Yen's freefall may force Japan to dial back on Abe-era stimulus

The Japanese yen's slide against the U.S. dollar since March may prompt Japan's central bank to abandon its ultraloose monetary policy amid growing inflationary pressures.

As the U.S. dollar continues to rise, a breach above the ¥140 mark could be a trigger for the Bank of Japan to adjust its yield curve control policy designed to keep long-term interest rates near zero, a policy the central bank has had since 2016.

The dollar piercing the ¥130 level "was not a problem," Mark Dowding, chief investment officer at U.K.-based BlueBay Asset Management said. "But as it rose above this level, it would grow into more of an issue," Dowding said in an email to S&P Global Market Intelligence.

BlueBay started selling Japanese government futures at the beginning of May in anticipation of a change in the Bank of Japan's policy, Dowding said, adding that the change may occur around September.

The dollar fetched ¥137.34 on July 13, matching the 24-year high reached on July 11, based on Market Intelligence data.

Mixed expectations on policy action

Investors, mostly those overseas, have sold off Japanese assets such as government bonds, allocating their funds to U.S. Treasuries to seek better returns. Foreign players sold off ¥4.811 trillion of long-term Japanese bonds, mainly sovereign bonds, on a net basis in the week of June 12, according to data from Japan's Finance Ministry. The largest-ever sale reflected investor expectations that the central bank will adjust its monetary easing.

The weakening yen also underscores inflationary pressure from increasing import prices that are weighing down on Japanese industries including energy, materials and food. Japan's annual core consumer inflation topped the central bank's target for a second consecutive month in May. The nationwide core consumer price index, which excludes volatile fresh food but includes fuel costs, rose 2.1% year over year in May, the same pace as in April.

Some, however, expect the Bank of Japan to stick with the loose monetary policy for longer. Raising interest rates has "both merits and demerits," said Koichi Fujishiro, economist at Dai-ichi Life Research Institute. The Bank of Japan may hold steady at least until after the central bank governor ends his 10-year tenure in April 2023, the economist added.

The Bank of Japan will keep interest rates near zero until inflation stabilizes at around 2%, Governor Haruhiko Kuroda said at a June 17 press conference after a two-day policy meeting. Kuroda added, however, that the yen's rapid fall against the dollar "will be negative and undesirable for the economy, making it harder for companies to make business plans."

The July 8 assassination of former Prime Minister Shinzo Abe, who appointed Kuroda and led Japan down a path of extraordinary stimulus, can give the current premier, Fumio Kishida, a greater hand in deciding the next central bank chief, analysts said.

Ending the yield curve policy

The central bank's loose monetary stance "would let the yen slide further and spark criticism from consumers" as higher prices hurt, said Takero Doi, professor at the faculty of economics at Keio University. "They will need to act" to arrest the currency devaluation, added Doi, who also serves as a member of the working group on fiscal policy at the Finance Ministry.

Under its yield curve control policy, the Bank of Japan targets a yield of about 0% on 10-year government bonds, with a tolerance of 0.25 percentage point on either side, as well as a short-term yield of negative 0.1%. The central bank, one of the few to drive interest rates below zero, holds these lines with the aggressive purchases of government bonds when it sees a need. Still, yield on the benchmark 10-year bond broke through the cap to jump above 0.30% several times in June and is currently hovering around 0.24%.

The yield curve control policy now appears dysfunctional and may come to an end, said Takahide Kiuchi, senior economist at Nomura Research Institute.

BlueBay's Dowding agrees. "[Yield curve control] was an exceptional monetary policy response in the face of deflationary pressures, but these have now passed and the world has changed and so it is not clear why these policies are now needed and how they would be beneficial," Dowding said.