MNI POLICY: BOJ Wary As 10-Year Yield Rise Hits Some Banks

Bank of Japan officials are closely watching banks unable to dispose of bond losses triggered by December's shock widening of the 10-year yield target to gauge whether their ability to lend or serve their intermediation role has been impaired, MNI understands.

Commercial banks, particularly regional financial institutions, that had lengthened the duration of their government bond portfolios to seek higher returns have been hit by the BOJ’s decision to widen the band to 50bp from 25bp. (See MNI BOJ WATCH: Kuroda Dismisses Market Speculation On YCC Hike)

Some banks find themselves in a position of having to hold these bonds as any sale would crystallise a loss, which in turn would lower their capital base. A diminished capital base would make it difficult for these banks to take risks in the form of new loans and would worsen their intermediation role in the financial system.

Bank officials expect the stability of financial system to be broadly maintained but they are alert to the risk that higher interest rates and a considerably weaker economy at home and overseas could lead to a deterioration in the banking environment. Some banks that have adequate capital strength can dispose of unrealized bond losses through sales of those bonds and then shift to high-coupon bonds. (See MNI POLICY: BOJ Watching Real Estate, Bond Threat To Banks)

Bank officials remain vigilant against the adverse impact of the inverted U.S. yield curve on Japanese banks, although the situation is assessed to have not worsened. Despite the rapid and big rate hikes by the Fed, financial burdens among firms and households haven't risen significantly as they hold ample liquidity due to government subsidies to minimise the impact of Covid-19.

FED IN FOCUS

The Fed’s large rate hikes are expected to weigh significantly on the economy, firms, and households, but BOJ officials cannot predict the scale of any economic downturn and its timing.

A potentially worrisome scenario is if the U.S. economy doesn’t weaken and U.S. inflation rate doesn’t fall as much as the Fed predicted, the BOJ warns. This would likely prompt the Fed to hike rates and increase the risk of stagflation in the U.S., which would dampen Japan’s exports and production.

Weaker exports and production, coupled with softer private consumption, would impact Japan’s economy and worsen the output gap, which will reduce upward pressure on prices and derail the economy from moving towards the BOJ's 2% price stability target.

The Fed’s Financial Stability Report released in November warned that U.S. rates "increase beyond levels currently expected" and U.S. economic activity could "slow substantially if inflationary pressures prove to be more stubborn than anticipated.”

“These developments would weaken the debt service capacity of households and businesses and lead to an increase in delinquencies, bankruptcies, and other forms of financial distress,” the FSR said.