Part 2: Effect on Bond and Currency Markets
Yield Curve Control (YCC)
In September 2016, BOJ introduced the YCC framework, which attempted to increase the money supply through purchasing long-term Japanese Government bonds (JGB) and to bring the 10-year JGB yield above negative territory. YCC worked, with the yield rising above 0% and remaining above 0% for the next few years. The Japanese bond market was much less volatile than that of US or Germany; however, volatility did pick up after the BOJ announced it would widen the 10-year yield fluctuation band to ± 20 basis points. This saw the yield’s volatility increasing, with the yield once again dropping below 0%.
JGB yield spreads between the 2-year and 10-year government debt collapsed in 2016 after the negative interest rate announcement. The collapse came about because the short-term and long-term yields converged. Short-term yields fell due to central banks’ target interest rates, and long-term yields fell from the heaving buying of long-term bonds (derived from an increasingly negative outlook). Apart from the expected impact on bank profitability and changes in economic outlook by investors, the collapse of the yield spread posed liquidity issues. It was suddenly more difficult for investors to make money by profiting on the spread between short- and long-term yields, discouraging investors from trading in this manner.
In theory, higher interest rates in a country increase the value of that country’s currency value relative to other nations offering lower rates. This is because higher interest rates have a tendency to attract foreign investment, increasing the demand for the home currency. Contrariwise, lower interest rates tend to be unattractive for foreign investment and decrease the currency’s relative value. However, we will see that such simple straight-line calculations did not apply when the ECB and BOJ implemented negative interest rates.
When the ECB cut rates in 2014, investors moved money into Europe rather than exiting it. The Euro (EUR) currency rose in value relative to the US Dollar (USD), the Swiss Franc (CHF) rose relative to USD, and the EUR rose relative to the CHF. The underlying reason was the prolonged fear from investors due to global events that were taking place in 2016 such as the US political tensions, North Korean earthquakes and Brazilian political crisis. Investors had moved money into Switzerland and other parts of Europe because it is regarded as a safe haven due to its stable economic history and long tradition of secure banking.
The problem arose when imports into Switzerland were becoming too expensive for a country that relies heavily on it. The Swiss National Bank (SNB) imposed a cap on the exchange rate at CHFEUR=1.20 to stop import costs rising any further. However, when the ECB announced its intentions to start quantitative measures to support the economy, the SNB was not able to support the cap any longer, forcing them to lift it. Within days, the SNB also announced a cut of interest rates to -0.75%, which saw the currency fall sharply and gradually fall for the next few years.
When BOJ announced negative rate cuts, Japan saw its currency depreciate in value relative to USD. This is because falling currencies tend to encourage exporters and discourage importers which enhances a countries competitiveness and assist in the economic downturn recovery. Despite the Japanese Yen being considered a safe haven like the Swiss Franc, the conventional theory held for Japan and the negative rates negatively affected its currency.