By the end of July, an unexpected move by the Bank of Japan (BOJ) set off global market fluctuations, with the yield on the 10-year Japanese government bond facing upward pressure.
Morgan Stanley's latest research report mentions that the BOJ is sticking to a 0%-0.5% fluctuation range for the 10-year bond rate, but it will allow for rates above 0.5%. This is achieved by fixing the bond-purchasing rate at 1%, essentially similar to expanding the upper limit of the Yield Curve Control (YCC) range to 1%.
After last week's meeting, Kazuo Ueda explained that a key motivating factor behind this decision is to prepare for the risk of inflation. Analysts from Morgan Stanley highlight that the BOJ has successfully distinguished the "adjustment of YCC" from "monetary policy normalization", which has anchored short-term interest rate expectations, thereby stabilizing the Yen interest rate.
Unexpected bond-purchasing actions to control yield
On July 31, the yield on the 10-year Japanese government bond soared to over 0.6%, prompting the BOJ to announce unplanned bond purchases to curb the rise in yields. On August 3, the 10-year Japanese government bond yield rose by 1.5 basis points to 0.640%, a nine-year high, prompting the BOJ to act again, announcing the purchase of JPY 400 billion ($2.8 billion) in government bonds. This caused a slight retreat in the 10-year bond yield.
Moh Siong Sim, a foreign exchange strategist at the Singapore Bank, pointed out that the BOJ's twice-weekly unplanned bond-buying operations show that it is intent on controlling yields and will not tolerate a short-term rise to these levels.
Bright outlook for Japan's 10-year OIS price
Considering the 10-year Overnight Index Swap (OIS), Morgan Stanley believes that Japanese investors may seek to hedge before summer, which would apply downward pressure on the yield. They recommend direct purchase of the 10-year OIS given its current low price.
Analysts suggest switching from holding the 10-year Japanese government bonds to the 10-year OIS directly due to potential demand from banks and the uncertainty of the BOJ's policies.
Curtailing expectations of Yen devaluation
Morgan Stanley suggests that foreign exchange prices have had a relatively limited reaction to the BOJ's "unexpected fine-tuning", as the market now understands this is not the first step toward "normalization". Given Japan's long-standing lack of boosters to stimulate the Yen, this move is expected to help control devaluation expectations.
Preparing for a 6-12 month rise in Japanese stocks
Morgan Stanley believes that the BOJ has successfully made its policy more flexible without signaling the start of a tightening cycle. The decision to cap the 10-year Japanese government bond yield at 1% will contain tail risks for the domestic financial industry and help to suppress expectations of yen depreciation.
Favorable industries
In the market, Morgan Stanley favors industries focused on Japan's domestic market, rather than export industries, and is optimistic about the transportation and construction sectors.
Nomura previously also believed that the BOJ's "surprise" was the "last piece of bad news" for Japanese stocks and cited three reasons to continue to promote Japanese stocks. The most significant being the market's wider recognition that YCC adjustments will not directly lead to an increase in key short-term interest rates (-0.1%).
