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A seismic policy shift by Japan’s central bank is still a matter of when not if, say investors now hunkering down for fresh havoc in bond markets and wild swings in currencies.

The Bank of Japan on Wednesday maintained ultralow interest rates, including a bond yield cap it was struggling to defend, defying market expectations it would phase out its massive stimulus program in the wake of rising inflationary pressure.

Analysts say a policy change is inevitable at some point given that Japanese inflation is at 41-year highs and the cost of keeping borrowing costs down rises.

“Although the timing is uncertain, we are not changing our view, this is something that has to happen at some point,” said Cosimo Marasciulo, head of fixed income absolute return at Amundi, Europe’s largest fund manager.

He added that Amundi remained positioned for rising Japanese government bond yields (JGBs) and for the yen to strengthen.

BNP Paribas said on Wednesday it expects the BOJ to widen the target range for the 10-year yield to 1 per cent above or below zero in March, from 0.5 per cent currently and was also betting on a rise in the yen.

Japan’s 10-year bond yield, trading at 0.4 per cent, fell on Wednesday but is not far off its highest levels since 2015.

Expectations that yields will move higher are enticing cash back home and investors now have to adapt to a potentially sustained fall in Japanese demand for global bonds. That is a risk some say is underestimated at a time when major central banks have started off-loading bonds they own as part of their monetary tightening efforts and government debt sales surge.

Total holdings of foreign bonds by Japanese institutional investors, excluding Japan’s US$1-trillion reserve portfolio, reached US$3-trillion at their peak. While they have been trending down lately, they are estimated to remain well above US$2-trillion.

With Japanese investors the biggest foreign holder of U.S. Treasuries and among the biggest foreign buyers of debt in the likes of Australia and France, those flows are significant for sovereign bond markets worth almost US$70-trillion.

“The scary thing about Japanese [monetary] policy discussions is the numbers are absolutely enormous,” said Simon Edelsten, global equity manager at Artemis. “So, any direction of travel matters and you have to pay attention to it.”

GOING HOME

The implications of higher inflation and a possible end to ultralow rates are not lost on Japanese investors. For the first time in years they would not need to send their cash overseas in search of a return.

A rapid sale of foreign bonds is unlikely as investors would incur sharp losses, analysts said.

Still, anticipating a shift, Japanese investors sold a net 2.1-trillion yen (US$15.94-billion) of foreign bonds in December, marking a fourth straight month of selling.

Brad Setser, a senior fellow at the Council on Foreign Relations, said it was no exaggeration to say that Japanese flows have had at least as much of an impact on the global bond market as Chinese flows over the last decade.

U.S. Treasuries and French bonds are vulnerable, said Canada Life Asset Management fund manager David Arnaud. Japanese U.S. Treasury holdings are worth more than US$1-trillion or just over 4 per cent of the US$24-trillion market.

UBS estimates Japanese investors hold at least 10 per cent of France’s €2.3-trillion (US$2.45-trillion) sovereign bond market and around $260-billion Australian dollars (US$181.14-billion) or some 19 per cent of Australian debt.

TO THE YEN, AND STOCKS

The yen initially fell more than 2 per cent after the BOJ decision but then rose and was expected to gain from Japan moving away from its ultra loose policy – which some say they anticipate after BOJ chief Haruhiko Kuroda steps down in April.

Mr. Kuroda’s last meeting is in March and who will succeed him as Governor remains unclear.

“What they’re doing with yield curve control is not long-run sustainable,” said Christopher Jeffery, head of rates and inflation strategy at Legal & General Investment Management.

LGIM calculations show the BOJ has spent the equivalent of US$264-billion on its yield curve control purchases since Dec. 1.

A further surge in the yen – one of 2023′s most favoured trades – means volatility in the US$7.5-trillion-a-day foreign exchange markets is unlikely to go away soon, another headwind for investors.

The yen has already gained almost 18 per cent since October.

“There are a lot of people willing to take a bet that the yen goes considerably further,” said Kit Juckes, chief global foreign exchange strategist at Société Générale.

Heightened volatility could support the safe-haven dollar though, analysts said, muddying the impact for major currencies from a BOJ shift.

Finally, global equities could be another casualty.

According to Nomura, Japanese investors have been far more active buyers of global and overseas equities than domestic stocks in the last decade.

Global equity investment trusts sold in Japan received more than 14-trillion yen of net inflows from January, 2013, until November, 2022, according to Nomura. However, it forecasts much less Japanese interest in investing local currency in overseas funds going forward.

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