BOJ normalisation could strain global bond markets: ECB

5:27 am Wednesday, May 31st, 2023

FRANKFURT (Reuters) – Policy normalisation by the Bank of Japan could test the

resilience of global bond markets, the European Central Bank warned on Wednesday in an unusually strong message about policy prospects in another jurisdiction.

Bank of Japan (BOJ) Governor Kazuo Ueda has said the central bank is unwavering in its stance of patiently maintaining ultra-loose monetary policy, reassuring markets Japan will be a dovish outlier as its global peers combat stubbornly high inflation.

    But with inflation exceeding its 2% target, markets are rife with speculation the BOJ will soon phase out its massive stimulus programme that has been criticised for distorting market function and triggering an unwelcome yen fall that pushes up the cost of raw material imports.

“A shift away from the low interest rate environment in Japan could test the resilience of global bond markets,” the ECB said in its quarterly Financial Stability Review, arguing that higher rates at home could lead to a repatriation of vast sums held by Japanese investors overseas.

“Inflation in Japan has been increasing over the past year, leading market participants to expect the Bank of Japan to start normalising its monetary policy,” the ECB added.

Central banks around the world raised interest rates at break-neck speed over the past year and half but the BOJ has been the notable outlier, saying price pressures there seem transitory and vowing to keep policy super-loose until wage growth and consumer spending improves.

If Japan normalises policy, this could rechannel investments by Japanese investors who have a large footprint in global financial markets, the ECB warned.

“A rapid decline in rate differentials and increased exchange rate volatility could reduce the attractiveness of their carry trades,” the ECB said.

Policy normalisation could also lead to wider term premiums on local government bonds, which could also stimulate the repatriation of portfolio investments, the ECB added.

Such a withdrawal of Japanese investments could then have a material effect on bond markets elsewhere, particularly for more concentrated instruments, the ECB said, adding this process could be amplified by the increased net supply of bonds resulting from quantitative tightening in the euro zone.

(Reporting by Balazs Koranyi; additional reporting by Leika Kihara; Editing by Kim Coghill)