The BOJ and the Fed - What's the Story Again?
A number of interesting stories are being groomed at the moment in financial markets. Investors looking for a “Reverse Twist” story at the BOJ were partly vindicated by the introduction of yield curve control, but the details were underwhelming. In the end, the BOJ opted to commit to the maintenance of status quo.
"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)."
The most interesting aspect of this policy move, however, has been the interpretation of its significance and what indeed it is trying to achieve. The main story, as I see, is that the BOJ wants a steeper yield curve, and they’re trying to achieve that by playing chicken with the momentum chasers in duration. They are sending a signal to the market that they will continue to do QE, but that they won't buy as much duration as before. They are betting on herding and front-running here. That has worked before for central banks, but will it this time, and will investors start to discount a similar move in Europe? The initial evidence doesn’t really suggest that this theme will have legs. The curves in Japan and Germany were steepening into the BOJ meeting, but have since flattened. This won’t be easy for the BOJ. A friend of mine noted the following;
"My concern is it doesn't work: there's no inflation spark, yields continue to be biased downward. And the BoJ ends up having to sell down its portfolio, which is more deflationary. How do you get of that? Cutting front-end rates more only worsens the problem. And lowering the 10y target also doesn't help. I'm not sure how this works unless a 10bps curve is in fact enough to reignite the banking channel and all the good things that entails."
It is indeed a potentially crazy implication that the BOJ could end up selling 10-year bonds to steepen the yield curve, and defend the yield curve control policy, if inflation does not increase. This seems to be the definition of a counterproductive action. But I doubt that it will come to that. In the extreme where the budget deficit is increased, and where the BOJ moves into the belly of the curve to finance that, I can’t see why the private sector would pile into duration. The real problem risk here really is the implicit refinancing risks of moving down the curve as oppose to allowing the government to term out its liabilities. All this suggests that, absent a higher yield target, the move by the BOJ will be a damp squib.
Other investors, though, have focused on a different aspect of the BOJ’s policy, namely the transition towards a price target in the bond market. In short, up until this point central banks have set targets for their balance sheets, but not yields. Even when the Fed did Operation Twist, it didn’t include a formal target, but merely the “intention” to purchase more long-dated bonds as part of QE. A price target is not without precedence, though. During the Second World War, long-term rates in the U.S. were at 2.5% capped via the Treasury-Federal Reserve Accord despite surging inflation. Of course, the BOJ is trying to cap rates to the downside, but some investors are thinking further ahead and linking the move in Japan to what happened in the U.S. CLSA’s Chris Wood describes it as follows;
"This attempt to fix the price of ten year money represents a massive hostage to fortune since, in a world where bond markets sell off, the BoJ is committed to potentially unlimited balance sheet expansion to hold the 10-year JGB at 0%."
I completely agree with this, although I doubt that the target set by the BOJ here is as “hard” as Mr. Wood implies. After all, the provision “around zero” can be interpreted in many ways. Additionally, a discussion on the risks to the BOJ is pointless without also including front-end rates in the analysis. If the front-end remains anchored close to zero, the roll and carry should ensure that the private sector would help if the BOJ got more than it bargained for, and long-end rates increased to uncomfortably high levels. This is to say, I would hold this to be true as long as the economy has a domestic savings surplus, which Japan currently does.
Japan will blow up if it runs out of money to buy foreign assets and/or when the CA slips into a deficit. In such a situation, though, I would imagine all the action will be on the front-end. The long-end will be a sideshow just as it was in the EZ periphery; the key story will be bear flattener. In that situation, the BOJ's target, whatever it might be, will be null and void. You can't print foreign currency.
Incidentally, I think it is worth repeating here that if the BOJ were stupid enough to announce a policy where it would buy foreign bonds as part of QE, I think that would be a bad omen. It would be a nuclear strike in the currency wars, but it also would be a sign that they had run out of options. Printing domestic currency to buy foreign assets won't be accepted by markets, or Japan’s trading partners, for long.
The efficiency-wage theory of central banking?
The Fed meeting offered up the “hawkish hold” that investors were expecting with the added spice of a number of keynote dissenters. This puts November in play, but my money remains on a December hike. I concede, though, that the elections, and the craziness that might follow, could scupper the Fed’s plans. The “will she-won’t she” analysis of the FOMC has been done ad nauseum, and I have little to add. An interesting aspect of the Fed story recently, however, has been the idea that a firmer signal of higher rates could in fact boost animal spirits and confidence in the economy. The argument here is that if policy makers keep telling investors, firms and consumers that the world is a horrible and uncertain place, they’ll end up believing it. Conversely, if they show confidence in the economy it might rub off on the real economy.
Economy theory gives precedent for this theory. In labour economics, the efficiency wage theory can be used to rationalise why wages in some industries are higher than the “market clearing” level. Managers might be pay higher wages to avoid employees skirting, to increase productivity or to retain workers if the (search)costs of replacing workers are structurally high [1]. Applied to macroeconomics a similar argument would suggest that central banks should increase rates above the natural rate to increase productivity. A corollary to this point is also that extreme low rates for an extended period also has lead to overcapacity, low productivity and deflation—the opposite of the intention—in key sectors of the economy.
I think it is safe to say that this idea remains a fringe discourse, but if the world doesn’t end immediately as the Fed slowly raises rates, it could gain in importance. In the end, it could well be the pillow of complacency which allows central banks to gradually reduce their intervention with the certainty that they are doing the right thing. I will let others define what exactly constitutes “the right thing”, but I am sure that such a move eventually would have adverse consequences for risk assets, as such shifts in policy always have.
Meanwhile, the most interesting aspect of this idea is, I think, that it is diametrically opposite the prevailing wisdom of monetary policy since the crisis, where the “commitment to irresponsibility” and “inflation overshooting” have been the key tenets. Both theories and policy frameworks can’t be true at the same time, and it will be interesting to see whether the efficiency-wage theory of central banking increases in dominance next year.
A little concern about the U.S. election perchance?
This week is a busy one in my neck of the woods with a plethora of EZ economic data, but focus inevitably will increasingly be homing in on the U.S. election as the main event risk. After that, markets undoubtedly will create all kinds of horror stories about EZ political risks, but that probably won’t hit its zenith until next year.
Generally, I concede that the noose is tightening for those of us who have come down on the bearish side of the fence since the summer. But the whole thing still looks very sideways to me, and as seasonality gets increasingly difficult, I am happy staying on the side lines here. I have reduced my long equity positions, and added to shorts with the result that my gross exposure is boringly neutral here. Just the way I like it going into a U.S. election, which has a volatile character such as Trump in the mix.
Meanwhile, however, a fascinating emerging asset-allocation story is that EMs now are subject to less political uncertainty than the key G4 markets. How about that for a change in discourse? I am not quite sure that this is true, but if it becomes a story, the outperformance of EM so far this year has merely been a timid starter. In other words, if excess liquidity in the developed economies begins to seek out a combination of “relative safety” and yield in EMs, things will get really silly, really quick.
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[1] The structural part is important here as oppose to a cyclical increase in cost of finding new workers due to a tight labour market and bottlenecks.