Yield Curve Control – the road to infinite QE

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Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

  • The BoJ unveiled their latest unconventional monetary policy on 21st September
  • In order to target 10 year yields QE must be capable of being infinite
  • Infinite Japanese government borrowing at zero cost will eventually prove inflationary
  • The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”.  New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited.  This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds.  Zero-coupon bonds are not a joke – 28th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.  

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

  • Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
  • Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

nikkei-share-buybacks-may-2016-goldman-sachs

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

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Will Japan be the first to test the limits of quantitative easing?

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Macro Letter – No 57 – 24-06-2016

Will Japan be the first to test the limits of quantitative easing?

  • The Bank of Japan made its first provision against losses from QQE
  • As the JPY has strengthened the Nikkei 225 has fallen more than 16% YTD
  • Domestic institutions have been switching from bonds to stocks
  • Japanese share buy backs are on the rise

The Japanese stock market peaked in December 1989, marking the end of a period of economic expansion which briefly saw Japan eclipse the USA to become the world’s largest economy. Since its zenith, Japan has struggled. I wrote about this topic, in relation to the economic reform package dubbed Abenomics, in my first Macro Letter – Japan: the coming rise back in December 2013:-

As the US withdrew from Japan the political landscape became dominated by the LDP who were elected in 1955 and remained in power until 1993; they remain the incumbent and most powerful party in the Diet to this day. Under the LDP a virtuous triangle emerged between the Kieretsu (big business) the bureaucracy and the LDP. Brian Reading (Lombard Street Research) wrote an excellent, and impeccably timed, book entitled Japan: The Coming Collapse in 1989. By this time the virtuous triangle had become, what he coined the “Iron Triangle”.

Nearly twenty five years after the publication of Brian’s book, the” Iron Triangle” is weaker but alas unbroken. However, the election of Shinzo Abe, with his plan for competitive devaluation, fiscal stimulus and structural reform has given the electorate hope. 

In the last two years Abenomics has delivered some transitory benefits but, as this Japan Forum on International Relations – No. 101: Has Abenomics Lost Its Initial Objective? describes, it may have lost its way:-

The key objective of Abenomics is a departure from 20 year deflation. For this purpose, the Bank of Japan supplied a huge amount of base money to cause inflation, and carried out quantitative and qualitative monetary easing so that consumers and businesses have inflationary mindsets. This “first arrow” of Abenomics was successful to boost corporate profits and raising stock prices by devaluing the exchange rate, but falling oil price makes it unlikely to achieve a 2% inflation rate, despite BOJ Governor Haruhiko Kuroda’s dedicated effort. The quantitative and qualitative monetary easing will not accomplish the core objective.

Another reason for such a huge amount of base money supply is to expand export through currency depreciation and to stimulate economic growth, but that has neither boosted export nor contributed to economic growth. We cannot dismiss world economic downturn, notably in China, but actually, Japanese big companies that lead national export, have shifted their business bases overseas during the last era of strong yen. From this point of view, I suspect that the Japanese government overlooked such structural changes that deterred export growth, even if the yen was devalued. The “second arrow” is flexible fiscal expenditure to support the economy, and the result of which has revealed that it is virtually impossible to keep the promise to the global community to achieve the equilibrium of the primary balance in 2020.

In view of the above changes, I would like to lay my hopes on the “third arrow” of economic growth strategy. The growth strategy has been announced three times up to now, in 2013, 2014, and 2015, respectively. The strategy in 2013 launched three action plans, but they were insufficient. The 2014 strategy was highly evaluated internationally, as it actively involved in the reform of basic nature of the Japanese economy, such as capital market reform, agricultural reform, and labor reform. But it takes ten to twenty years for a structural reform like this to work. Meanwhile, it is quite difficult to understand the growth strategy approved by the cabinet in June 2015. Frankly, this is empty and the quality of it has become even poorer. Abenomics was heavily dependent on monetary policy, and did not tackle long term issues so much, such as social security and regional development. However, people increasingly worry about dire prospects of long term problems like 2 population decrease, aging, and so forth, while the administration responds to such trends with mere slogans like “regional revitalization” and “dynamic engagement of all citizens”. But it is quite unlikely that these “policies” will really revitalize the region, or promote dynamic engagement by the people.

The Bank of Japan (BoJ) has held up its side of the bargain but the “Third Arrow” of structural reform seems to be stuck in the quiver. It is prudent, in light of this policy failure, for the BoJ to look ahead to the time when they are required by the government or forced by the markets, to unwind QQE. Last month they began that process.

As this article from the Nikkei Asian Review – BOJ seen preparing for exit from easing with reserves  explains, the BoJ has made a provision of JPY 450bln for the year ending March 2016 against potential capital losses which might be incurred upon liquidation of their JGB holdings. This is the first provision of its kind and substantially reduces the percentage of seigniorage profits remitted to the Japanese government.  The level of remittances has been falling –from JPY 757bln in 2014 to JPY 425bln last year. As at the end of May 2016 the BoJ held JPY 319.5trln of JGBs – 36.6% of outstanding issuance. Japan Macro Advisors estimate this will reach 49.3% by the end of 2017. This year’s provision, whilst prudent, is a drop in the ocean. Under the current Quantitative and Qualitative Easing (QQE) programme they are obligated to purchase JPY 80tln per annum. The Association of Japanese Institutes of Strategic Studies – The Fiscal Costs of Unconventional Monetary Policy put it like this:-

It is quite likely that quantitative easing through high-volume purchases of long-term bonds will cause the Bank of Japan enormous losses over the medium to long term, imposing burdens on taxpayers both directly and indirectly. If the current quantitative easing continues, the Bank of Japan may find itself in the near future unable to cover such losses even using all of its seigniorage profits.

…The BoJ’s seigniorage will be roughly equivalent in present value to the balance of banknotes issued. If the BoJ procures funds by issuing cash at a zero interest rate and purchases JGBs, the present discounted value of the principal and interest earned by the BoJ from its JGBs will equal the balance of banknotes. If interest rates are about 2%, Japan’s demand for banknotes will fall from 19% of GDP at present to less than 10% of GDP, and the BoJ’s aforementioned losses would even exceed the present value of its seigniorage.

Here is an extract from the BoJ’s 16th June Statement on Monetary Policy the emphasis is mine:-

Quantity Dimension: The guideline for money market operations

The Bank decided, by an 8-1 majority vote, to set the following guideline for money market operations for the intermeeting period:[Note 1]

The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen.

Quality Dimension: The guidelines for asset purchases

With regard to the asset purchases, the Bank decided, by an 8-1 majority vote, to set the following guidelines:[Note 1]

a) The Bank will purchase Japanese government bonds (JGBs) so that their amount outstanding will increase at an annual pace of about 80 trillion yen. With a view to encouraging a decline in interest rates across the entire yield curve, the Bank will conduct purchases in a flexible manner in accordance with financial market conditions. The average remaining maturity of the Bank’s JGB purchases will be about 7-12 years.

b) The Bank will purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at annual paces of about 3.3 trillion yen1 and about 90 billion yen, respectively.

c) As for CP and corporate bonds, the Bank will maintain their amounts outstanding at about 2.2 trillion yen and about 3.2 trillion yen, respectively.

Interest-Rate Dimension: The policy rate

The Bank decided, by a 7-2 majority vote, to continue applying a negative interest rate of minus 0.1 percent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.[Note 2]

[Note 1] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. T. Sato, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Kiuchi. Mr. T. Kiuchi proposed that the Bank conduct money market operations and asset purchases so that the monetary base and the amount outstanding of its JGB holdings increase at an annual pace of about 45 trillion yen, respectively. The proposal was defeated by a majority vote.

[Note 2] Voting for the action: Mr. H. Kuroda, Mr. K. Iwata, Mr. H. Nakaso, Mr. K. Ishida, Mr. Y. Harada, Mr. Y. Funo, and Mr. M. Sakurai. Voting against the action: Mr. T. Sato and Mr. T. Kiuchi. Mr. T. Sato and Mr. T. Kiuchi dissented considering that an interest rate of 0.1 percent should be applied to current account balances excluding the amount outstanding of the required reserves held by financial institutions at the Bank, because negative interest rates would impair the functioning of financial markets and financial intermediation as well as the stability of the JGB market.

The decision by the BoJ not to increase QQE at its last two meetings has surprised the markets and lead to a further strengthening of the JPY. Governor Kuroda, gave a speech Keio University on June 20thOvercoming Deflation: Theory and Practice in which he described the history of BoJ policy in its attempts to stimulate the Japanese economy:-

As mentioned, the aim of QQE is to overcome the prolonged deflation that has gripped Japan. Even if this deflation has been mild, the fact that it has continued for more than 15 years means that its cumulative costs have been extremely large. Looked at in terms of the price level, an annual inflation rate of minus 0.3 percent over a period of 15 years implies that the price level will fall by around 5 percent, but an annual inflation rate of 2 percent over a period of 15 years means that the price level will rise by around 35 percent.

It is worth noting that the UK and USA was subject to a long period of deflation during the “Great Depression” between 1873 and 1896 (approximately -2% per annum) by this comparison Japan’s experience has been very mild indeed. The BoJ has a 2% inflation target, however, so we should anticipate more QQE. Kuroda-san, who has previously stated that the effect of NIRP will take time to feed through and that NIRP may be increased from -0.1% to -0.5%, gave no indication as to what the BoJ may do next; although he did say that Japan provides an interesting case study for academia.

On June 8th Professor George Selgin delivered the Annual IEA Hayek Memorial Lecture – Price Stability and Financial Stability without Central Banks – lessons from the past for the future in which he discussed good and bad deflation together with “Free Banking” – the concept of financial stability without central banks (if you have 45 minutes and enjoy economic history, the whole speech it is well worthwhile). With regard to the current situation in Japan – and elsewhere – he highlights the different between good deflation which is driven by supply expansion and bad deflation which is the result of demand shrinkage. Selgin also goes on to allude to Hayek’s view that that stability of spending should be the objective of monetary policy rather than the stability of prices – akin to what Market Monetarists dub the stability of monetary velocity.

Japan’s monetary base has expanded by 170% since March 2013 but at the same time the money multiplier – Money Stock/BoJ Monetary Base – has declined from 8.27 times (April 2013) to 3.35 times (March 2016). Lending market growth was at its weakest for three years in March (+2%) principally due to household hoarding.

Bloomberg - Japan Money Mult and Money base

Source: Bloomberg, BoJ

Since the announcement of Negative Interest Rate Policy (NIRP) in January the sale of safes for domestic residences has increased dramatically. Whilst I have not found evidence from Japan, this article from Bloomberg – Cash in Vaults Tested by Munich Re Amid ECB’s Negative Rates reports that MunichRE – the world’s second largest reinsurer – is setting a worrying precedent, it’s one thing when individuals hoard paper money but, when financial institutions follow suit, monetary velocity is liable to plummet. I suspect institutions in Switzerland and Japan are also assessing the merits of stuffing their proverbial mattresses with fiat money.

The chart below reveals that declining monetary velocity is not exclusively a Japanese phenomenon:-

Monetary Velocity - CLSA

Source: CLSA, CEIC

The Yotai Gap – the difference between bank deposits and loans – is another measure of household hoarding. It widened to JPY 207.6trln in March, close to its record high of JPY 209.9trln in May 2015. The unintended consequences of NIRP is an increase in demand for paper money and a reduction of demand for retail loans even as interest rates decline.

Japanese industry looks little better than the household sector, as this excellent article from Alhambra Investment Partners – It’s Not Stupidity, It Is Apathy (For Now) explains:-

Japanese industry has not gained anything for the surrender of Japanese households, with industrial production falling 3.5% in April, the 18th time in the past the 22 months. IP in April 2016 was slightly less than the production level in April 2013 when QQE began. Worse, IP is still 3.4% below April 2012, which further suggests both continued economic decline and a distinct lack of any effect from all the “stimulus.”

Barron’s – Unintended Consequences of NIRP listed the following additional effects:-

1) compress net interest margins and bank profits;
2) damage consumer and business confidence;
3) provide little incentive for business invest in capital rather than buy back stock;
4) hurt savers;
5) makes active management more difficult by dampening dispersion;
6) increase demand for gold and other hard assets; and,
7) likely widen the wealth gap

The BoJ can continue to buy JGBs, Commercial Paper, Corporate Bonds, ETFs and, once these avenues have been exhausted, move on to the purchase of common stocks and commercial loans. It can nationalise the stock market and circumvent the banking system in order to provide liquidity to end users or even consumers. At what point will the markets realise that they have been pushing on a string for decades? I suspect, not yet, but a dénouement, an epiphany, draws near.

Markets since the announcement of NIRP

Since the BoJ NIRP announcement at the end of January, the JPY has strengthened by around 14%. The five year chart below shows the degree to which the hopes for the first arrow of Abenomics have been dashed:-

japan-currency 5yr

Source: Trading Economics

Currency weakness has put pressure on stocks. International investors sold around JPY 5trln during in a 13 week selling binge to the beginning of April:-

japan-stock-market 5yr

Source: Trading Economics

The Government Pension Investment Fund (GPIF) and other domestic institutions took up the slack – the GPIF has moved from 12% to 23% equities since October 2014 – here is the 31st December breakdown of the asset mix for the JPY 140trln fund:-

31-12-15 % Allocation Policy Target Permitted Deviation
Domestic Bonds 37.76 35 10
Domestic Equity 23.35 25 9
International Bonds 13.5 15 4
International Equities 22.82 25 8
Short term assets 2.57

Source: GPIF

In theory the GPIF could buy another JPY 15.5trln of domestic stocks and reduce its holdings of JGBs by nearly JPY 18trln. I expect other Japanese pension funds and Trust Banks to follow the lead of the GPIF. Domestic demand for stocks is likely to continue.

As I mentioned earlier, JGBs are being steadily accumulated by the BoJ even as the GPIF and other institutions switch to equities. This is the five year yield chart for the 10 year maturity:-

japan-government-bond-yield 5yr

Source: Trading Economics

JGBs made new all-time lows earlier this month, with maturities out as far as 15 years turning negative, amid international concerns about the potential impact of Brexit.

Looking more closely at Japanese stocks, non-financial corporations have followed the lead of the eponymous Mrs Watanabe, accumulating an historically high cash pile. Barron’s – Abenomics Watch: Japan’s Corporates Are Hoarding Cash, Too takes up the story:-

During the three years of Abenomics between 2013 and 2015, Japan’s non-financial corporate sector increased its holding of cash and deposits by roughly 30 trillion yen, or 6% of GDP. This amount is equivalent to about 35% of retained earnings, estimates Credit Suisse.

This amount is high by historical standards. During the previous economic upswing between the end of 2002 and the beginning of 2008, Japan’s corporations held only 11.5% of their retained earnings.

So why are Japanese companies hoarding cash?

One explanation is larger intangible assets. It is easy for companies to put up their fixed assets as collateral for loans, but how should banks value intangible assets such as intellectual property? Cash would be a viable collateral option. However, Credit Suisse finds that there is not much correlation between cash and intangible asset positions. The ratio of cash to intangible fixed assets investments has moved broadly between 8.6 years and 11.6 years over the two decades since 1994.

A second explanation is lax corporate governance, which Abe has been trying to fix. Are Japanese companies only paying him lip service?

A third explanation is increasing pension liabilities. As Japanese society ages, companies feel compelled to hoard more cash to pay off employees who are due to retire in the coming years. Encouraging women to enter the labor force is a key component of Abenomics’ Third Arrow. He has not gone very far.

Last, perhaps Japanese companies are feeling uncertain about the future? Toyota Motor, for instance, drastically changed its yen assumption from 120 to 105 in the new fiscal year. Companies hoard more cash when they don’t know what’s going to happen.

According to the latest flow of funds data from the BoJ – corporate cash was estimated to be JPY 246trln in Q1 2016 – the 29th consecutive quarterly increase, whilst household assets rose to JPY 902trln the highest on record and the 36th quarterly increase in a row. A nine year trend.

Another trend which has been evident in Japan – and elsewhere – is an increase in share buybacks. The chart below tells the story since 2012:-

Topix Share buy backs

Source: FT, Goldman Sachs

Compared to the level of share buy backs seen in the US, Japanese activity is minimal, nonetheless the trend is growing and NIRP must assume some responsibility. Perhaps it was the precipitous decline in capital expenditure, which prompted the BoJ to introduce NIRP. The chart below is taken from the December 2015 Tankan report:-

japan-tankan-capex-index-q1-2016

Source: Business Insider Australia, BoJ

In the March 2016 Tankan, the Business Conditions Diffusion Index remained generally positive but the decline of momentum is of concern:-

Dec-15 Mar-16 June-16(F/C)
Large
Manufacturers 12 6 3
Non-Manufacturers 25 22 17
 
Medium
Manufacturers 5 5 -2
Non-Manufacturers 19 17 9

 Source; BoJ

I doubt capital expenditure will rebound while share buy backs appear safer to the executive officers of these companies. The Japanese stock market is also attractive by several valuation metrics. The table below compares the seven most liquid stock markets, as at 31st March, is sorted by the yield premium to 10 year government bonds (DY-10y):-

Country CAPE PE PC PB PS DY 10y DY-10y
Switzerland 20.3 22.5 13.9 2.3 1.8 3.50% -0.33% 3.83%
France 16 20.9 6.5 1.5 0.8 3.50% 0.41% 3.09%
Germany 16.8 19 8 1.6 0.7 2.90% 0.15% 2.75%
United Kingdom 12.7 35.4 12.8 1.8 1.1 4.00% 1.42% 2.58%
Italy 11.1 31.5 5 1.1 0.5 3.50% 1.23% 2.27%
Japan 22.7 15.3 7.9 1.1 0.7 2.20% -0.04% 2.24%
United States 24.6 19.9 11.6 2.8 1.8 2.10% 1.77% 0.33%

Source: StarCapital.de, Investing.com

For international allocators, the strength of the JPY has been a significant cushion this year, but, for the domestic investor, the Nikkei 225 is down 16.2% YTD. Technically the market is consolidating around the support region between 16,300 and 13,900. If it breaks lower we may see a return towards to 10,000 – 11,000 area. If it recovers, a push through 18,000 should see the market retest its highs. I believe the downside is supported by domestic demand for stocks as bond yields turn increasingly negative.

International investors will remain wary of the risks associated with the currency. Further BoJ largesse must be anticipated; that they have made a first provision against losses from the unwinding of QQE is but a warning shot across the bows of the ministry of finance. As I suggested in Macro Letter – No 49 – 12-02-2016 Why did Japanese NIRP cause such surprise in the currency market and is it more dangerous? a currency hedged equity investment is worth considering. Prime Minister Abe, who began campaigning, this week, for the upper house elections on July 10th, has promised to boost the economy if he wins a majority of the 121 seats being contested. The monetary experiment looks set to continue but the BoJ may be the first central bank to discover the limits of largesse.

 

Will the Nikkei breakout or fail and follow the Yen lower?

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Macro Letter – No 25 – 05-12-2014

Will the Nikkei breakout or fail and follow the Yen lower?

  • The Japanese Yen has declined further against its main trading partners
  • The Nikkei Index has trended higher on hopes of structural reform and QQE
  • JGBs remain supported by BoJ buying

The Nikkei 225 index is making new highs for the year as the JPY trends lower following a further round of aggressive quantitative and qualitative easing (QQE) from the Bank of Japan (BoJ). The Japanese Effective Exchange Rate has fallen further which should help to improve Japan’s export competitiveness whilst import price inflation should help the BoJ achieve its inflation target.

Net Assets

For several decades Japan has been a major international investor, buying US Treasury bonds, German bunds, UK Gilts as well as a plethora of other securities around the globe.  Japan has also been a source of substantial direct investment, especially throughout the Asian region.  May 2014 saw the release of a research paper by the BoJ -Japan’s International Investment Position at Year-End 2013 – the authors observed:-

Direct investment (assets: 117.7 trillion yen; liabilities: 18.0 trillion yen)

Outward direct investment (assets) increased by 27.9 trillion yen or 31.1 percent. Inward direct investment (liabilities) remained more or less unchanged.

Portfolio investment (assets: 359.2 trillion yen; liabilities: 251.9 trillion yen)

Outward portfolio investment (assets) increased by 54.1 trillion yen or 17.7 percent. Inward portfolio investment (liabilities) increased by 71.4 trillion yen or 39.5 percent.

Financial derivatives (assets: 8.2 trillion yen; liabilities: 8.7 trillion yen)

Financial derivatives assets increased by 3.6 trillion yen or 77.5 percent. Financial derivatives liabilities increased by 3.3 trillion yen or 62.5 percent.

Other investment (assets: 178.4 trillion yen; liabilities: 193.6 trillion yen)

Other investment assets increased by 25.5 trillion yen or 16.7 percent. Other investment liabilities increased by 31.6 trillion yen or 19.5 percent.

Reserve assets (assets: 133.5 trillion yen)

Reserve assets increased by 24.1 trillion yen or 22.0 percent.

The chart below shows how Japan continues to accumulate foreign assets despite their balance of payments moving from surplus to deficit:-

Japanese_assets_vs_liabilities_-_IMF_-_BoJ

Source:BoJ

From the mid 1980’s until the aftermath of the bursting of the 1990’s technology bubble, international investment was one of the principle methods by which Japanese firms attempted to remain competitive in the international market whilst the JPY appreciated against its main trading partners.

The Japanese Effective Exchange Rate chart below shows how the JPY has weakened since the initial flight to safety after the bursting of the “Tech Bubble” and again after the flight to quality during the “Great Recession”. This currency weakness was accelerated by the introduction of Prime Minister Abe’s “Three Arrows” economic policy:-

JPY Real Effective Exchange Rate 1970- 2014 BIS

Source: BIS

We are now back to levels last seen before the Plaza Accord of 1985 – after which the JPYUSD rate rose from 250 to 130.

Whilst Japan’s foreign investments returns should remain positive – especially due to the falling value of the JPY – Japanese saving rates continue to decline, just as negative demographic forces are pushing at the door. The stock-market bubble, which burst in 1990, was most excessive in the Real-Estate and Finance sectors. With housing demand expected to decline, for demographic reasons, and financial firms now representing less than 4% of the Nikkei 225 these sectors of the domestic economy are likely to remain moribund. The chart below shows the evolution of Japanese house prices from 1980 to 2008:-

Japanese Home Prices - 1980 - 2008 Market Oracle

Source: Market Oracle

After the slight up-tick between 2005 and 2008 house prices have resumed their downward course despite increasingly lower interest rates.

What Third Arrow?

In order to get the Japanese economy back on track, fiscal stimulus has been the government solution since 1999, if not before.  Shinzo Abe won a second term as Prime Minister with a set of economic policies known as “The Three Arrows” – a cocktail of QQE from the BoJ, JPY devaluation and structural reform. The Third Arrow of “Abenomics” is structural reform. This type of reform is always politically difficult. With this in mind Abe has called an election for the 14th December – perhaps prompted by the release of Q3 GDP data (-1.6%) confirming that, after two consecutive negative numbers, Japan is officially back in recession. He hopes to win a third term and fulfil his mandate to make the sweeping changes he believes are required to turn Japan around.

Energy reform is high on Abe’s agenda. Reopening nuclear reactors is a short term fix but he plans to make the industry more dynamic and spur innovation. In a recent interview with CFR – A Conversation With Shinzo Abethe Prime Minister elaborated on his plan:-

…On the other hand, we wish to be the front-runner in the energy revolution, ahead of others in the world. I would like to implement the hydrogen-based society in Japan.

The development of fuel cells started something like 30 years ago as a national project. Last year, I have reformed the regulations that inhibited the commercialization of the fuel cell vehicle. And at last, a first ever in the world, we have implemented the commercialization of hydrogen station and fuel cell vehicles.

Early next year, in the store windows of automotive dealers, you’ll be able to see the line up of fuel cell cars.

In the power sector, we shall put an end to the local monopoly of power, which continued for 60 years after the war. We will be creating a dynamic and free energy market where innovation blossoms.

He then went on to discuss his ideas for reform of corporate governance:-

Companies will have to change as well. I will create an environment where you will find it easy to invest in Japanese companies. Corporate governance is the top agenda of my reform list. This summer, I have revised the company law on the question of establishment of outside directors. I have introduced the rule called “comply or explain.”

Amongst listed companies in the last one year, the number of companies which opted to have outside directors increased by 12 percent. Now, 74 percent.

Tax reform is another aspect of Abe’s package. In the past year, corporate tax rates have been cut by 2.4%. Another term in office might give Abe time to make a difference, but his ill-conceived decision to increase the sales tax earlier this year had a disastrous impact on GDP – Q2 GDP was -7.1%. A further increase from 5% to 8% was scheduled for October 2015 but has now been postponed until April 2017 – as a palliative to the “deficit hawks” the increase will be from 5% to 10%. Whilst this was a relief for the stock market it led to a further weakening of the JPY. Last week, Moody’s downgraded Japanese debt due to their concerns about the government’s ability to control the size of its deficit.

The Association of Japanese Institutes of Strategic Studies – Tax System Reform Compatible with Fiscal Soundness – makes some interesting suggestions in response to the looming problem of lower tax receipts: –

Given Japan’s challenging fiscal circumstances, broadening the tax base while lowering corporate tax rates seems a realistic compromise to head off a decline in corporate tax revenues. However, simply lowering corporate tax rates on the condition that corporate tax revenues be maintained is of limited effectiveness in stimulating the economy. If the emphasis is to be placed on the benefits of this approach for economic revitalization, then corporate tax rates will need to be drastically lowered and the rates for consumption tax and other taxes raised. Steps will also need to be taken to reform the tax system overall rather than just to secure revenues by increasing consumption taxes. Although the weight of the tax burden will inevitably shift toward consumption tax, the tax base must also be expanded through income tax reform to secure tax revenues. An obvious choice is reconsidering the spousal deduction that gives tax benefits to full-time housewives so that the tax system can be made neutral vis-a-vis the social advancement of women. A major premise in tax increases is ensuring efficiency and fairness in fiscal matters. If the public can be persuaded that tax money is being put to good use, high consumption tax rates such as those in Scandinavia will enjoy public support. A taxpayer number system should be promptly introduced and an efficient and fair tax collection environment put into place.

Japan’s government debt to GPD is currently the highest among developed nations at 227%, however, according to Forbes – Forget Debt As A Percent Of GDP, It’s Really Much Worse – as a percentage of tax revenue debt  is running around 900%, far ahead of any other developed nation.

Labour market reform is high on Abe’s wish list, in particular, the roll-out of incentives to encourage Japanese women to enter the labour market. This would go a long way towards offsetting the demographic impact of an ageing population. It has the added attraction of not relying on immigration; an perennial issue for Japan for cultural and linguistic reasons:-

Japan - Female participation in Labour market OECD

Source: OECD Bruegal

Agricultural reform is also an agenda item. It could significantly improve Japan’s competitiveness and forms a substantial part of the Trans-Pacific Partnership (TPP) negotiations which have been taking place between Japan, USA and 11 other Asian countries during the past two years. Sadly the free-trade agreement has stalled, principally, due to Japanese reluctance to embrace agricultural reform. The Peterson Institute – Will Japan Bet the Farm on Agricultural Protectionism? – takes up the story: –

What is at stake? The gains for Japan from entry into the TPP are substantial, more than what nearly any other member of the agreement would reap. Peter A. Petri, visiting fellow at the Peterson Institute for International Economics, estimates that the agreement would add 2 percent to Japan’s GDP by 2025. More broadly, the TPP represents an opportunity for Japan to reinvigorate its unproductive domestic industries (agriculture included) by permitting greater foreign competition. It would also enable Japan to reassert itself as a leader and a model in the Asia Pacific. Facing an uncertain future with China gaining influence in the region, Japan needs to remain strong and dynamic at home, economically enabling it to leverage its technical and market-size advantages to secure its position in the region. These gains are now in jeopardy largely because of Japan’s agricultural protectionism.

How protectionist is Japan? To be fair, Japan has made progress on lowering support for agriculture since the 1980s. The United States—the primary objector to the protection afforded to Japan’s agricultural sector—also still provides support for its own agriculture sector. However, the magnitudes are starkly different. For every dollar of agriculture production, Japan provides 56 cents of subsidies to farmers. The United States and European Union provide just 7 cents and 20 cents for every dollar, respectively. Additionally, Japan spends nearly 1.25 percent of its GDP on agriculture subsidies (which includes support for producers, as well as consumers). The United States and European Union spend 1 percent and 0.7 percent, respectively. There are also many internal barriers, such as restrictions on the sale and use of farm land and preferential tax structures for farmers, which discourage older generations from leaving or corporate farms from entering the farming sector in many areas.

The political importance of the rural vote may have caused Abe to backtrack on his timetable for reform. This is another example of how important the forthcoming election will be both for the Japanese economy and its stock market.

Kuroda and GPIF to the rescue (again)

On October 31st the BoJ announced an increase in its stimulus package from JPY60trln per month to JPY80trln. On the same day the Government Pension Investment Fund (GPIF) which, with $1.2 trln in assets, is the world’s largest, announced that it planned to reduce its holding of government bonds to 35% from the current 60%, this money will be reallocated equally between domestic and international equity markets. That’s $150bln waiting to be allocated to Japanese equities. The BoJ also announced an increase in their ETF purchase programme, but this pales into insignificance beside the GPIF action.

Writing back in January 2013, Adam Posen of the Peterson Institute – Japan should rethink its stimulus – gave four main reasons why Japan has been able to continue with its expansionary fiscal policy: –

Japan was able to get away with such unremittingly high deficits without an overt crisis for four reasons. First, Japan’s banks were induced to buy huge amounts of government bonds on a recurrent basis. Second, Japan’s households accepted the persistently low returns on their savings caused by such bank purchases. Third, market pressures were limited by the combination of few foreign holders of JGBs (less than 8 percent of the total) and the threat that the Bank of Japan (BoJ) could purchase unwanted bonds. Fourth, the share of taxation and government spending in total Japanese income was low.

Last month saw the release of a working paper from Peterson – Sustainability of Public Debt in the United States and Japanwhich contemplates where current policy in the US and Japan may lead, it concludes:-

The implication of these projections is that even for just a 10-year horizon, somewhat more effort will be required to keep the debt-to-GDP ratio from escalating in the United States, and much more will need to be done in Japan. Using the probability-weighted ratio of net debt to GDP (federal debt held by the public for the United States), holding the ratio flat at its 2013 level would require cutting the 2024 debt ratio by 8 percentage points of GDP for the United States and by 32 percentage points of GDP for Japan. In broad terms achieving this outcome would involve reducing the average primary deficit by about 0.75 percent of GDP from the baseline in the United States and by about 3 percent of GDP in Japan.

The Japanese economy is now entirely addicted to government fiscal stimulus, reducing the primary deficit by 3% and maintaining that discipline for a decade is unrealistic.

I’m indebted to Gavyn Davies of Fulcrum Asset Management for this chart which puts the BoJ current QQE policy in perspective: –

Total CB assets vs GDP - Fulcrum

Source: Fulcrum

Whither the Nikkei 225?

With the JPY continuing to fall in response to QQE and the other government policy decisions of the last two months, the Nikkei has rallied strongly; here is a 10 year chart:-

Nikkei 225 - 10yr - source Nikkei

Source: Nikkei

The long-term chart below, which ends just after the 2009 low, shows a rather different picture:-

nikkei-225 - 1970 - 2009 - The Big Picture - The Chart Store

Source: The Big Picture and The Chart Store

From a technical perspective, recent stock market strength has taken the Nikkei above long-term downtrend. Confirmation will be seen if the market can break above 18,300 – the level last reached in July 2007. A break above 22,750 – the June 1996 high – would suggest a new bull market was commencing. I am doubtful about the ability of the market to sustain this momentum without a recovery in the underlying economy – which I believe can only be achieved by way of government debt reduction. Without real reform this will be another false dawn.

The chart below shows the Real Effective Exchange Rate for a number of economies. The JPY on this basis still looks expensive however the impact of a falling JPY vs KRW or RMB will be felt in rising political tension and potentially a currency war:-

Real_Effective_exchange_rates_-_1980_-_2012_BIS_-_

Source: BIS

Japan can play the “devaluation game” for a while longer, after all, a number of its Asian trading partners devalued last year, but the long-run implications of a weaker JPY will be seen in protectionist policies which undermine the principles of free trade.

Conclusions and investment opportunities

JPYUSD

The Japanese currency will continue to weaken versus the US$. This chart from the St Louis Fed, which only goes up to 2012, shows how far the JPY has appreciated since the breakdown of the Bretton Woods agreement:-

usdjpy1971 - 2010 Federal Reserve

Source: Federal Reserve

I think, in the next two to three years,  JPYUSD 160 is to be expected and maybe even a return to JPYUSD 240.

JGBs

The BoJ currently owns around 24% of outstanding JGBs but this is growing by the month. Assuming government spending remains at its current level the BoJ will hold an additional 7% of outstanding supply by the end of next year. By 2018 they could own more than 50% of the market. In order to encourage longer-term investment – or, perhaps, merely in search of better yields – the BoJ has extended the duration of their purchases out to 40 year maturities. The latest BoJ data is here.

Central bank buying will support the JGB market as the GPIF switch their holdings into domestic and international stocks. . International ownership remains extremely low so adverse currency movements will have little impact on this decidedly domestic market. With 10 year yields around 0.45%, I see little long-term value in holding these bonds when the BoJ inflation target is at 2% – they are strictly for trading.

Nikkei 225

The Nikkei is heavily weighted towards Technology stocks (43%) and on this basis the market still appears relatively cheap, it also looks cheap on the basis of the P/E ratio, the chart below shows the P/E over the past five years:-

Nikkei 225 - PE - Source TSE

Source: TSE and vectorgrader.com

Here for comparison is the Price to Book ratio, this time over 10 years:-

Nikkei 225 Price to Book 10 yr

Source: TSE and vectorgrader.com

Neither metric indicates that the current valuation of the Nikkei is excessive, but, given the frail state of the economy, I suspect Japanese stocks are inherently vulnerable.

Over the next year the Nikkei will probably push higher, helped by buying from the GPIF and international investors, many of whom are still under-weight Japan. A break above 18,300 would suggest a move to test the April 2000 high at 20,833, but a break above the June 1996 high at 22,757 is required to confirm the beginning of a new bull market. In the current economic environment I think this will be difficult to achieve. There are trading opportunities but from a longer-term investment perspective I remain neutral.