Monday, 3 October 2016

Yen Bomb

To parody Tom Jones -  "Yen bomb. Yen bomb. You're my yen bomb.  Everyone is long it just as it all goes wrong".

My friend Ryan Shea wrote a very good piece on the importance of the BoJ's actions soon after they were announced, but work commitments have prevented me from commenting upon them until now. His post is here and should be read in its entirety but I’m going to pick out the nuggets that interested me most and thank him for permission to do so.

His first point is that the BoJ is about to lose all control of its balance sheet-

The reality is that once a central bank adopts a long-term interest rate target its balance sheet shifts from being exogenously determined (ie under the control of the central bank) to endogenously determined. This is because even an institution as powerful and far-reaching as a central bank cannot set both the price and quantity of an asset (Japanese government bonds in this case). If its commitment to targeting the 10-year JGB yield is to be maintained, it must necessarily lose control of its balance sheet[3] as it has no way of determining what excess market demand or supply of JGBs there will be at the target rate as this depends upon the preferences of the private sector over which it has no direct control (influence perhaps, but not direct control)[4],[5].
The amount of JGBs the BoJ finds itself having to purchase to ensure its yield target is achieved could, over time, be potentially significant given they also shifted their monetary policy goal – namely the CPI inflation target – up from 2% to “exceeding 2%… in a stable manner”

But he goes on to point out what he sees as the real reason for the action - facilitation of fiscal stimulus -

Nevertheless, the significance of the BoJ announcement is that they have made a change that is (always was in our opinion) a necessary prerequisite for the successful reflation of Japan’s moribund economy. It is a policy-making stepping stone, but a very important stepping stone.
As we made very clear in the previous post (and numerous others before) Japan’s fiscal position is dire; government debt is on an unsustainable trajectory and given the current level is nigh impossible to rectify via fiscal consolidation. Correcting this problem is not just an economic imperative but it has become a political imperative as well, as evidenced by the emergence of Abenomics. Japan needs sustained positive inflation- it really is that simple. It is just achieving this objective has been much more challenging than widely expected.
If the BoJ is unable to generate sustained positive inflation by calibrating monetary policy at super accommodative levels, then it will require the intervention of the fiscal authority, namely the Japanese government. The BoJ even hinted as much in their statement when they referred to “synergy effects” between monetary and fiscal policy.
Such thinking is hardly new or cutting edge. Indeed, as Tily (2012)[9] points out Keynes concluded as much in The General Theory of Employment, Interest and Money, published in 1936. To wit,
“Keynes’s support for fiscal policy did not follow primarily from any lower bound to this process but from a recognition that a low long-term rate of interest might not be sufficient for recovery. A low long-term rate of interest was necessary to prevent recession, but it might not be sufficient to effect recovery from recession.”
But here is the really interesting bit -
By agreeing to backstop the JGB market, the BoJ is, in effect, facilitating the Abe government’s ability to engage in reflationary fiscal stimulus by loosening its constraints. After all, with the BoJ guaranteeing the price of government bonds, the threat of increased bond issuance triggering a JGB “death-spiral” is completely eradicated[10]. It also removes a more realistic threat that a back-up in interest rates chokes off the recovery as and when it materialises
To those still sceptical about such a reflationary outcome, it is worth noting that a yield target not only facilitates, but is a pre-condition for, outright monetary financing (OMF – or helicopter money in the vernacular); a policy that is very effective because the government can just keep issuing bonds – at a price now guaranteed by the BoJ – to satisfy the demands of any stimulus programme[13].
It is for these reasons that the BoJ’s adoption of a yield target is so significant.

So whilst many appear to have shrugged the BoJ actions off as interesting but really not that impactful (targeting only one point in the curve, cranking up inflationary wishes etc), Shea points out that what they have done may not be money printing but it is laying the path to effective helicoptering of money into the economy via an accounting wheeze that opens up the fiscal/monetary backdoor. He has long been a proponent of the idea that the end game for this phase of central bank action is yield curve control, so I was straight on to him when the BoJ took the first step. His thesis is that it ultimately leads to capital controls.

Commentary on what will happen to JPY since the BoJ has been pretty much focused on the US to JP bond switches with many suggesting that the attractiveness of JGBs has gone up on a relative basis. I can go along with that view to an extent for two reasons -

1- If you have a bond thats price is effectively underwritten via the central bank targeting its price then your risk in investing in it drops dramatically and your incentive to buy it on a risk-weighted basis increases.

2- as my own thoughts would suggest that if you take a bond, and you pin its price at zero you have effectively turned that bond into cash. It behaves in just the same way as cash. Its capital value won't change and it pays zero interest. It is cash. The difference is that this bond can have a denomination of any size you like and it won't take a huge safe to store it in. You could fit a bond who a face value of Yen 12billion in your wallet. Now compare that to a Europe where with the demise of the €500 note you need a fairly big vault to stash away €100m. The BoJ has just issued the biggest denominated bank note in the world which could be hugely attractive to those stashing cash.

However, I agree with Shea as to the ultimate outcome, as these considerations will be outweighed in the end by an upcoming fiscal tsunami BoJ. As he points out -

It is patently obvious from the current level of crowd sentiment towards Japanese stocks and the JPY that this reflation theme does not yet feature on the radars of most investors. This suggests that once investors look beyond the lack of immediate monetary stimulus, and begin to comprehend more fully the longer-term ramifications of the BoJ announcement, there is potential for a very significant price move in both (unlike nominal JGBs).
And back to his theory that the curve pinning trade will be the end game for many central banks -
Regards the global implications that flow from this decision. As we have previously stated the BoJ is a monetary policy vanguard; it has had to be because of circumstance. This remains the case. With global debt levels now higher than they were at the onset of the Great Recession, Japan may be the first country to have entered the era of fiscal dominance(possibly by some margin) but it won’t be the last; currency markets will see to that.
If you didn't read his whole post linked at the beginning here it is again   and you can follw Ryan Shea at @BlackSwanEcon

And for disclosure - I am now long USD/JPY having waited for post BoJ JPY buying to fizzle.

1 comment:

Anonymous said...

"...Shea points out that what they have done may not be money printing but it is laying the path to effective helicoptering of money into the economy via an accounting wheeze that opens up the fiscal/monetary backdoor. He has long been a proponent of the idea that the end game for this phase of central bank action is yield curve control..."
Fully agree, thanks for the link to his post. This is a topic that should be getting far more attention imho...