One week after we explained not once but twice that next week’s main central bank event is not the Fed – which won’t do anything – but the Bank of Japan, even CNBC has finally figured it out, observing with about a 7 day delay that “Everyone’s waiting for the Federal Reserve in the week ahead, but the real action may be coming out of Tokyo.” Well, thanks for that.
But while it’s clear that Yellen won’t dare shock the market (which now trades with a 20% probability of a September rate hike and as we showed a year ago, the Fed has never hiked unless the market is already pricing in at lest 60% odds), the question remains – just what will Kuroda and the BOJ do, especially since as we wrote last week, not even the BOJ knows what it will do, and has instead flooded the market with news report trial balloons covering every possible, even contradictory, possibility. Which also makes the BOJ’s decision that much more important.
As DB points out, “this week will be the litmus test for whether central banks are in shift mode as regards ongoing accommodative monetary policy. Investor consensus revolves around the notion that monetary policy has run its course and it “needs” to be supplanted by fiscal policy or at least combined with fiscal policy, via helicopter money, to be effective. The potential for a BoJ move on short rates and a shift in QE plus a Fed insistence on hiking despite market expectations (including a “hawkish” hold for September) might be considered to be consistent with a steeper curve.”
Here is what DB’s Dominik Constam, one of Wall Street’s best credit strategists expects the BOJ will reveal on Wednesday:
The BoJ is conducting a comprehensive review of monetary policy. It is fair to say that there is substantial uncertainty as to what they may choose to do but recent policy speak has suggested that further cuts in the deposit facility rate are possible as well as a shift in the duration target away from the 7-12 year sector towards the 3-5 year sector. The proposed logic would be to steepen the yield curve, offering extra NIM to banks whilst also alleviating pressure on the entitlement industry. Some Fed officials meanwhile have also chimed in regarding the concern for financial stability that emanates from low long yields that in turn have compressed risk premia across asset classes as part of a “hunt for yield”. The implication is that if long rates stay artificially low, there may be a case for earlier moves higher in short rates to compensate even if the data itself was less compelling for such a move, all else equal. In both cases the potential for a BoJ move on short rates and a shift in QE plus a Fed insistence on hiking despite market expectations (including a “hawkish” hold for September) might be considered to be consistent with a steeper curve. Even the ECB could be added to this mix after the recent “disappointment” around not committing to an extension of its QE program nor adjusting the parameters.
In other words, in line with what we predicted ten days ago, Japan may engage in a reverse Twist, where it cuts short end rates while slowing down purchases of longer maturities to force the JGB curve steeper. Citigroup’s Brent Donnelly caught up to this idea this over the past week, and added the following notable color:
there is an interesting and lively debate going on here at Citi and elsewhere about the JPY impact of the recently-touted BoJ actions. If they cut front end rates and reduce 30-year purchases in a Twist-type operation, is that good or bad for USDJPY? I feel it is 100% terrible for USDJPY but there are enough smart people disagreeing that I’m not fully confident. I think it is negative USDJPY because:
- It’s not great for Japanese banks (see Chart1, note they gapped lower overnight after the rate cut story came out in NY time).
- The last time the BOJ cut (and the last time the ECB cut) the currency ripped. There is no empirical evidence that rate cuts below zero are bad for a currency. There is a small body of evidence that rate cuts below zero are good for a currency.
- When the US did Twist, the currency ripped and equities tumbled aggressively as you can see in the next two charts.
Overall I think what the market wants from the BoJ is pretty simple: Incremental stimulus. The composition of current stimulus, the shape of the yield curve and all that is just noise. If the BoJ buys foreign assets, USDJPY will explode higher and if they do not, it will go down. I really think trading the BoJ meeting is that simple… Note one important point made by Deegs this morning: US Twist flattened the curve and Japanese Twist would steepen the curve so it’s not unreasonable to guess the reaction in the currency would be opposite. That’s not my view but it’s certainly a reasonable view.
So while DB and Citi agree on what the BOJ may (or may not do) with Japan’s interest rate (cut from -0.1% to -0.2%), and shifts to QE (fewer purchases on the long end, perhaps shifting the focus from 7-12 to 7-10 to 5-10 year bonds), others like CLSA take aim at a different aspect of the BOJ’s monetary lunacy, namely the ongoing nationalizaton of the stock market.
According to Bloomberg, CLSA’s Nicholas Smith says he’s “absolutely certain” the Bank of Japan will stop buying exchange-traded funds tracking the Nikkei 225 Stock Average amid criticism its use of the measure is distorting the market.
The central bank will make the change at its meeting next week, shunning ETFs following the price-weighted stock gauge in favor of those linked to more modern indexes, Smith said. He says he’s been talking to BOJ officials within the last three days, while declining to name them. BOJ board members have made no public indication of an impending shift in the ETF program ahead of announcing their monetary policy review on Sept. 21.
The Nikkei 225 gives undue influence to certain stocks because it determines its rankings by the price of one share, rather than market capitalization. Fast Retailing Co., for example, accounts for 8 percent of the gauge, versus just 0.3 percent of the Topix. That means it benefits disproportionately from the central bank’s Nikkei 225 purchases. Since the BOJ almost doubled its annual budget for ETFs on July 29, the issues associated with the Nikkei 225 have become more pronounced, Smith said.
“I am absolutely certain that they will shift their buying to pretty much Topix-based,” Smith, a Tokyo-based strategist at the brokerage, said by phone Friday. “The Nikkei 225 is a Flintstones index from the abacus era,” he said. “It’s been a laughing stock for a long time.”
Perhaps he is right, although adjusting ETF purchases would be peanuts in the grand scheme of things, where the BOJ needs to inject trillions instead of trifling with billions in stocks here and there.
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Finally, the most comprehensive assessment of the BOJ’s “comprehensive assessment” due next week, comes from Goldman’s Naohiko Baba, who has a rather unexpected conclusion: don’t expect much if anything, at all.
Here is Goldman’s full report:
Final update on BOJ’s “comprehensive assessment”
At the next Monetary Policy Meeting (MPM) on September 20-21, the Bank of Japan (BOJ) will conduct a “comprehensive assessment” of trends in economic activity and prices under the current policy framework, as well as the policy impact, with a view to achieving its 2% price stability target at the earliest possible time. We gave our take on this in our August 5 Japan Views and September 7 Japan Views, and our overall view remains essentially unchanged. Below we provide a final update of our view in a Q&A format ahead of next week’s MPM, focusing on the most common queries we have fielded, particularly from overseas investors, since our last report.
- We believe the BOJ’s comprehensive assessment has four main objectives: (1) reiterate the positive aspects of its easing policy (quantitative/qualitative easing with a negative interest rate); (2) switch from quantitative easing to a negative interest rate policy (NIRP) as its primary policy tool; (3) correct the excessive impact of the easing policy on the yield curve; and (4) curve excessive market expectations of additional easing by extending the policy timeframe.
- We expect the BOJ to retain its 2% target due to the risk of severe yen appreciation if scrapped.
- The BOJ will highly likely move towards negative interest rates as its primary policy tool, as quantitative and qualitative easing are approaching the limits of their effectiveness. The BOJ also sees negative rates as an effective tool for combating the strong yen.
- We think possibilities of both helicopter money and foreign bond purchases by the BOJ as extremely unlikely.
- Although taking interest rates deeper into negative territory is likely to be seriously discussed at the policy meeting next week, we expect the BOJ ultimately to opt to push back the rate cut until a later date.
Q1: What are the purposes of the BOJ’s comprehensive assessment?
A1: We believe the BOJ’s review has four main objectives: (1) reiterate the positive aspects of its three-dimensional monetary easing policy (quantitative/qualitative easing a with negative interest rate); (2) switch from quantitative easing to a negative interest rate policy (NIRP) as its primary policy tool; (3) correct the excessive impact of the easing policy on the yield curve; and (4) dampen excessive market expectations of additional easing by extending the policy time-frame.
Below we touch on each of these points.
- We believe the BOJ will attribute its inability to reach the 2% inflation target so far to deflationary pressure from external factors beyond its control, including lower crude oil prices, a slowdown in emerging market economies, and greater-than-expected downward pressure on the economy following the consumption tax hike, and explain how this impact has spread to backward-looking inflation expectations. In other words, we expect the BOJ to stress that its QQE with NIRP policy would have had sufficient clout to achieve its objective if not for the impact of such factors out of its control, and that this policy could still be effective moving forward.
- The BOJ faces various issues relating to its “quantitative” easing (QE) policy, such as (1) the likelihood that it will eventually reach a physical limit to its large-scale JGB purchases, (2) excessive flattening of the yield curve due to the combination of large-scale JGB purchases and the NIRP, and the concerns this has generated for financial intermediation, and (3) the drying up of liquidity in the JGB market. As such, we believe the BOJ has a strong desire to shift from QE to the NIRP as its primary policy tool (see Q3 below). At the same time, we think the BOJ seeks to remove uncertainty over the future direction of policy by clearly defining the fulcrum of its policy framework. In a recent speech, BOJ Governor Haruhiko Kuroda said that “in order to ensure the effectiveness of monetary policy…the important thing is…to maintain consistent and predictable policy responses.”
- The excessive decline in interest rates, particularly in the super-long zone, has raised concerns over the potential impact on life insurance and pensions, and thus we believe the BOJ could well shorten the maturity of JGBs it purchases. However, we believe it will not shift its annual purchase target from ¥80 tn to a more flexible range of ¥70-¥90 tn, for example, as has been suggested by some observers (Sankei newspaper, August 9), given the risk of further yen appreciation should the market focus only on the lower figure of ¥70 tn.
- We expect the BOJ will effectively scrap its two-year time-frame for achieving its 2% inflation target in favor of the less defined and more ambiguous wording, “at the earliest possible timing.” This is not just because 3.5 years have passed already since the launch of the easing program, but because we believe the BOJ also aims to curb excessive market expectations for additional easing by redefining the QQE with NIRP as a long-term strategy, strengthening the bias towards status quo, rather than a quick-fix policy.
Q2: Will the BOJ stick to its 2% inflation target?
A2: We expect the BOJ to retain its 2% target due to the risk of severe yen appreciation if scrapped.
The BOJ originally chose 2% as its inflation target primarily focusing on the impact on the exchange rate. The widely held view is that long-term exchange rate trends are formed based on purchasing power parity (PPP: a comparison of inflation levels between two countries). In many developed economies, such as the US, long-term inflation (or inflation expectations) is viewed as anchored around the 2% level, whereas in Japan, inflation levels were markedly lower. This is perceived to have formed the long-term trend in yen appreciation, from a PPP perspective. For this reason, the BOJ has had to make a strong commitment to achieving 2% inflation, an international norm, in order to reverse the long-term trend of yen appreciation. If it were now to scrap its 2% inflation target, forex market expectations could reverse completely as the BOJ would be viewed as tolerating a severe appreciatory yen trend. Also, we expect the BOJ not to adopt a more flexible band target such as between 1% and 3% at least at this stage.
Q3: Why is the BOJ likely to choose the NIRP as its primary policy tool?
A3: Within the current policy framework, QQE is approaching the limits of its effectiveness, so we think the BOJ wants to place the NIRP as its primary policy tool before this occurs. Another important reason is that the BOJ sees negative rates as an effective tool for combating the strong yen.
We touched on the “quantitative” aspect of easing in Q1 (2) above. The “quality” aspect of the current policy, which centers on the purchase of equity exchange-traded funds (ETFs), has already seen purchases balloon out to ¥6 tn annually, and there is strong recognition now of three potential side-effects (see our August 3, 2016 Japan Economics Analyst).
First, there is the possibility of across-the-board rises in share prices, including for companies that should be exiting the market or else languishing at low valuations due to poor earnings prospects. Second, stocks that are substantially overvalued by the market may become even more so on the influx of funds. Third, from a corporate governance perspective, we think the market’s surveillance function could be diminished. This last point, in particular, would appear to run contrary to the Abe administration’s corporate governance reform efforts.
Furthermore, a simple estimate of potential risk from the BOJ’s equity holdings suggests this will likely surpass the BOJ’s capital even for a 1-year holding period. Under the current BOJ Act, the BOJ is prohibited from receiving loss compensation from the government. Because erosion of a central bank’s balance sheet could undermine confidence in the value of the currency, further expanding ETF purchases could be difficult.
We believe there is a strong willingness at the BOJ to move the focus on to its NIRP not only because its QQE options are approaching their limits, but also because the BOJ considers the NIRP to be an effective means of countering the strengthening yen.
In a recent speech, Governor Kuroda stated that “The basic mechanism of monetary policy … is to drive the real interest rate higher or lower than the “natural rate of interest”. In normal times, this can be achieved by adjusting short-term rates; namely, simply lifting or lowering them.” He went on to say, “Any additional monetary easing entails ‘costs’ which negatively affects some sectors. That said, we should not hesitate to go ahead with it as long as it is necessary for Japan’s economy as a whole; namely, if its ‘benefits’ outweigh its ‘costs’”. We think both statements can be seen as very supportive of the NIRP.
Q4: What is the likelihood of helicopter money and foreign bond purchases by the BOJ?
A4: We think both possibilities are extremely unlikely.
Both helicopter money and foreign bond purchases are in a legal gray zone and therefore cannot be ruled out entirely (see our July 15 Japan Views, and August 30 Japan Views). With helicopter money, however, we see a major risk of the BOJ having difficulty exiting such a policy once it has been set in motion. This is because of the high possibility that giving the government a really convenient tool, namely monetary financing, would cause it to lose fiscal discipline. Given Governor Kuroda is a notable proponent of fiscal consolidation, we think the likelihood of him agreeing to such a policy is extremely low.
With foreign bond purchases, we think they cannot be dismissed if positioned as a means of expanding the monetary base and not for the purpose of influencing foreign exchange rates. However, even if foreign bond purchases were positioned as a means of monetary base expansion by the BOJ, they would almost certainly be seen by the international community as an attempt to influence foreign exchange rates, in our view. We think foreign bond purchases would be very difficult, especially in light of the US Treasury including Japan on its new currency monitoring list in April 2016.
Q5: What is the likelihood of the BOJ easing further at the September MPM (next week)?
A5: If the BOJ were to position the NIRP at the center of its easing policy, we think that it would be only a matter of time before it takes interest rates deeper into negative territory, and that there will be serious discussions on the topic at the September MPM next week. However, we expect the BOJ ultimately to opt to push back additional easing until a later date.
If the comprehensive assessment was to result in negative interest rates becoming the central pillar of the BOJ’s efforts to achieve its 2% inflation target, it may be natural to think the BOJ would then seek to immediately show a strong commitment to the NIRP, and therefore a deeper negative rate at the September meeting is a possibility. At the next meeting, however, we believe the BOJ will ultimately opt to stand pat and is likely to postpone a deeper interest rate cut for the following three reasons.
First, in its July Outlook Report, the BOJ sharply raised its GDP growth forecast for FY2017 (to +1.3%, from +0.1%), and kept its bullish inflation forecast (+1.7%) for the same period. Behind this are two main measures on the fiscal front, including a postponement of the second consumption tax hike, and the formation of an economic stimulus package. By the time of the September MPM, however, the only additional macro data available to the BOJ since the July-end Outlook Report will be that for July. While the figures are mixed, we think macro data are unlikely to be weak enough to warrant a major downgrading of the overall economic assessment (see our September 5 Japan Economic Flash).
The BOJ identified overseas economic developments as the largest downside risk to the economy and prices, but we note that the turmoil in the wake of the Brexit decision has eased, and Chinese macro data, among others, have somewhat improved. Based on the BOJ’s most fundamental approach, we believe that it would see no need to urgently implement additional easing measures if there was no basis for downgrading its economic assessment.
Second, because the September MPM and the US FOMC meeting will be held on the same day, the BOJ will need to make its monetary policy decision half a day ahead of the FOMC due to the world time differences. This means that, even if the BOJ were to decide to cut interest rates further, there is a risk of the FOMC decision nullifying the impact on the markets (especially the foreign currency market) of any additional BOJ easing. Considering the possible side-effects and the limited number of chances the BOJ has to take negative interest rates deeper, we believe it will need to think very carefully about the optimal timing when making its next move.
Third, we believe there is considerable risk in the BOJ cutting rates further before ensuring a more stable steepening of the yield curve. While the yield curve has steepened significantly of late on anticipation of more flexibility on the maturity of JGB purchase, we think this mainly reflects expectations running ahead and that the curve may not stabilize based solely on any news of a more flexible purchase maturities. Rather, with market expectations driving wild fluctuations in yields, we think an actual decision could invite more volatility. If the yield curve fails to steepen in a stable manner in spite of the BOJ taking the negative rate deeper, we think this could have consequences for the financial intermediation function. Consequently, we expect the BOJ to adopt a phased approach, and to consider the timing of future rate cuts only after adjusting the maturity of its JGB purchases first.