The past two weeks saw a number of moves by central banks – and in different directions. After 17 years, Japan raised rates. Switzerland's central bank cut rates, and the Bank of England and the US Federal Reserve held them unchanged. In the case of Japan, what does the hike imply?

Bond fund investors can garner fresh opportunities in the aftermath of the Bank of Japan rate rises of a fortnight ago, according to PIMCO, the US-headquartered fixed income house.

The Bank of Japan (BOJ) has bid farewell to its negative interest rate policy (NIRP), yield-curve control (YCC) and quantitative and qualitative easing (QQE), marking the end of an era – 17 years – of extraordinary monetary easing.

This paves the way for a more normalized Japanese bond market, offering fresh opportunities for investors who have been wary of this space over the past decade, according to Tomoya Masanao (pictured) at PIMCO Japan. PIMCO, overseeing $1.86 trillion of assets (as of December 31, 2023), wields a lot of influence.

The BOJ's shift from a complex and overly accommodative stance (combining NIRP, YCC and QQE) to a 0 per cent to 0.1 per cent positive policy rate and a simpler approach was no surprise. “The fundamentals were supportive, and the changes were well telegraphed ahead of the BOJ's meeting,” Masanao said in a note.  

Like its peers, PIMCO has been trying to make sense of changes in Japan's economy and financial markets. Having languished for decades after stocks and real estate markets slumped in the late 80s, Japan has at last recovered some of its older energy. 

Inflation expectations in Japan have been largely re-anchored to more positive levels, PIMCO noted. The combination of global inflation induced by Covid-19 and a weak yen, exacerbated by central bank policy divergences, served as the catalyst Japan needed to break free from entrenched deflationary expectations and offered an opportunity for the BOJ to retire some of its more inflexible policies.

The BOJ's pre-meeting communications underscored its expectations that it would maintain an accommodative policy stance, including continuing government bond purchases, Masanao continued. This cautious rate increase is strategically aimed at managing the potential uptick in bond yields without causing market disruption.

A new inflationary landscape for Japan
Masanao thinks that the BOJ’s policy changes, while largely anticipated, should have minimal immediate market impact. However, the medium- to long-term implications could be significant, as the potential scale of the BOJ’s policy changes may be more than the financial markets currently anticipate.

A key question is whether Japan’s trend inflation rates will stabilize post-pandemic. Although Japanese inflation has shown signs of moderation, and further moderation is quite possible, Masanao believes that the country appears to have settled into a “one-point-something” per cent inflation rate, if not 2 per cent. This marks a significant departure from the near-zero per cent trend of the past three decades.

This new baseline represents a structural shift in the labor market and corporate pricing behavior. The pandemic’s global inflationary impact, coupled with the yen’s depreciation, has been a major catalyst for significant shifts in inflation expectations and corporates’ price and wage-setting behavior, Masanao said. While the BOJ’s 2 per cent inflation target remains elusive, given the country’s still inflexible labor system and low productivity, he believes that a reversion to zero per cent inflation seems equally unlikely.

BOJ policy in the new inflationary context
Although the BOJ reiterated its commitment to the 2 per cent inflation target, it is improbable, in his view, that the BOJ will maintain its accommodative monetary policy indefinitely to secure achieving its 2 per cent target. A more realistic approach would be to accept a 1 to 2 per cent inflation range as a practical target for a nation with low economic growth potential.

Outlook for investors
For investors, Masanao believes that the Japanese bond markets should start offering a higher risk premium and modestly higher yields in response to the BOJ's continued policy adjustments and the transition of government bonds back to market forces. As the market digests the new and evolving policy stance, there will be tactical opportunities for active managers to capitalize on the inefficiencies in the Japanese bond and interest rate swap markets during this period of increased volatility, he said.

Structurally, however, Japanese investors are generally underweight in Japanese bonds. Masanao believes that they should consider increasing their allocations over time given the higher yield levels. Although he anticipates a modest uptick in bond yields, the trajectory is expected to be gradual and nuanced on the yield curve. Japanese bond yields are correlated with global counterparts, and with major central banks poised to initiate rate cuts this year, any sharp yield fluctuations in Japan could prompt BOJ intervention, he added. The positive carry from Japanese bonds, supported by a steep yield curve, should over time offer a buffer for bondholders against rising yields.

Masanao does not expect Japanese investors to significantly influence market dynamics globally. Domestic flows into Japanese bond markets will rise, but he doesn’t expect those investors will have an urgent need to offload foreign bonds in favor of Japanese duration. Japanese investors possess ample yen liquidity to deploy domestically and there is a discernible demand for US duration to hedge against potential recession risks.

Wrapping up, Masanao said that the BOJ's policy evolution should usher in a period of normalization for Japanese bond markets, eventually attracting investors at higher yields who have been hesitant to invest over the past decade. See more commentary about Japan here.