The Bank of Japan's balance sheet reduction brings liquidity shock and Japanese stock market faces headwinds test.

The Bank of Japan is cautiously adjusting its strategy for withdrawing from the bond market, but the fact remains that quantitative tightening measures are already being implemented and may lead to instability in some stocks. The potential impact of quantitative tightening policies may cast a shadow over further gains in the Nikkei 225 index, as the index reached a four-month high this week. The blue-chip index is mainly composed of growth stocks, such as Fast Retailing, the parent company of Uniqlo, as well as chip-related companies Advantest and Tokyo Electron. In addition to growth stocks that are known to be easily affected by higher bond yields, large-cap stocks are also vulnerable. Akemi Hatano, Chief Quantitative Analyst at SBI Securities, stated that the negative correlation between these stocks and bond yields is strengthening. This highlights the need for investors to remain cautious, even though the Bank of Japan announced this week that it will slow down the pace of reducing its bond purchase program. This measure is seen as a move to stabilize the market after recent significant increases in Japanese government bond yields (affecting global bond markets as well). Hatano said, "The rise in bond volatility will have a significant impact on how investors choose stocks. When bond volatility spikes, large blue-chip stocks will be affected because these stocks are the easiest tool for investors to reduce risk when they want to reduce risk exposure in the short term." The Bank of Japan began gradually reducing its large-scale bond purchases in August last year, but the pace has been slow. Over the past year, the total amount of bonds it holds has decreased by 16.7 trillion yen (approximately $115 billion). This decrease is less than 3%, while the Federal Reserve reduced its holdings of government bonds by about 10% in the first year of implementing quantitative tightening measures. Masao Muraki, Senior Analyst at Mitsubishi UFJ Morgan Stanley Securities, said, "The actual impact of the Bank of Japan's measures will be realized over a longer period. Currently, we expect that quantitative easing policy will enter a stage of reducing excess liquidity in the banking system, leading to more intense competition for deposits and causing market instability." However, concerns about serious disruption in the Japanese market due to balance sheet reduction may be exaggerated. For example, some might point out that despite the Federal Reserve starting to taper asset purchases in 2022, the US stock market has remained resilient overall. Nevertheless, the large-scale sell-off of Japanese bonds last month has made stock investors aware of the risks posed by rising yields. Muraki stated, "Asset categories that have benefited from quantitative easing policies, such as stocks, may be affected by quantitative tightening policies."