Yield Curve Control and Exchange Rate: What Are the Implications

Yield Curve Control (YCC), a monetary policy tool introduced by the Bank of Japan (BoJ) in September 2016, has been a subject of intense scrutiny due to its significant impact on both the domestic bond market and the exchange rate.

The BoJ implemented YCC in response to persistently low inflation and declining inflation expectations. This policy involves targeting a specific yield, typically the 10-year Japanese Government Bond (JGB) yield, through a combination of communications and asset purchases. Unlike traditional Quantitative Easing (QE), which focuses on buying a predetermined amount of bonds, YCC aims to control the yield curve directly.

One of the key challenges facing the BoJ is the desynchronization of monetary policies between Japan and other major economies, particularly the United States. The Federal Reserve's rate hikes have led to a significant widening of the yield differential between US Treasuries and JGBs, exerting upward pressure on JGB yields. This has forced the BoJ to adjust its YCC policy gradually, including widening the control band for the 10-year JGB yield from +/-10 basis points to +/-20 basis points in July 2018.

The impact of these adjustments on the exchange rate has been pronounced. The weakening of the yen, driven by the divergence in monetary policies, has increased the risk of higher inflation in Japan. A weaker yen makes imports more expensive, which can fuel inflationary pressures. Furthermore, the risk of a sudden appreciation of the yen, or 'snapback,' once the BoJ tightens its policy, is a significant concern. This snapback could be exacerbated by investors closing their carry trade positions, where they borrow in low-interest-rate currencies like the yen to invest in higher-yielding currencies.

The BoJ's cautious approach to policy normalization is understandable given the domestic and international risks involved. However, this slow approach has led to investor disappointment and further yen depreciation. For instance, recent expectations of a decisive change to YCC were not met, leading to a significant weakening of the yen before it partially recovered.

The effectiveness of YCC in managing the yield curve and its implications for market liquidity and transaction volumes are also noteworthy. Studies have shown that while YCC can reduce bid-ask spreads and increase transaction volume in the JGB market, it can also lead to a nonlinear widening of spreads if the BoJ's holdings of JGBs exceed a certain threshold.

In conclusion, the interplay between YCC and exchange rates is complex and influenced by a range of factors, including global monetary policy dynamics and domestic economic conditions.

Reference Articles:

• 'Japan: Yield curve out of control?' (BNP Paribas, Economic Research)
• 'The Impact of Quantitative and Qualitative Easing and Yield Curve Control on the Functioning of the Japanese Government Bond Market' (Bank of Japan)