Bank of Japan unwinds its ETF purchase

The Bank of Japan announced on Sept. 19 that it would start selling its stock of exchange-traded funds -- showing it's still capable of surprising markets even after unwinding decades of unconventional monetary policy in recent years.

The ETF purchases -- an unprecedented policy for a major central bank -- began in 2010 in an effort to lower the cost of capital for Japanese companies. The program expanded significantly in 2013 during the era of "Abenomics." Today, the BoJ has JPY 37 trillion in ETFs on its balance sheet, and the central bank has effectively become a major shareholder in many blue-chip companies.

We've tapped fund-flow data from our partners at EPFR to show how private investment into Japanese ETFs evolved alongside the central bank's purchases and the Topix stock benchmark. For much of the past decade, the BoJ served as a “backstop buyer,” helping to stabilize markets during episodes of stress -- most visibly in 2016’s economic slowdown and the 2020 pandemic crash.

As the BoJ gradually sells off its ETF stockpile (at a pace of JPY 330 billion in book value per year), equity market watchers' focus will increasingly shift to private flows. That could be a problem.

As our second chart shows, inflows to domestic-domiciled equity ETFs have largely dried up since mid-May, according to EPFR. However, foreign investors remain net buyers of Japanese equities as they diversify from US assets.

The third chart turns to the composition of the BoJ's balance sheet. Stock ETFs rank third after loans and the dominant category -- Japanese government bonds (JGBs). This balance sheet will be in flux during "normalization" not only from the ETF reversal but the BoJ tapering its purchases of JGBs. The government bond yield curve has been steepening, reflecting this lessened central bank support and waning demand for the long end.

We conclude with the US-Japan yield differential, another key metric to watch for the Japanese stock market. Since the BoJ started hiking rates and the Federal Reserve started cutting, the spread has narrowed. Should it narrow further, the yen could strengthen -- potentially weighing on Japanese equities by pressuring exporters and reducing carry trade-driven liquidity.

At the same September meeting that saw the ETF surprise, the BoJ kept its policy rate at 0.5%, as expected. We previously demonstrated how the swap markets were predicting this outcome. Revisiting the JPY Overnight Index Swap (OIS) market, we can see that the 1/3-month differential widened significantly right after the meeting. That means rising odds of a rate hike in October.

However, perceptions of BoJ policy (and, in turn, the markets) could be upended should a past critic of the central bank's "normalization" become Japan's prime minister.

Sanae Takaichi stirred markets last year by calling the BoJ's rate hikes "stupid;" she also favors an expansionary fiscal policy. Her policy mix could keep the yen weak but drive long-end bond yields higher. She's considered one of the frontrunners to be leader of the Liberal Democratic Party when the vote is held on Oct. 4.

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