BOJ yield curve control

THIS DOCUMENT IS A MARKETING COMMUNICATION: It has not been prepared in accordance with legal requirements designed
to promote the independence of investment research and is also not subject to any prohibition on dealing ahead of the
dissemination of investment research.
Cristiana Corno
Strategist
Global Markets-Trading
cristiana.corno@bancaimi.com
Data as of 26-Sep-16
GLOBAL STRATEGY
26-Sep-16
Market focus
QQE with yield control
BOJ has introduced a further step in unconventional monetary
policy: yield curve control via long term rate targeting and securities
buying. More precisely, the new framework consists of two major
components:
1. Yield curve control via long term rate targeting.
2. A commitment to inflation overshooting. The CB commits itself to
expand the monetary base (now 80% GDP up to 100% or 100
trillion JPY from current levels) in order to achieve and maintain
an above 2% inflation target.
Long term rate targeting
In history, long rate targeting has been used in war times (Fed
1
) and Latam to foster economic growth and
allow cheap fiscal financing.
More recently, their use as a possible source of additional monetary stimulus, has been discussed and
analyzed by the Fed in 2003.
In that occasion, the debate concluded in favor of QE which, in Fed thinking, would have ensured more
control on the bank’s balance sheet committing the bank to a finite quantity of buying.
Long term rate targeting has seen renewed interest more recently (Geneva report, IMF “Monetary Policy in
the New Normal”) in the debate on monetary policy’s unconventional tools, as a more flexible instrument to
add monetary stimulus, avoiding the distortion and limitation of QE buying.
One of the limit of QE is that it is quantitatively finite due to the dimension of the eligible pool of assets and,
as the market anticipate the limits, it undermines the central banks objectives in a self-fulfilling mechanism.
In the IMF paper “Portfolio rebalancing in Japan: constraints and implications for QE”, the authors calculate
that, taking in account demand for safe assets from banks and institutional investors (insurers and pension
funds), the BOJ, under current policies, would have to taper, starting 2017-2018. In the same paper moving
to interest rate targeting is mentioned as a possible solution out to QE-finity.
In chart below, we show how much the BOJ holds of each subsector and which is the average holding on
outstanding per maturity buckets.
Figure. 1 – BOJ holding along maturities and % of holding on outstanding amount in each maturity
bucket. Source BOJ, Banca IMI
Table. 1 – Non government
1
https://www.federalreserve.gov/monetarypolicy/files/FOMC20030618memo01.pdf
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
2 5 7 10 15 20 30 >30
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
2 5 7 10 15 20 30 >30

2
THIS DOCUMENT IS A MARKETING COMMUNICATION: It has not been prepared in accordance with legal requirements
designed to promote the independence of investment research and is also not subject to any prohibition on dealing ahead
of the dissemination of investment research.
Long rate targeting as a monetary policy instruments: pro and cons
Theoretically, long-term yields reflect the expected future path of short-term interest rates and a time-varying
maturity premium
2
. The arguments that support long rate targeting as an instrument of monetary policy are:
• since the targeted long rate communicates to the markets a path for future interest rates, it reduces the
risk of hitting ZLB, if not there, while enhancing forward guidance with a stronger commitment (use of
balance sheet);
• it shields the economy from unwanted rise in term premiums due to risk aversion or demand-supply
shocks;
• it allows the CB to focus on the relevant rates for spending/investment decision.
Sinthetically, long rate targeting includes the strength of both forward guidance and QE. The downside are:
• the potential risks to CB balance sheet, given unpredictable path of asset purchases necessary to keep the
target (credibility and potential economic losses);
• the loss of CB independence due to fiscal dominance (monetary policy subordinated to cheap financing).
In literature, there are not definitive conclusions on the instrument: the IMF review (2014) concludes that
there are insufficient theoretical or empirical work to conclude that the benefits outweigh the costs and that
the operational hurdles can be overcome.
Fed experience
3
highlights three important issues on long term rate targeting:
1. There is not clear evidence that the government cap is effective in holding down the general yield level.
2. It is important to have an exit strategy to avoid market disruptions.
3. By directly managing the Treasury financing cost, it increases the potential conflicts between CB and fiscal
authorities.
In terms of market implications, long rate targeting is expected to increase in relative the volatility of short-
medium term rates (Woolford
4
comment, 2005). On BOJ announcement rate volatility has, in fact, decreased
overall with 10y maturity underperforming more.
Figure. 2 – 1y forward volatilities for 5y,10y and 20y maturities and fly Source: Bloomberg,
Banca IMI
Rate-targeting and QE differences
Both targeting longer-term rates and quantitative easing involve buying of large quantities of securities; the
first sets a quantity, the other sets a price.
In QE, the CB commits itself in buying a fixed quantity of securities, without determining directly yields.
In rate-targeting, CB specifies the yield it is trying to achieve and the quantity of securities becomes a
consequence of the CB’s credibility and other factors (securities supply and demand).
Relative to QE operations, interest-rate targeting has some positives:
• achieves: greater certainty about the interest rate that will result from the policy, potentially
reducing both the level and volatility of interest rates;
2
Gürkaynak and Wright, 2012.
3
4
http://www.columbia.edu/~mw2230/CRcomment-LongTermInstrument.pdf
15
20
25
30
35
40
45
50
55
60
JPNE110 ICPL Curncy JPNE15 ICPL Curncy JPNE120 ICPL Curncy
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
vol 10520 fly

3
• a well-designed framework has the potential to reduce the magnitude of purchases required to
keep interest rates near desired levels, giving the CB more flexibility and limiting market distortion;
and negatives:
• it generates great uncertainty about the quantity of securities that will be added to the central
bank’s balance sheet, with the consequences in term of credit risk and potential loss in case of
adverse market move;
• it could be interpreted as being fiscal dominance (allowing cheap financing to the Treasury).
Long term targeting design
In the Fed note
5
, discussing long term rate targeting two features are considered in the targeting design
framework: horizon and hardness of target.
Targeting yields at short- and intermediate-term horizons implies a less frequent need to adjust them sizably,
it make the exit strategy easier and gives to the policymakers probably more visibility on the optimal yield
level. On the other side, targeting long term rates provide more stimulus to the economy.
In a “hard” target regime, operations are designed to keep yields continuously at the targeted level, while in
a “soft” target they are adjusted on a periodic basis. The hard line is attractive, because it reduces
uncertainty about yields, but it carries substantial risk as the targeting horizon lengthens: possible large
increase in the size of balance sheet to defend it and significant capital losses for the central bank in the cap
exit.
BOJ “yield curve control”
In its new monetary framework, BOJ has chosen a “long term soft” target, that can be reviewed at each
policy meeting, thereby mitigating the potential risk of disruption in the cap exit. From now on, the outcomes
of next BOJ meeting will be the short and long term rates. Besides, BOJ buying will shape the rest of the
curve according to its view on the optimal interest rate path and forecasted sensitivity of the economy to
each different curve bucket. The introduction of “Yield curve control” is justified in order to avert excessive
flattening and control financial stability (banking and insurance system safeguard), but it has also strong
implication for monetary policy and fiscal policy financing.
• Regarding monetary policy, the new approach gives to the BOJ the ability to design the desired yield
curve, taking in account the economy sensitivity to the different maturity buckets
6
.
• The commitment to the 2% inflation target, the control of long term rates, the fiscal stimulus, all go
in the direction of more coordination, “synergie” between fiscal and monetary policy in a soft form
of “monetary financing”. Long rate targeting happens to be “part 2” of “what tools does the Fed
have left?” in the Bernanke blog, being Part 1 and 3, respectively, Negative Rates and Helicopter
money.
Summarizing, the positive of the new frameworks are:
1. If credible, it will allow BOJ to maintain yield control without the limitation (quantity) and distortion(supply
demand imbalances) of QE and possibly reducing the amount to be purchased and relatively market
distortions.
2. The CB could act on the shape of the curve communicating to the market the exact path of interest rates
3. BOJ will be still be able to ease further monetary policy with further cut in rates, and increasing the pool
of eligible assets.
4. It will provide support to the fiscal stimulus avoiding a sharp increase in rates, if the stimulus has real
effect on the economy.
On the negative side:
5. The framework creates risk in the BOJ balance sheet developments, in case of abrupt increase in yield
level. The risk is reduced by being the long term target “soft”.
6. The market could test the CB on the downside. For what we understand, under long term targeting the
BOJ should sell the bonds, thereby, reducing the monetary base and liquidity of the system (currently
huge). BOJ could as well twist or barbell the purchases (selling the long end to buy shorter term, or
5
6
In a recent paper, “The natural yield curve: its concept and measurement” by Kei Imakubo, Haruki Kojima
and Jouchi Nakajima, June 2015, BOJ estimates a natural real yield curve, which can be used as benchmark
for monetary policy.

4
barbelling long and short maturities to sell 10y to maintain the monetary base unchanged), in order to
maintain the curve shape, but still this will hit the limit of QE buying (issues availability) and the floor of
the deposit rate, ending up with forcing the BOJ to lower further the short term rates.
With this premises, it will be difficult to express a market view on the JPY curve. Curve movements will
probably become more directional. Sub 10y we would expect asset swap steepening in a bull move and the
opposite in the bear move.
BOJ new framework, could be hardly be implemented in Europe, but the ECB postponement of QE process
revisions make us suspect that they may be thinking at something similar. We will wait for next ECB meeting
for eventual hints.
Table. 1 – Non government

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Document produced on 26 settembre 2016 at 15.13 and disseminated for the first time on 26 settembre 2016 at 15.16

BOJ yield curve control

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