UK pension schemes need to be aware of what is happening at the Bank of Japan as the outcome of a key risk to UK real yields is gradually being determined in Tokyo.

Over the past several years global bond markets have been influenced by the propensity for Japanese investors to favour non-domestic investments.

In yen terms, investing overseas on a hedged basis has offered Japanese investors better returns from those available in Japanese Government Bonds (JGBs).

That’s changing. A factor that has helped keep real yields low outside of Japan – even whilst inflation has soared – is being removed. Now, JGBs are increasingly looking more attractive to domestic investors than bond markets elsewhere.

Part of the explanation is to be found in the flattening of US, UK and European curves. Japanese monetary policy and the steepening of the JGB curve have played their part too.

Despite domestic inflationary pressures JGB curve steepening has actually been relatively modest. This is due to the Bank of Japan’s yield curve control measures (i.e. their willingness to buy unlimited JGBs and maintain a predetermined range for 10 year yields).

Our view is that yield curve control won’t last forever. It is set to be removed this year.

Whilst the pace of policy normalisation has so far been slow, any unexpected acceleration would further improve the attractiveness of JGBs to domestic investors. This will have profound implications for real yields around the rest of the world.

The upcoming monetary policy meetings from April will be pivotal.

Update from March 10 2023

March’s meeting was Haruhiko Kuroda’s last as Governor. The meeting was convened amidst an unhelpful macro-economic background. Industrial production is weakening, inflationary pressures are broadening but, pressure from wages is modest despite a tight labour market. Neither has today been ideal timing, coming just before Japan’s traditional fiscal year-end

As we expected there were no changes to yield curve control and a negative policy rate of -0.1% remains in place.

A desire to ensure market stability into the fiscal year-end has prevailed. Kuroda is now passing over the big decisions to his successor, who will have to see them through. The initial market reaction was rather muted although the yen did weaken a little and JGB yields fell.

Next month in Japan

• April 27^th/28^th will be the first meeting for now confirmed new Governor; Kazuo Ueda
• Last month Ueda, expressed a willingness to persevere with easy policy settings – if a 2% inflation target could be sustained – but accepted the need to normalise policy sometime
• Inflation trends will be further developed in April. A continuation of the present trajectory will put pressure on the Bank of Japan to act
• Similarly to March, April’s meeting is not ideally timed: just before Golden Week holidays. The next meeting after that is June 15^th/16^th 

If inflation is still on an upward path in April Ueda may feel obliged to make changes to yield curve control (or at least indicate a willingness to make intra-meeting adjustments given how far away mid-June will feel at that time).

Further ahead

We expect inflation to begin to ease in Japan through the course of this year. Global supply chains are normalising and as fiscal policy lowers inflationary pressures. This sets up a difficult path for the Bank of Japan to navigate. They must balance their price stability mandate against market pressure to end their yield curve control policy, potentially leading to market dysfunction.

UK schemes have seen more helpful trends for UK inflation and gilt yields since the turmoil of last Autumn. Looking ahead it could well be that Japanese inflation and JGB yields will become the more important indicators to watch.

The investment risks faced by UK schemes sometimes arise in remote and unexpected places. Cardano’s approach to combining globally diversified multi-asset growth portfolios, with best-in-class LDI and cashflow matching, provides schemes with the tools to navigate today’s challenging investment markets.