Amidst a backdrop of an improving economy and stabilizing inflation rates, discussions among the Bank of Japan officials have spurred considerable excitement and anxiety in the financial marketsThe prospect of adjustments to existing policies—including negative interest rates and yield curve control—has become the center of attentionObservers note a noticeable rise in 10-year Japanese government bond yields, an appreciating yen, and a subsequent pullback in Japanese equitiesSuch market movements echo widespread concerns about potential tightening in monetary policy, raising questions about how these transformations might reshape the financial landscape.

The plan to unwind what has been labeled as "ultra-loose monetary policy" appears to cast a shadow on the Japanese stock market, impacting both the numerator and denominator of equity valuation

The exit from negative interest rates could push bond yields higher, exerting downward pressure on equity valuations from a denominator perspectiveMeanwhile, changes to ultra-loose policies may further drive the yen's appreciation, potentially squeezing corporate profits within the stock marketSince 2023 began, close correlations between exchange rates and equity returns have been evident, as a weakening yen has provided a boost to exporters, crucially supporting the profitability of Japanese companies that derive a significant portion of their revenues from abroad; approximately 41.6% of earnings for companies listed on the Tokyo Stock Exchange emanated from overseas sourcesDuring earlier times, net exports bolstered Japan's economy; however, the transition away from ultra-loose policies may lead to complications in sustaining economic growth.

After numerous subtle adjustments, the definitive abandonment of the Yield Curve Control (YCC) policy is projected to have limited effects on bond yields

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For context, YCC was initially implemented by the Bank of Japan as a strategy to cap 10-year bond yields within a specific range through unlimited fixed-rate bond purchasesHowever, since August 2023, the BOJ has refrained from purchasing bonds indefinitely at a fixed rate, and the rigid upper limit for YCC was abolished during the September meeting, rendering YCC essentially ineffectiveYet, from a forward-looking market perspective, the current 10-year swap rate stands at a modest 0.89%, while the yield spread relative to the 10-year government bonds has narrowed to just 10 basis pointsThis indicates that market expectations for significant increases in bond yields are not particularly robust.

Furthermore, any substantial appreciation of the yen—is predicted to be relatively muted and is likely to have a delayed impact on exports, potentially softening the adverse effect on corporate earnings

In addition, as hedging costs rise, the crowded nature of the yen-carry trade diminishes the urgency to worry about substantial reversals affecting the yen's valueIt's essential to note that movements in the yen's exchange rate often precede changes in Japanese exports, and with the yen previously at relatively high levels in the same period, the depreciation may still support export growth for Japanese companiesIndustries such as semiconductors that rely heavily on overseas revenue exhibit a unique dynamic, as parts of their foreign income arise from direct investments rather than traditional exports, coupled with a degree of pricing power that can mitigate the impacts of a strong yen.

Moreover, Japan is gradually paving its way out of a "deflationary trap," revealing tangible internal momentum within its economyWith the exit from ultra-loose monetary policies, a transition to support for consumer and fiscal measures is expected to sustain economic recovery

On a fundamental level, Japan is steering towards normalcy, with projections for vibrant earnings growth from Japanese firms over the next couple of yearsRecent labor negotiations yielded significant results, with average wage increases for labor union members reaching 5.3%, which surpasses last year’s 3.8% raiseThis emergence of wage inflation could further catalyze Japan's departure from its deflationary constraints, contributing positively to economic normalization.

Also noteworthy is the ongoing dynamics concerning foreign investmentCurrently, the allocation of overseas capital towards Japanese equities remains relatively lowHowever, as reforms within the Tokyo Stock Exchange start showcasing tangible outcomes, Japanese firms are poised to enhance their attractiveness on the global stageSince 2022, a period marked by rising Japanese stock prices, there has still been a net foreign selling totaling ¥2.7 trillion

The present allocation levels appear insufficiently weightedMeanwhile, inherent advantages related to yen financing costs remain, and ongoing reforms are poised to further bolster the appeal of Japanese stocks for global investors.

In terms of market sentiment, the recent upward adjustments in Japanese equities have been underpinned by profit expectations, with several sectors now exhibiting relatively appealing valuations, thereby allowing for some room for further upsideWhile recent surges have slightly diminished the risk-return profile associated with the Nikkei 225 index—now at a risk premium of 3.7%, slightly below the one standard deviation of the past three years—the substantial contributions from profitability, risk-free rates, and investor sentiment still paint a promising picture overall for stocksSince 2012, the ascent of the Nikkei 225 has seen profits explain around 90% of the increase, with non-risk adjustments playing a considerably lesser role