Stop me if you’ve heard this one before. A major central bank persists in holding short-term interest rates near zero and continues to buy huge amounts of government bonds even in the face of rising inflation that bankers deem to be transitory.
This time it isn’t the Federal Reserve, which committed a similar blunder two years ago, but the
Bank of Japan.
That makes Friday’s BoJ meeting arguably the most important central bank confab in a busy week when both the Fed and European Central Bank also meet to decide on rate hikes.
“We think near-term BOJ policy is the most significant global-macro event this week, and one that most traders globally will be watching the closest: an un-anchoring of yield-curve control has the potential to shift global capital flows and yield curves in a historic way,” John Brady, managing director for global institutional sales at futures broker R.J. O’Brien wrote to his firm’s clients earlier this week.
The importance extends beyond Brady’s high-powered institutional customers. The BoJ has been behind some of the major market moves important to Barron’s readers, including the rally in Tokyo stock—in which Warren Buffett’s
Berkshire Hathaway
has participated—and the gains in emerging market debt and equity, which have gotten an indirect lift from Japan’s easy-money policies. All of which stems from the resulting weakness of the
yen,
which trades around a two-decade low.
Stay with me and I’ll explain how it all ties together.
Yield-curve control is BoJ jargon for its policy of pegging 10-year Japanese government bond yields within a band of plus or minus 50 basis points around 0%. (A basis point is 1/100 of a percentage point.) In practice, that translates to a cap of 0.5% on benchmark 10-year JGBs, which the BoJ effects by purchasing massive amounts of bonds, a process the Fed and the ECB dub as quantitative easing or QE.
Whatever it is called, it means that central banks are creating new money out of thin air with the express aim of creating inflation. The success of that strategy from the Fed and the ECB are evident on both sides of the Atlantic with inflation now their common enemy.
In Japan, inflation also has exceeded the BoJ’s 2% target for 15 consecutive months, which central bank officials nonetheless deem as “temporary” (“transitory” being the word monetary authorities dare not speak any more.)
Yet the consensus among economists is that the BoJ will maintain what the bank itself calls its “ultraloose” policy at Friday’s meeting (which will be announced at noon Tokyo time.) Long after other central banks have moved away from near-zero or negative short-term policy rates, the BoJ’s key rate remains minus 0.10% because it stubbornly continues to forecast lower future inflation and that the 2% target hasn’t been sustainably attained.
The BoJ “appears to be ignoring what is front of its nose,” Russell Silberston, investment strategist for macroeconomic and policy research at Ninety One, a global investment manager, pithily puts it. Consumer prices are rising faster in Japan than in the U.S. and measures of underlying inflation are at their highest since the 1990s, he points out.
“We think that economic fundamentals have already justified some adjustment of the current super-accommodative monetary easing stance,” J.P. Morgan economist Ayako Fujita, writes in a client note. “Upward pressure on prices has broadened to a wide range of goods and services, and a combination of structural and cyclical factors has heightened pressures on wages, leading to a rise in inflation expectations.”
If the BoJ accedes to reality, it will have to raise its inflation forecast. In which case, the most likely policy response would be for it to tweak its yield-curve control. That would likely involve allowing JGB yields to rise, which in turn would result in less BoJ bond buying.
Where the rubber meets the proverbial road is in the yen’s exchange rate. Printing more money has resulted in the weakest yen in about 20 years, now roughly around 140 yen to the dollar. The cheap Japanese currency has had two significant effects.
The most obvious has been to lift Japanese stocks. According to the MSCI data, Japan stocks returned almost 24% in the year through June, nearly half-again the performance of U.S. stocks, as measured in local currencies. But when measured in dollars, which is what matters to American investors, the first-half return of Japan stocks was 13%, less than the 16.84% return for U.S. equities.
There is a less-apparent effect of the cheap yen on global markets. Since all money is fungible, global investors can borrow in one currency to buy assets in another currency. What they have done is to borrow cheap yen at bargain-basement yields to invest in higher-yielding assets, notably emerging markets. The cognoscenti call this the “yen-carry trade.”
This gambit works as long as the yen is cheap as a result of BoJ policies. And it’s been popular; according to a survey of J.P. Morgan it’s among the most crowded trades among institutional investors.
But if the BoJ shifts to a less-accommodative policy, these yen-carry trades may be vulnerable. So may be Japanese stocks. According to Capital Economics, the recent outperformance of Japanese equities seems to reflect largely the sharp weakening of the yen.
A full BoJ volte face to monetary stringency seems unlikely given the high costs of a shift from money printing. High Frequency Economics founder Carl Weinberg asserts a sudden rise in interest rates or halt to bond buying would threaten “bankrupting the financial system.”
Japanese government debt equals a huge 182% of the nation’s gross domestic product. Of that, the BoJ owns over half, or roughly 100% of GDP. The volume of Japan debt owned by the public equals 80% of GDP. Weinberg asserts that, given this massive debt, any significant tightening by the BoJ raises the risk of economic Armageddon.
Yet, as Herbert Stein, the late economist observed, if something cannot go on forever, it will stop. So it may be with the Bank of Japan’s ultra-easy policy, which has made the yen cheap, pushed up Japanese stocks, and lifted emerging markets. At some point, the BoJ should acknowledge the inflationary effects of its massive money printing.
Unlike the obvious moves by the Fed and the ECB, what the BoJ does is less certain but may be of more import to global markets.
Write to Randall W. Forsyth at [email protected]
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