Worries about a possible policy tweak by the Bank of Japan threw a wet blanket on a stretched U.S. stock-market rally Thursday, with the Dow Jones Industrial Average snapping its longest winning streak since 1987 after the 10-year Treasury yield surged back above the 4% level.
The Japanese yen also strengthened after a news report said policy makers on Friday would discuss a possible tweak to the Bank of Japan’s so-called yield-curve control policy that would loosen the cap on long-dated government bond yields.
Nikkei, without citing sources, reported that BOJ officials would talk about the matter at Friday’s policy meeting and that the potential change would allow the yield on the 10-year Japanese government bond
TMBMKJP-10Y,
to trade above its cap of 0.5% “to some degree.”
‘Ultimate fear’
Why is that a negative for U.S. Treasurys and, in turn, U.S. stocks?
The “ultimate fear” is that Japanese investors, who have vast holdings of U.S. fixed income, including Treasury notes and other securities, “begin to see a higher level of yields in their own backyard,” Torsten Slok, chief economist at Apollo Global Management, told MarketWatch in a phone interview. That could prompt heavy liquidation of those U.S. positions as investors repatriate holdings to reinvest the proceeds at home.
That dynamic explains the knee-jerk reaction that saw the 10-year U.S. Treasury yield
TMUBMUSD10Y,
surge more than 16 basis points to end above 4%, he said. Yields rise as debt prices fall.
The surge in yields, in turn, saw stocks give up early gains, with U.S. indexes ending lower across the board.
What is yield curve control?
The Bank of Japan began implementing yield curve control, or YCC, in 2016, a policy that aims to keep government bond yields low while ensuring an upward-sloping yield curve. Under YCC, the BOJ buys whatever amount of JGBs is necessary to ensure the 10-year yield remains below 0.5%.
Nikkei said a possible tweak would allow gradual increases in the yield above 0.5%, but would clamp down on any sudden spikes, allowing the BOJ to rein in fluctuations driven by speculators.
Global market participants are sensitive to changes in YCC. The BOJ sent shock waves through markets in December when it lifted the cap from 0.25% to 0.5%. Investors were rattled by the prospect of the Bank of Japan giving up its role as the remaining low-rate anchor among major central banks.
BOJ Gov. Kazuo Ueda in May said the bank would start shrinking its balance sheet and end its yield-curve control policy if a 2% inflation looks achievable and sustainable after many years of undershooting.
Yen rallies
The yield on the 10-year JGB has traded above 0.4%, but remained below the 0.5% cap. Continued interest rate rises by the Federal Reserve and other major central banks in the past year have raised worries that the 10-year JGB yield could test the limit, Nikkei reported. Those rate hikes, meanwhile, have added pressure to the yen, whose weakness is seen contributing to inflation pressures.
The yen
USDJPY,
strengthened following the report. The U.S. dollar was off 0.5% versus the currency, fetching 139.48 yen.
The Dow Jones Industrial Average
DJIA,
ended the day down nearly 240 points, or 0.7%, snapping a 13-day winning streak, while the S&P 500
SPX,
declined 0.6% and the Nasdaq Composite
COMP,
lost 0.5%.
Japanese stocks have solidly outpaced strong gains for U.S. equities in 2023, with the Nikkei 225
NIK,
up 26% so far this year versus an 18.7% rise for the S&P 500.
See: Japan’s stock market is roaring 25% higher. These 4 things could keep the rally going.
What’s next
Investors are waiting to see what the Bank of Japan actually has to say.
While the Nikkei report helped “exaggerate” a selloff in Treasurys, the market may be inoculated against bigger swings after the BOJ’s December adjustment to the rate band, said Ian Lyngen and Benjamin Jeffery, rates strategists at BMO Capital Markets, in a note.
The analysts said they expect that “the magnitude of the follow through repricing in U.S. rates will be comparatively more contained than would otherwise be expected.”
More recently, the weak yen has raised the cost of hedging long Treasury positions for Japanese investors. So a stronger yen resulting from a shift toward tighter policy would help make hedging costs for owning Treasurys less onerous for Japanese investors as well, Lyngen and Jeffery wrote, “which over the longer term may begin to make Treasurys more attractive to Japanese buyers and add to the list of sources for duration demand.”
That could make U.S. debt more attractive to new Japanese buyers, Slok agreed.
But that’s oveshadowed by the near-term worry, Slok said, that existing Japanese investors will be inclined to sell Treasurys. Flow data will be very much in focus if the Bank of Japan follows through on the apparent trial balloon floated in the Nikkei report.
Investors will be watching, he said, to see “if the train is leaving the station.”
