The uncertain global macro environment has understandably dominated investor thinking and press reporting over the past 12 months—from heightened geopolitical tensions to rising inflation and interest rates, to the stress in the U.S. banking system and fears of a potential U.S. recession. One market that has perhaps flown under the radar amid all the macro noise is Japan, with the broad TOPIX Index hitting a 33‑year high in May.1 The post‑pandemic reopening of the Japanese economy, ongoing structural market reforms, and the fact that many of the global macro risks appear to be fully priced into Japan market valuations have all played a part in driving Japan’s strong performance year‑to‑date. What’s more, the Japan story is gathering momentum, and the outlook appears positive.

Relative to other major world economies, Japan remains a policy outlier. In a global environment of heightened inflation and rising interest rates, the Bank of Japan (BoJ) continues to hold short‑term interest rates at ‑0.1% while reiterating its 0% target for 10‑year Japanese government bond (JGB) yields. It continues to adhere to its large‑scale bond‑buying yield curve control (YCC) strategy, with 10‑year JGB yields allowed to fluctuate in the range of around +/‑ 0.5% from the target 0% level.

The idea behind the strategy is to control the shape of the yield curve, specifically to suppress short‑ to medium‑term rates, which affect corporate borrowers, without depressing super‑long yields too much and reducing returns for pension funds and life insurers. YCC worked well when inflation was low; however, as inflation has started to rise, investors have sold low‑yielding bonds, forcing the BoJ to ramp up its buying to maintain its yield range target. Amid growing criticism of distorting market pricing, the strategy has caused the value of the yen to fall sharply and, in turn, inflated the cost of raw material imports.

On April 9, 2023, Kazuo Ueda was announced as the new governor of the BoJ in a surprise move that raised hopes of a potential shift toward policy normalization in Japan. Such a move would be significant for Japan, unwinding policies that have kept the yen depressed for years, while higher rates would also help to encourage the trillions of dollars of Japanese cash back onshore, having been lost to higher overseas rates. In the short time since his appointment, Ueda has acknowledged that the bank’s current ultra‑loose policy is not sustainable; however, he has also indicated that the BoJ is in no rush to push through changes.

A prime consideration for any potential shift in policy is inflation. Core consumer price index (CPI) inflation rose at an annual rate of 3.4% in April, above the BoJ’s target 2% rate but sharply down from the multi‑decade‑high 4.2% recorded in January. However, the preliminary outcome of the annual spring wage negotiations between company management and labor unions, known as shunto, offer encouragement that inflation may at last be sustainable. Initial data point to an overall year‑over‑year wage increase in the range of 3%, which would be the highest number since the early 1990s. Such a wage increase will put pressure on the newly appointed BoJ governor to move forward with the normalization of Japanese monetary policy—the likely first step being the removal of the current yield curve control policy (Figure 1).

At its policy meeting in December 2022, the BoJ shocked the market by announcing a tactical change to its yield curve control strategy, shifting the band from +/‑ 0.25% of its target 0% interest rate to +/‑ 0.5%. This was a hugely unexpected policy change. The BoJ remains adamant that this is not a precursor to a broader policy pivot (yet) and insists that it wants to see durable signs of inflation above 2% before it tightens policy.