How Japan Took on the Bond Vigilantes and Won — For Now

(Bloomberg) -- Japan showed investors last week just how tenacious it would be in keeping interest rates locked near zero in the world's third-biggest economy despite skyrocketing inflation across the globe and the risk of weakening the yen to damaging levels.

The country was the epicenter of market drama, when the Bank of Japan set in motion a four-day long unlimited buying spree of government bonds last Monday to stave off a global debt rout that threatened to prise open its iron-clad grip on yields.

The move sent the yen plummeting to its lowest since 2015, sparking a flurry of comments from officials and a face-to-face meeting between BOJ Governor Haruhiko Kuroda and Prime Minister Fumio Kishida.

While some say the BOJ can count its historic market intervention as a success, others contend that it has just bought a little breathing space before the pressure mounts again.

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Tensions Build

Tensions had been building through March. While surging inflation in other parts of the world spurred policy makers to roll back stimulus and raise interest rates, the BOJ stood out with its commitment to keep them on the floor.

Dogged by decades of minimal price appreciation, the central bank had signaled it was less willing to relent until it was convinced a revival in inflation was sustainable. But that just made traders bet its yield-curve control policy could not possibly hold down the market while the rest of the world hiked rates to combat inflation.

Comparisons were made with efforts by the Reserve Bank of Australia to cap yields, which were summarily abandoned in November after weeks of market pressure -- a shocking victory for the so-called bond vigilantes now stalking Japan.

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After a rise in yields in February, the BOJ was forced to intervene with a fixed-rate operation for the first time since 2018. It announced a one-day offer to buy an unlimited amount of 10-year bonds, pushing back against weeks of speculation about policy normalization.

The relief was short-lived. Ten-year yields resumed their climb toward the BOJ's tolerated limit -- 25 basis points above zero. And hedge funds continued to aggressively short the yen, which had come under renewed pressure after Russia's invasion of Ukraine sparked concern about Japan's dependence on imported oil.

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When the BOJ unleashed its fixed-rate buying spree on Monday, investors sent a message straight back -- ‘Bring it on' -- pushing yields even higher to the 0.25% red line.

Standing Firm

But Japanese policymakers showed no signs of cracking. The BOJ followed up on unlimited purchases Monday with a three-day plan for even more buying from Tuesday -- the first time it has intervened over such a sustained period.

“The BOJ waited until the very last moment to conduct that fixed-rate operation due to their concern on the impact of a weak yen from its action,” said Yasunari Ueno, chef market economist at Mizuho Securities.

After announcing the extended buying -- a sign that the BOJ isn't giving up on low rates -- the yen plunged through the 125 per dollar level as the currency became a favored option to trade the widening rate differential between the U.S. and Japan.

That level is also widely seen as Kuroda's threshold for the currency becoming harmful for the economy -- a sign that he can't adhere to that and cap yields at the same time.

The benchmark yield stayed most of Tuesday at 0.245% with traders and BOJ officials staring at each other eyeball-to-eyeball.

Turning Point

Ramped up bond buying across a range of maturities in addition to the fixed-rate operation on Wednesday marked a turning point. And when the governor said the operations didn't directly affect currency levels, the implication was that yields took priority over the yen.

The central bank chief spoke after meeting Prime Minister Kishida in a symbolic meeting that showed the leaders were on the same page.

A move to put longer-dated bonds on its emergency buy list -- an area of the curve nominally outside of BOJ control -- was another crucial move that sent a rise in 30-year yields into reverse. That was a signal Kuroda had the stomach to do more than just target 10-year yields.

With their massive interventions Wednesday, the BOJ managed to wrench back control of 10-year yields, sending them below the 0.25% target. In three days it had bought a combined 2.9 trillion yen ($23.7 billion) of bonds.

“Once they decided to move in, they were unstoppable,” Ueno said. “The contrast between their hesitation earlier and determination later was dramatic and we saw the climax of that this week.”

Thursday Calm

The central bank hammered home its point Thursday with a quarterly bond buying plan that saw a modest increase in purchases of various maturities.

Investors were reminded the BOJ has bought far greater quantities of debt under Kuroda's watch. In 2015, net purchases topped 80 trillion yen compared with just 13.5 trillion last year, an indication that the bank still has deep pockets to draw on.

“When I saw their quarterly plan, I got the impression they were still holding back a big increase until it's really needed. They used to buy 7 or 8 trillion yen a month and the latest plan isn't even close to that,” said Makoto Suzuki, senior bond strategist at Okasan Securities. “I don't see the BOJ losing this battle to keep yields low.”

By then, bond markets and the yen had calmed. Benchmark yields had fallen back toward 0.20% and the currency steadied around 122 against the dollar, admittedly with some help from global market moves.

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Temporary Respite

Still, some are warning it may only be a temporary respite.

Clinging to yield-curve control will be “unsustainable if we're in an environment of high inflation and rising rates across other economies,” Zach Pandl, co-head of global FX and EM strategy at Goldman Sachs Group Inc., said on Bloomberg Television.

And currency experts expect further pressure on the yen.

Kit Juckes, who has nearly four decades of market experience, believes short bets on the yen have room to run. “If the weak yen trade gets popular, and the BOJ doesn't mind, there is plenty of room for it to grow,” Juckes, strategist at Societe Generale SA, wrote in a note.

Macquarie Futures' Thierry Wizman said the inevitable arrival of inflation in Japan will force the central bank to raise the cap on yields.

“As long as BOJ continues with its super easy monetary policy and yield-curve control while other central banks are turning more hawkish about the embedded inflationary pressures, the yen is likely to suffer,” said Amir Anvarzadeh, strategist at Asymmetric Advisors Pte. “This is a war the BOJ is going to lose.”