What Japan's New Monetary Policy Means for Investors

A Look at Japan's Bold and Controversial New Monetary Policy

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The Bank of Japan introduced a controversial new monetary policy strategy in September 2016 after struggling for decades to jumpstart inflation. Under the new policy, the central bank will keep the yield on 10-year government bonds at zero by adjusting the pace of its bond buying. The move comes at a time that many central banks have reached the limits of conventional monetary policy — forcing them to consider new options.

In this article, we will take a closer look at Japan’s bold new policies and what they mean for international investors.

Japan’s Bold New Policies

The Bank of Japan introduced new policies that will keep the yield on 10-year government bonds at zero (above current rates) by adjusting the pace of its bond buying. In addition, the central bank indicated that it would maintain negative interest rates and even deepen them in the future to reach its target 2% inflation rate. These measures could help steepen the yield curve by keeping long-term rates steady while dropping short-term rates.

The new policies also eliminate the Bank of Japan’s responsibilities to purchase set quantities of government bonds each year within certain maturity brackets. With the central bank already holding nearly a third of the market, there were concerns that it would run out of bonds to buy at some point. The steeper yield curve could further help improve bank profits that have suffered from a flat yield curve  since they borrow short-term and lend long-term.

Central banks have historically focused on controlling short-term interest rates, while leaving long-term rates in the hands of the market. While there have been some exceptions, such as the Federal Reserve’s actions after WWII to keep wartime debt cheap, the move could force banks to buy an unlimited number of bonds.

Some experts, like former Federal Reserve chairman Ben Bernanke, believe the move was the right one to make.

Impact on the Financial Industry

The Bank of Japan’s new policies will have the biggest impact on the financial sector, which depends on the yield curve to generate interest income. The central bank’s goal is to steepen the yield curve by controlling long-term rates, but at the same time, the move introduces uncertainty into the market. If successful in igniting inflation, the policies could bring about a significant long-term improvement in the economy and Japanese stocks.

While the Bank of Japan is optimistic about bank profits, some analysts are skeptical that the unconventional approach will be successful. Fitch indicated that the move could lead to ‘unintended consequences’ for the financial sector. The ratings agency warned that the unconventional approach could encourage banks to become even more cautious, while distortions in the bond markets could leave them vulnerable.

What This Means for Investors

The most common way for international investors to gain exposure to Japan’s economy is through exchange-traded funds (“ETFs”). Since these funds trade on U.S. exchanges, they can be easily purchased and sold without worrying about foreign taxes or brokerage accounts.

The most popular Japanese ETFs include:

  • iShares MSCI Japan ETF (EWJ)
  • WisdomTree Japan Hedged Equity ETF (DXJ)
  • Deutsche X-trackers MSCI Hedged Equity ETF (DBJP)
  • iShares Currency Hedged MSCI Japan ETF (HEWJ)
  • WisdomTree Japan SmallCap Dividend Fund (DFJ)

Aside from the direct exposure from these ETFs, investors should keep in mind that Japanese equities account for a significant portion of developed country and Asian ETFs. For instance, Japanese equities account for about 10% of the SPDR Global Dow ETF (DGT).

Conservative investors may want to consider reducing their exposure to Japanese equities until there’s a bit more certainty. On the other hand, speculative investors that are confident in the success of these policies may want to buy exposure through Japanese ETFs.

The Bottom Line

The Bank of Japan’s new monetary policies will target 0% interest rates on 10-year government bonds at all costs, while retaining the right to cut short-term interest rates further into negative territory.

These moves should steepen the yield curve and improve bank profits, but some analysts believe there could be unintended consequences. International investors may want to reevaluate their exposure to Japanese equities in light of these new policies.