BoJ: Outlook report points to early rate cut - RBS

Research Team at RBS, suggests that they have found UK investors to be very uncertain about the Bank of Japan's intentions following its shift to Quantitative and Qualitative Easing with Yield Curve Control and the 'comprehensive assessment' of its monetary policy last month.

Key Quotes

“We argued the next BoJ meeting on November 1 was live and saw dollar-yen heading back towards 110 on the risk of the BoJ cutting its deposit rate further from 0.10%, US election concerns fading and the Fed considering tightening before year end.

First, the BoJ will publish fresh forecasts in its next quarterly Outlook Report when it meets on November 1. BoJ policymakers, like FOMC members, produce the central bank's projections in contrast to the ECB and BoE where the staff are responsible. With the measure of inflation used by the BoJ for its forecasts national CPI excluding fresh food costs in deflationary territory at 0.5% y/y, Governor Kuroda has already signalled the central bank's current projection of reaching its 2% inflation goal in financial year 2017-18 is set to be pushed back again. We see lower inflation forecasts increasing the pressure on policymakers to respond with more easing using their new QQE with YCC framework.

Second, Governor Kuroda said last month in a speech in the Osaka region that interest rate reductions would be the main tool now for easing policy while still keeping the options of higher asset purchases and even an expansion of the ¥80trn a year monetary base growth target. The BoJ could cut its deposit rate by at least 10bps from 0.10% while either leaving its new target for 10 year yields 'around zero' or lowering it marginally. Thus it would increase the incentive for Japan's banks to exchange their reserves at the central bank for higher yielding domestic or foreign assets. At the same time, the BoJ would try to maintain a positive sloped yield curve to support financial sector profitability and thus aim to ensure its negative rate cuts had less of an adverse impact on Japanese bank shares.

Third, the BoJ is also likely to keep coordinating stimulus with the government with the latter loosening fiscal policy further. This week local media reported that Prime Minister Abe's supporters in the ruling Liberal Democratic Party are likely to change the party's internal rules to allow its leaders to be able to stay in post beyond the current limits of two-three year terms. This would enable PM Abe to remain in office beyond December 2018 until after the 2020 Tokyo Olympics. By avoiding becoming a lame duck leader until the end of the decade, PM Abe should thus be able to push through more fiscal reflation as he seeks to raise Japan's nominal GDP from ¥500trn to ¥600trn. A looser budget for the upcoming financial year would support the Nikkei and dollar-yen.

Fourth, the BoJ isn't likely to taper its current ¥80trn a year of Japanese government bond purchases. The central bank will not sell 10 year JGBs if yields fall far below zero provided 2 and 5 year yields remain lower and so Japan's overall yield curve slopes upwards. Further, Japanese banks continue to sell down JGBs as the BoJ raises its holdings and the prospects of looser fiscal policy may result in the Ministry of Finance raising its net new issuance of JGBs from ¥3540trn for the next fiscal year.

Last, we found hedge fund clients are more willing to consider upside exposure in dollar-yen for Q4'16 but asset managers and reserve managers appear to remain long yen. Some UK clients were concerned that when China returns from its Golden Week holidays, official investors will start buying yen again in the week ahead. But we think such flows do not determine Japan's exchange rate. Instead we think the marginal player is more likely to be Japan's life insurance and pension funds. With the cost of hedging Treasury bonds rising as US and Japanese short term rates diverge, lifers will need to lower their hedge ratios in order to keep delivering expected returns of 1.001.25% to their insurance policy holders.”