THE BEGINNING OF THE END
2016-09-21 4pm EDT | #Japan #Bank of Japan #BoJ #JGB
Last night’s Bank of Japan announcement has come and gone, and although markets have barely moved, there are larger consequences to their policy changes than first meets the eye.
Let’s recap Kuroda’s move (from ForexLive):
- Keeps negative rate unchanged
- To expand monetary base until inflation stable above 2%
- To modify its policy framework
- Adopts QQE with yield curve control
- To keep buying JGBs so balance of its holdings increases at annual pace of 80 trln yen
- Introduces new market ops for yield curve control
- Depending on market conditions may set JGB purchase size per auction to fixed amount or unlimited amount
- Purchasing yields will be set per auction by indicating the spread from the benchmark yield which BOJ determines separately
- Makes amendment to ETF purchases
- Decides to set target for long term interest rates
- Maintains -0.1 pct negative interest rate
- To abandon monetary base target
- Says no official base money target, but maintains annual pace of JGB buying at 80 trln yen
- To buy JGBs so 10 yr yield hovers around 0 pct
- Scraps range for duration of JGBs that BOJ buys
- Adopts commitment to let inflation overshoot above 2 pct
- BOJ can cut short term policy rate, target level of long term rates in future easing
- BOJ may accelerate expansion of monetary base as future policy option
- BOJ to continue expanding monetary base until CPI exceeds 2% and stays above target in stable manner
- Pace of monetary base increase may fluctuate in short run under market op that aims to control yield curve
- Ready to conduct fixed rate JGB buying ops for 10-yr, 20-yr JGBs in case interest rates spike
- To make yield curve control a centrepiece of its new policy framework
- Maintains commitment to achieve 2% inflation at earliest date possible
- Adopted new policy framework with view that further rise in inflation expectations may take time
But what does it mean?
While the market is focusing on the fact there seems to be no additional stimulus, there are a bunch of meaningful changes that deserve examining more thoroughly.
The Bank of Japan is attempting to control the yield curve through their new program of “QQE with Yield Curve Control.” Specifically they have pledged to peg the 10 year portion of the curve at approximately zero with the various different monetary tools available to them. Last night before the meeting the 10 year JGB was hovering around this level, so the JGB response has obviously being muted.
Yet pegging a longer part of the yield curve is a dramatic change in policy that has never been attempted by a major Central Bank. Many times Central Banks have tried to alter the curve through the buying and selling of various maturities (for a recent example, the Fed’s 2011 Operation Twist), but there has never been an explicit pegging.
Stop and think about the enormity of that development. That means the BoJ could potentially be forced to BUY or SELL unlimited amounts of 10 year bonds to defend the peg. Obviously this is impractical, which is why the BoJ made the “loose” commitment to holding the peg as opposed to a “firm” promise. But that still doesn’t diminish the possibility the market will test the Bank of Japan in the coming months and years.
Yet this raises an interesting question. Which way will the BoJ be tested? Will the market force the Central Bank to buy more 10 years as investors flee this part of the curve? Or could some sort of stress actually force the BoJ to sell 10 year bonds to keep rates from falling back below zero?
Pegging any market rate is always a dangerous proposition. It’s fine if you get the price right, but inevitably the price is always wrong, and the distortions created as you hold the peg can become quite dangerous.
With Kuroda’s new pledge, suddenly being short the 10 year JGB market seems quite boring. After all, the Bank of Japan has promised to keep the yield around 0%. So long or short, you seem destined to make no money.
The absurdity of pegging the 10 year rate at 0% seems to be lost on most market participants. There has been such a panic from long term yields falling below zero that stamping out the ponzi like speculation has dominated Central Bank thinking. Instead of listening to the market signals, the Bank of Japan has acted to further suppress volatility.
Here is a thought. Which way do you eventually think this battle with negative rates will break? I take comfort in the thousands of years of human history of inflating away currencies. I have yet to see a currency collapse because they didn’t print enough. So for me, I think inflation will eventually roar back, the only question is timing.
With these new developments, the timing for Japan doesn’t matter as much. You can short 10 year JGBs and wait for the peg to break. It doesn’t cost you anything. It’s not quite that easy as there is slight negative carry with the negative front end rate, but the worries of a big move higher should be vanished as long as the BoJ holds the 10 year rate at zero.
My suspicion is that hedge funds will realize the Bank of Japan has not eliminated volatility, but merely postponed it. Shorting the 10 year JGB seems like a great risk reward. Granted there is no rush to put it on as it will be boring for a long time. Yet at some point it will be the kind of trade that offers an unbelievable risk reward.
What about the other parts of the program?
Most market participants are laughing at the BoJ’s reaffirmation of their inflation target commitment. I saw someone say it was like an overweight man on a diet who has yet to lose any weight, commit to losing even more weight. And given the Bank of Japan’s poor record of achieving their inflation target, this criticism is justified. Yet I dug out the actual BoJ press release and examined the wording regarding this part of their program:
The new policy framework consists of two major components: the first is “yield curve control” in which the Bank will control short-term and long-term interest rates; and the second is an “inflation-overshooting commitment” in which the Bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner.
“Inflation-overshooting-commitment?” When have you ever seen those three words in that order in a Central Bank press release?
I will let everyone else laugh, but when I see a Central Bank pledging to “overshoot” on inflation, the last thing I want to bet on is their lack of success. I am reminded more of the line, “be careful what you ask for, you just might get it.”
What else is new?
This next tidbit comes from the always great Macro-Man blog site.
Finally, the BOJ has extended its version of an LTRO (supplying funds at a fixed rate against a pool of collateral) to ten years from one year, with a lending rate of zero. This has received almost no coverage.
Indeed MacroMan is correct, this development has received so little coverage I could not find mention of it in any news story. Believing Reagan was right in his “trust by verify” motto, I went digging to find the details. Sure enough, there it was in the Bank of Japan press release:
The Bank decided to introduce the following new tools of market operations so as to control the yield curve smoothly.
(i) Outright purchases of JGBs with yields designated by the Bank (fixed-rate purchase operations)
(ii) Fixed-rate funds-supplying operations for a period of up to 10 years (extending the longest maturity of the operation from 1 year at present)
This program is similar to the ECB’s LTRO (long term repo operation). But the Bank of Japan has pushed the term all the way out to 10 years!
That’s madness. Japanese banks will be able to borrow money at zero from the BoJ for a fixed period of ten years! This is cooking with gasoline type of monetary financing. It doesn’t get much better than that. How long before Goldman figures out a way to lever it up?
Most market participants think last night’s Bank of Japan’s announcement was either a disappoint or a non-event. I will take the other side of that trade. I suspect we will look back and wonder why we didn’t realize this was the beginning of the end.
Thanks for reading,