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In response to the clear failure of past monetary policies to meet growth or inflation goals, the Bank of Japan (BOJ) on Wednesday unveiled a new tactic called “yield curve management.” It has effectively sidelined the emphasis on negative interest rates and buying virtually all of the government bonds in existence. These actions only served to disincentivize credit creation, depress bank profits and cause savers to hoard more cash to meet their income goals. BOJ Governor Kuroda said the central bank will maintain the current level of short-term rates but shift to a target for longer-term bond yields. While the stated “targets” for 7- to 10-year Japanese government bond yields are not far from present levels, the implication is that the BOJ intends to steepen the curve. 

Investors quickly understood this as a material shift in focus from real to nominal interest rates designed to prioritize growth, credit creation and bank profitability. Banking and insurance shares added to their prior gains and the yen strengthened relative to the U.S. dollar (USD). Mr. Kuroda directly highlighted a goal of generating an “inflationary overshoot” as this new policy framework of targeting nominal rates will likely extend stimulus well into a reflationary recovery period. In short, the central bank of the world’s second largest bond market has effectively abandoned policies that have supported one of the greatest bond bull runs in human history. Given that many of the new BOJ tactics have been outlined in the recent blogs of Ben Bernanke, I suspect the goal of driving long rates up will not be limited to Japanese central bankers. If true, then we may look back at the introduction of “yield curve management” as the beginning of a profound shift in relative asset pricing and performance.

Consistent with our “boiled frog” thinking, this policy experiment may initially not be overly disruptive to the crowded bond trade beyond modest losses for investors. However, as the liquidity and “exit doors” in most bond markets have been shrinking, a fall in prices could rapidly lead to panic selling and a rise in volatility.

 

Exhibit 1: Japanese REITs vs Banks Performance

Source: Bloomberg.

 

From a stock perspective, the potential for a steeper or more normal yield curve will directly benefit banking and insurance companies. REITs and other real estate-related income shares would suffer on a relative basis as long-term rates rose and NAVs fell. This would represent a sharp reversal from recent performance (Exhibit 1). The effective abandonment of central bank inflation concerns and the shift to nominal rates is strongly reflationary and would also support the performance of commodity and cyclical stocks. So this shift in policy in Japan could also act as a catalyst to deflate the low volatility/defensive stock bubble. Emerging market shares tend to also do well in reflationary environments, especially if the USD continues to weaken.  

Should the BOJ actions begin to catch on with other central banks in combination with expansionary fiscal policies, this could begin a shift in leadership from all things bond-correlated to long suffering value stocks, especially outside the U.S.