Quick take on the BoJ shock rate cut

Posted on January 29th, 2016

The Bank has cut the effective cash interest rate to -0.1% from +0.1% (-20bp).  Banks will be required to pay 0.1% on balances held in their current account that are above a certain threshold.

In order not to tax banks too much, the BoJ has introduced a three-tier system with current account balances up to the first tier still earning 0.1%, zero on the second tier and -0.1% on the third tier.

This third tier rate will be the most relevant to money market rates since, with excess reserve balances in the system generated by the BoJ QE purchases of JGBs …. this third rate of -0.1% should operate as the marginal cost of excess reserves.

The BoJ’s statements today emphasis this point that the policy is designed to push down short term rates, and its QE policy will operate to transmit this lower rate policy across the curve.

The bank said that it will conduct its purchases of JGB assets, “With a view to encouraging a decline in interest rates across the entire yield curve.” (The amount JPY80tn net per year and the average maturity of purchases (7-12 yrs) were unchanged from the previous December meeting).

The Bank says, “As before, the Bank will not set a lower bound for yields on its JGB purchases.  Thus, the Bank can carry out outright purchases of JGBs with negative yields lower than minus 0.1%.”

The bank said, “It will cut the interest rate further into negative territory if judged necessary.”

“The Bank will lower the short end of the yield curve and will exert further downward pressure on interest rates across the entire yield curve through a combination of a negative interest rate and large-scale purchases of JGBs.”

In a Q&A style supplementary release the BoJ answers a question probably flummoxing the market:

“Will a negative interest rate be effective under the three-tier system, given that the negative rate will be applied partially?

The Bank answers as follows.

“Transaction prices in financial markets (e.g. interest rates, stock prices, and exchange rates) are determined by marginal losses or gains made in a new transaction. Although a negative interest rate is not applied to the total outstanding balances of current accounts, costs incurred with an increase in the current account balance brought by a new transaction will be minus 0.1 percent if it is applied to a marginal increase in the current account balance. Interest rates and asset prices will be determined in financial markets based on that premise.”

Furthermore, the BoJ even says that if banks choose to increase their cash holdings (I presume they mean physical currency?) instead of placing this cash on deposit at the Bank of Japan in its current accounts, then the BoJ will charge banks 10bp on the second tier balances in a principle equal to the increase in the banks physical cash holdings.  In other words, if banks try and get around paying -10bp, the BoJ will charge them on the tier where they set rates ate zero.

Market interest rates in Japan appear to more-or-less agree with the BoJ on the effectiveness of this policy.  2 yr swap rates are down 7.8bp to 0.016%.  2yr JGB yields are down 2.1bp to -0.052%.  10 year JGB yields are down 8.6bp to 0.0143%

Euroyen 3mth futures contracts are down in yield 6 to 10bp.  3mth overnight interest rate swap rate is down 6.5bp to -0.013%.

If fully implemented as the BoJ intends, there appears room for rates to fall further towards -0.10% across the front of the curve, and exert more downward pressure across the curve.

The interest rate cut decision was another close vote 5-4 majority (the same was the case in Oct-2014 when the Bank expects its QE, and it doesn’t mean much).

The rate cut comes out of the blue, and is another shock tactic from the BoJ.

The bank will continue to operate its term loan programs to support financial institutions in disaster areas.  But has lowered the lending rate to zero from 0.10% to zero.

The bank has maintained the same QE amounts on ETFs and J-REITS.  And continues to hold the same outstanding’s in CP and corporate bonds.

The FX market has been extremely volatile in the wake of this announcement, but we see a persistent move to the downside for the JPY, particularly against higher yielding and risk sensitive currencies, including the AUD.

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