Bank of Japan Running Short of Policy Ammunition

Market Trends - 20/09/2016

Even though the Yen is softening from intraday highs hit against the US dollar during the European session, traders are increasingly concerned that the Bank of Japan will not be able to significantly change the recent course of the Yen as it meets to formulate a monetary policy strategy. The currency has gained close to 20.00% during the past year alone notwithstanding the Central Bank’s sustained efforts to weaken it.  Officials at the Central Bank have hinted that despite taking interest rates into negative territory earlier this year, there still remains room for deeper cuts. Criticism of the negative rate regime has been widespread, with many arguing that the corresponding damage to financial institutions could trigger fresh economic turmoil. Furthermore, should the Yen continue to appreciate, it could crush exporter profits and plunge the economy back into a recession.  Policymakers conceded the pitfalls of unorthodox policy measures, giving rise to market expectations that the Bank of Japan may take monetary policy in a different direction.

One possible strategy the Bank of Japan can employ to avert a new crisis is steepening the yield curve to reduce the adverse impacts of negative interest rates on the financial sector.  What this means is that the Bank of Japan would sell some assets on its balance sheet, specifically longer-term debt, to buy short-term debt that would help fulfil this objective, known as a “twist.  However, economists, sensing that the BoJ may be running out of firepower, speculate that such a step may not necessarily dampen the rally in the Yen.  Dealers in fact suggest that bearish USDJPY positions post BoJ policy meetings have proved to be a winning strategy during past decisions, with the Yen strengthening markedly after each of the Central Bank’s last three meetings.  Adding to the downward USDJPY pressure is currency speculators raising net bets on gains in the Yen close to the record highs set back in April, further supporting the thesis that Yen weakening does not appear imminent.

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