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July 21, 2017

The Market Sentimentalist – Monetary Delusions

by Amareos.

Last September the BoJ announced a major change to its monetary policy operations. It introduced an explicit target for long-term Japanese government bond yields[1] as a complement to its short-term interest rate target, a policy tool investors have become very familiar with given its widespread adoption over the past 30 or so years. As we argued at the time[2], the significance of this policy change was lost on many investors. Incredibly, this remains so.  Many commentators have concluded that because BoJ purchases of JGBs have been declining over recent months it is conducting a “stealth taper” to it QE programme. Such perceptions are flawed. Indeed, this is only one of the delusions we have come across in relation to Japanese monetary policy of late, delusions that are likely to prove detrimental to the financial health of investors fooled by them.

When the BoJ announced its yield curve targeting framework (0% nominal rate for the 10-year JGB) it also provided quantitative guidance for the pace of its government bond purchases – approximately JPY 80 tr per annum[3]. The motivation for announcing a quantity figure was that financial market participants had grown accustomed to central banks detailing the magnitude of their asset purchase programmes during the era of QE and JPY 80tr was consistent with the size of the previous purchase programme. Hence, providing this estimate was judged a prudent measure to minimize investor confusion (and, therefore, the potential for disruptive market moves) about the new monetary policy operations.

Since the introduction of the yield target, the pace of BoJ purchases of JGBs has fluctuated widely. During the first few months, gross monthly JGB purchases exceeded JPY 11tr. More recently[4], the monthly pace of purchases has slowed to just over JPY 7tr, such that on a net basis BoJ holdings of JGB have been increasing at a rate significantly below the JPY 80tr guidance[5].

It is not just the deceleration in the pace of buying by the BoJ that has fuelled speculation of a “stealth taper”. After years of quantitative easing, the BoJ has amassed almost JPY 400tr worth of JGBs on its balance sheet – roughly 40% of total outstanding issuance. Such ownership concentration, combined with the yield target, has had a detrimental effect on the liquidity of Japanese fixed income instruments in the secondary market. For example, there have been days when some new 10-year JGB issues, and even shorter-term interest rate futures, have not traded. Moreover, the implied volatility in JGBs has slumped. Hence, so the argument goes, the BoJ is tapering because it is hitting the operational limits of monetary policy, something it does not want to acknowledge publicly for rather obvious “credibility” reasons – hence the necessity of “stealth”.

The reality is, however, somewhat different. No entity, not even a central bank, can set both the price and quantity of a traded asset simultaneously as it violates the laws of economics[6]. If the price is fixed, ex ante the quantity is necessarily unknown and vice versa. The BoJ’s knows this only too well, which is why the JPY 80tr is only guidance and not, like the yield level, a target.

Soon after the operation started global investors became bewitched with the post-Trump reflation narrative and US Treasury yields backed-up sharply, a trend that, naturally, exerts upward pressure on government bond yields in Japan and elsewhere. Thwarting the impact of this rising tide of longer-term global government bond yields required BoJ purchases to be roughly in line with the quantity guideline[7]. However, concomitant with the subsequent loss of the crowd’s confidence in the Trump reflation narrative[8], US Treasuries recovered and the resultant fall in bond yields provided a tailwind for JGBs. Hence, the BoJ no longer had to intervene as heavily in order to achieve its yield target.

What we have seen since is the start of this month is a resumption of this rising yield environment as investors have reacted to the concerted (if not co-ordinated) hawkishness of central banks in the developed world (excluding the BoJ we might add). And, lo-and-behold, the BoJ have responded by acting more aggressively, committing to unlimited purchases in defence of its yield target last Friday[9] – a true central bank policy bazooka.

The key thing that investors should take note from all of this is, in terms of quantities of JGBs purchased, the BoJ has been an entirely passive player. Fluctuations in its purchase rate have been influenced by global financial market trends and the subsequent shift in private sector holding preferences of longer-dated Japanese government bonds. It has not been reflective of a shift in the BoJ’s policy reaction function.

For the BoJ to willingly alter its policy stance – either via a deliberate tapering of JGB purchases (stealthy or otherwise) or by lifting the yield target, to say 20bp – requires a change in the domestic economic outlook.

Recent official macroeconomic data in Japan confirm the pace of real GDP growth has been weaker than expected in Q1 while inflation has remained subdued, running around 0.4% y/y – well below the BoJ’s 2% goal. Commenting on the outlook, during the BoJ quarterly branch managers meeting this week Governor Kuroda reiterated the view that the Japanese economy is “turning towards moderate expansion” and anticipated “inflation moving towards target”. Encouraging perhaps, but hardly sufficient improvement to justify altering its policy stance.

Reinforcing this perception, when we look at the evolution of crowd sentiment towards economic growth and future inflation in Japan it is clear that although both are in positive territory neither can be considered overly exuberant – see exhibit below.

Exhibit 1: Growth And Inflation Crowd Sentiment – Japan

Source: www.amareos.com

Certainly, there has not been a radical shift in the private sector perceptions since the BoJ’s yield target was introduced. This is important because although there are well-founded economic forces generating structural disinflationary headwinds in Japan – specifically the aging of the population – after two decades of stagnation there is also a major psychological aspect to it.   Indeed, as Krugman concluded many years ago (our emphasis)[10]

A monetary expansion that the market expected to be sustained (that is, matched by equiproportional expansions in all future periods) would always work, regardless of whatever structural problems the economy might have; if monetary expansion does not work, if there is a liquidity trap, it must be because the public does not expect [Ed. Note – The psychological aspect] it to be sustained.”

Such sentiment readings indicate that the BoJ’s battle to foster a more reflationary mindset in Japan is far from over. Given this, we see no gravitational pull from other developed central banks, who seem intent on shifting towards a less accommodative stance, on the BoJ. In fact, monetary policy divergence is arguably a positive for them in that it will help them achieve their desired outcome.

Assuming the rise in global government bond yields in the rest of the world continues then, as alluded to above, the private sector will be less inclined to hold relatively lower yielding JGBs. Maintaining its 0% yield target will force the BoJ to step up the pace of their monthly JGB purchases. Not only will this inject additional domestic monetary stimulus, but wider interest rate differentials will serve to undermine investor demand for the JPY – a currency that was a firm crowd favourite earlier in the year but which has become less so over the past month (it is firmly in the middle of the pack – see exhibit below).

Exhibit 2: Crowd-Sentiment – Developed Currencies

Source: www.amareos.com

The second Japanese monetary delusion is, as one Wall Street economist[11] vividly described it, the BoJ simply “burns” its vast holding of JGBs – a pyrotechnic cancelling of 40% of Japan’s government debt. Although not explicitly stated in the comments we saw, the notion underlying such ideas – which are far from new – is that because the central bank is just another branch of the administration at the aggregate level the liabilities net out, ie. it is like owning a debt to oneself.

This proposition looks intuitively appealing. However, there are two problems with this line of reasoning – one minor and one major.

The minor one is that the BoJ is not wholly-owned by the Japanese government.  It has publicly traded stock[12] because Article 8 of the 1942 Bank of Japan Act[13] states that JPY 100mn capital was contributed by government and non-government persons, with the government contributing no less than JPY 55mn. Although unusual, this is not unique. The same is also true of the Swiss and Belgian central banks and (even less well known) the twelve regional Federal Reserve Banks, which are owned by private-sector commercial banks[14]. Hence, there are legal impediments to the BoJ putting the match to its holdings of JGBs (although this is probably not an unsurmountable objection –hence only a minor problem).

The second, and major, problem is that the proposal is based on a fundamental misunderstanding of how the fiat money system operates, which makes it a complete nonstarter. To see why we need to consider how a central bank balance sheet works[15]. The following exhibit is taken from 2016 Bank of England working paper[16].

Exhibit 3: Stylized Central Bank Balance Sheet

Source: www.bankofengland.co.uk [17]

As per the above exhibit, JGB holdings constitute an asset on the BoJ’s balance sheet (monetary policy assets category). Hence, if they cancel the debt, the liability side of their balance sheet must show an equivalent decline – this is double-entry bookkeeping 101.

One way this could occur is via a drop in Japan’s domestic money supply, either in notes and coins in circulation (bank notes) or more likely as they are held in electronic form and hence easier to eradicate in commercial bank reserves (deposits from banks). Regardless which of the two options is chosen, the drop in the money supply would be considerable and hugely deflationary – a far from satisfactory outcome.

The other possibility is that the JGB write down is absorbed within the BoJ’s equity position. As mentioned above, JGB holdings on the BoJ’s balance sheet equate to JPY 390tr. The BoJ’s JPY 8tr in equity (its combined capital + provision + special reserves) pales into insignificance next to such a number[18]. A write down of JGB holdings of a magnitude that would be meaningful for Japan’s government finances would push the Japanese central bank deep into negative equity.

Theoretically such an outcome is possible[19] but the optics are terrible. The BoJ could, of course, get a capital injection from the government but they would have to increase JGB issuance by almost the same amount as the write down to fund the capital raise (completely self-defeating). Alternatively, the BoJ could try to earn its way back to a positive equity position, which would be an extremely long (decades in fact) process given the magnitude of the numbers involved.

In short, the notion that the BoJ can simply burn its holdings of JGBs and lift the heavy fiscal burden on the Japanese government is fanciful and not founded in reality. There are no good solutions for Japan at this point – they have been long exhausted. It is now a case of choosing the least bad, and that almost certainly means the BoJ is stuck with a large amount of JGBs on its balance sheet effectively ad infinitum[20].

What bursting this second delusion does is highlight that the fortunes of the BoJ and the Japanese government are increasingly intertwined, not unlike two late night revellers leaning on each other for support. The yield target is the linchpin keeping them upright. One investors appreciate the importance of the new monetary policy tool to Japan’s economic prospects, they will better understand the commitment of policymakers in Japan to it. It is their best – perhaps only – way to avoid the long anticipated and much talked about JGB “death spiral”. What’s more, when investors realize this they will also likely wake up to the fact that it is the JPY that will be the Japanese financial price that has to move most. Our crowd-sourced sentiment indicator suggests we are not yet at this point, but it will not take much and hence may not be that long, before we are.

_____________________________________________________________________

Amareos crowd-sourced sentiment indicators are based on MarketPsych Indices

FOOTNOTES:

[1] Explicitly targeting long-term interest rates is unusual but not unprecedented. Both the US and UK central banks adopted such frameworks between the Great Depression until several years after the end of World War II.

[2] See: https://amareos.com/financialresearch/the-worlds-most-important-central-bank/ and https://amareos.com/financialresearch/the-fix-is-in/

[3] Net of redemptions.

[4] That is prior to Friday June 7 – see below.

[5] Below JPY 70tr on most recent estimates.

[6] Assuming, of course, that one is not operating under a strictly enforced omnipotent dictatorship – then the laws of economics are suspended (not eradicated as such regimes eventually collapse, but suspended).

[7] Sharp eyed readers may note that the BoJ programme started in September two months prior to Trump’s victory. In this two-month period, BoJ purchases were close to the guideline rate because investors were unsure as to the credibility of the yield target.

[8] The rise and fall of the post-Trump reflation trade was fully traced out in our crowd-sourced sentiment indicators of future US inflation – see: https://amareos.com/financialresearch/market-sentimentalist-whos-eating-porridge/.

[9] As we reference in footnote 4 above.

[10]See: https://ideas.repec.org/a/bin/bpeajo/v29y1998i1998-2p137-206.html

[11] Having been professionally acquainted with the person in question we prefer an anonymous attribution.

[12] Ticker 8301:JP

[13] See: http://www.japaneselawtranslation.go.jp/law/detail/?id=92&vm=02&re=01

[14] Stock in the regional Federal Reserve banks are not tradeable. This is the source of many a financial conspiracy theory. That said, the history of the creation of the Federal Reserve System is fascinating and we recommend the following book to those interested in knowing more – see: https://www.amazon.com/Creature-Jekyll-Island-Federal-Reserve/dp/091298645X

[15] Read on, we promise it is not as boring or as complex as it sounds.

[16] See: http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp604.pdf and also http://www.bankofengland.co.uk/education/Documents/ccbs/handbooks/pdf/ccbshb32.pdf

[17] Although the Bank of England has a .co.uk rather than a .gov.uk domain it is wholly owned by the UK government.

[18] The BoJ balance sheet is regularly published on their website – see: https://www.boj.or.jp/en/statistics/boj/other/acmai/index.htm/

[19] Buiter (2009) “Can Central Banks Go Broke?” – see: http://econpapers.repec.org/paper/cprceprdp/6827.htm

[20] Other central banks have responded in this way when faced similar situations in the past. NB. Regards the notion that the BoJ is running out of JGBs to purchase, investors should realize that there is no upper limit as the Japanese government can simply issue as many JGBs as the BoJ requires – a policy mix often labelled “helicopter money”.

 

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