Why the Bank of Japan’s surprise policy twist is rattling global markets

Analysts and economists debated the significance of the move. But the market reaction showed global investors were rattled by the potential for the Bank of Japan to eventually give up its role as the last remaining low-rate anchor.

“The fact that investors see today’s move as heralding a bigger shift is evident from the market reaction,” said Jim Reid, strategist at Deutsche Bank, in a note.

The BOJ, at a regular policy meeting, said the yield on the 10-year Japanese government bond could rise as high as 0.5% from a previous cap of 0.25%. The central bank, as part of a program known as yield curve control, has maintained a target range around zero for the benchmark government bond yield since 2016 and used that as a tool to keep overall market interest rates low.

For its part, the BOJ didn’t cite inflation as a reason for the move, instead highlighting concerns about the functioning of the government bond market.

The yen soared, strengthening by more than 3% versus the U.S. dollar
USDJPY,
-3.95%,
while yields on 10-year Japanese government bonds
TMBMKJP-10Y,
0.417%
were up 16 basis points at 0.413%, after hitting their highest level since 2015. U.S. Treasury yields
TMUBMUSD10Y,
3.696%
 spiked as global bond yields rose. The dollar weakened broadly versus major rivals, with the ICE U.S. Dollar Index
DXY,
-0.62%
down 0.8%.

The widening differential between Japanese and other developed market interest rates had translated into a steep selloff by the yen this year, with the currency hitting a multidecade low versus the U.S. dollar earlier this year.

Equity markets in Asia felt the heat from rising yields, with Japan’s Nikkei 225
NIK,
-2.46%
falling more than 2%. Stocks in Europe and the U.S. saw a more subdued reaction, with U.S. stocks shaking off modest early losses to trade higher as the Dow Jones Industrial Average
DJIA,
+0.56%,
S&P 500
SPX,
+0.38%
and Nasdaq Composite
COMP,
+0.24%
attempting to snap a four-day losing streak.

Speculation around a broader shift in policy has been mounting.

The U.S. Treasury market felt ripples in Monday’s session after the Kyodo News agency over the weekend reported that Japan’s Prime Minister Fumio Kishida was looking to make the country’s 2% inflation target more flexible. The report said that Kishida, as soon as next spring, could discuss details of how to revise the government’s decade-long accord with the BOJ on the 2% target after a new central-bank governor succeeds Haruhiko Kuroda, whose term ends in April.

The Bank of Japan has spent massively in its effort to maintain the cap on the 10-year yield as global bond yields jumped this year in response to policy tightening by other major central banks, noted Robin Brooks, chief economist at the Institute of International Finance, on Twitter. That pressure may intensify “because markets smell blood,” he said.

While prospects for a move were being built into expectations for 2023, there was a widespread view that nothing was likely to happen in the final months of Kuroda’s term as governor, said Adam Cole, chief currency strategist at RBC Capital Markets, in a note.

He noted that other aspects of policy, including forward guidance and the policy balance rate, were left unchanged and the statement played up the market functioning role of the band widening, rather than characterizing it as a tightening of monetary policy.

“But coming in illiquid conditions, the market reaction has been sharp. In the near-term, we would not stand in the way of JPY strength and note that positioning, while much reduced in recent weeks, was still net long USD/JPY heading into the decision and covering of these JPY shorts may carry JPY higher still,” he wrote.