By Bill Witherell
Japan's central bank, the Bank of Japan (BOJ), undertook this past week a first test of its new policy of "yield curve control." In proclaiming that policy in September, the BOJ set a target for the yield on 10-year government bonds at "around 0 percent."
Japanese bond yields advanced last week, following with a lag the sharp rise in government bond yields globally that was stimulated by the expectation that the coming Trump presidency would bring faster economic growth and increasing inflation. On Thursday, the BOJ stepped in, offering to buy unlimited amounts of government bonds with terms between one year and five years at a fixed price slightly below prevailing prices. No banks offered to sell government bonds at the fixed prices. In the wake of the BOJ's offer, the short end of the yield curve became less steep. The markets appear to have gotten the message that the bank is both ready and able to intervene to keep yields from rising too far. The one-to-five-year focus of the BOJ's action probably responded to the particularly sharp increase in the spread between the one-year and five-year bonds that had developed.
The BOJ did not find it necessary to offer to buy 10-year government bonds on Thursday, or on Friday when the 10-year JGB rose to 0.035%, the highest level since mid-February. This led some commentators to wonder what "about zero percent" means. The BOJ carried out one of its regular quantitative easing operations on Friday, which made it a poor day to also take action to defend the 10-year rate. The latter action may well be needed in the coming days.
The latest economic data for Japan suggest that a modest recovery is finally taking shape. The preliminary real GDP growth for the third quarter was at 2.2% annual rate, the third quarter in a row of positive growth. Before that, the last interval of positive growth spanning three quarters was in 2013. The final Markit/Nikkei Purchasing Managers Index (PMI) for October was the strongest since January. Output rose the most in 10 months. Exports were solid and should be more so with the recent weakness in the Japanese yen. Employment income (wages per worker times the number of workers) is growing and should strengthen consumption going forward. There will also be important support from the projected fiscal stimulus, including higher spending for defense. President-elect Trump's call for Japan to spend more for Japan's defense coincides with Prime Minister Abe's own wish to strengthen the nation's military capabilities. There will be ample opportunities for Japan to buy more US military hardware and for the two countries to cooperate on military research and development.
A first meeting between Abe and Trump occurred Thursday and reportedly went well. There should be agreement on maintaining the US-Japan Security Treaty. The greatest threats for the Japanese economy relate to the future Trump administration's stance on trade policies. The Trans-Pacific Partnership (TTP) strongly supported by Abe and opposed by Trump now looks as though it will not be completed. The greater trade risk is that the Trump administration may take a hard-line, protectionist trade policy stance that leads to a global wave of protectionism, seriously impacting global trade and growth.
Japan's equity markets have been improving, with the Nikkei index on Friday ending up 20% from its June low, which puts the index in "bull market" territory. The market is being driven by a weaker yen, robust US economic data, and the strengthening economic recovery in Japan. Japan bank stocks have rallied in response to the movement of bond yields into positive territory.
The weakening yen, down 9% over the past three months, has hurt the returns of unhedged Japan ETFs for US dollar-based investors. The unhedged iShares MSCI Japan ETF (NYSEARCA:EWJ) is up only 1.17% on a total return basis over the past three months, while the corresponding currency-hedged version of this ETF, the iShares Currency Hedged MSCI Japan ETF (NYSEARCA:HEWJ) is up 11.23% over this period. We are using the WisdomTree Japan Hedged Equity Fund ETF (NYSEARCA:DXJ) which, in addition to the currency hedge, selects export-oriented, dividend-paying firms and weights them by the dividends. These factors contributed to its 14.71% total return over the past three months. In contrast, the iShares MSCI All Country ex-US ETF (NASDAQ:ACWX) registered a total return of -4.15% over the same period. We are continuing to maintain our largely hedged Japan positions in our International and Global ETF portfolios.