official measure of inflation used for its forecasts national CPI excluding fresh food costs remained at 0.5% y/y and the central bank’s internal measure of inflation that excludes both food and energy prices dipped to 0.4%y/y.

Only August’s industrial production showed strength, rising 1.5% m/m and 4.6%y/y. This makes the Q3’16 Tankan survey in the week ahead a key release. In Q2’16 large manufactures’ business conditions remained solid at +6 but large non-manufacturers’ business conditions fell again from 25 year highs of +25 at the end of last year to +19. Further deterioration in corporate confidence now would increase demand for additional BoJ easing.

This week Governor Kuroda made clear that interest rate cuts would be the main instrument now for easing monetary conditions further. He said ‘with regard to possible options for additional easing, the main policy tool will be further cuts in the negative short-term policy interest rate and lowering the target level of the long-term interest rate. Expanding asset purchases the ‘quality’ dimension also continues to be an option. Moreover, if the situation warrants it, acceleration in the expansion of the monetary base the ‘quantity’ dimension could be an option.’

With the governor also saying the BoJ’s current forecast of achieving 2% inflation in financial year 2017 was now uncertain and thus signaling it will be revised in the upcoming Outlook Report the risk is the BoJ uses its new framework of ‘Quantitative and Qualitative Easing with Yield Curve Control’ to lower its deposit rate from 0.10% and to cut its new target yield on ten year bonds from zero at next month’s board meeting.

Dollar-yen is currently trading heavily in its 100-105 range as concerns about European banks had spurred safe haven flows this week. But the risk of further BoJ rate cuts plus Fed tightening is likely to push the pair into a higher 105-110 range in Q4’16.

In the run up to next month’s meeting, the BoJ will also consider whether it needs to react if ten year JGB yields keep drifting lower by tapering its bond purchases. This week Reuters reported ‘sources’ familiar with the central bank’s thinking say policymakers do not feel its 0.10% deposit rate should be seen as a floor for ten year yields as long as yields curve in the right direction. With two and five year yields trading below 0.25%, there was no strong reason to see 0.10% as a floor for ten year yields.

This view was borne out in Friday’s announcement that the BoJ planned to maintain its overall monthly pace of JGB buying at ¥812trn for October. This would be the same pace as September and in line with the central bank’s annual ¥80trn a year bond buying target. The central bank did say it would trim purchases of JGBs with maturities of ten years or more consistent with its new policy of targeting an upwardly sloping curve. But the BoJ did not cut its overall pace of JGB buying. The lack of any tapering signal caused dollar-yen to tick up on the news.”