Click to enlarge (Source: Bloomberg)
The last report discussed the BOJ's pause and its consequences from a strengthening of the Yen. This Yen strength was seen as paving the way for the next monetary expansion by the BOJ. Eisuke Sakakibara aka Mr. Yen, also seems to be forming the same view. Having called for the Yen to go to 110 versus the US Dollar, at the beginning of the year, he is now looking at further strength through 105 to 100 by year end.
It is increasingly looking like Kuroda's experiment with negative interest rates has totally undermined all the work he did to weaken the Yen by expanding QQE last September. The conclusion swiftly being drawn is that only QQE works in weakening the Yen. Since G20 requires the consensus of all members for a nation to weaken its currency, Kuroda must now play the waiting game. If and when he goes back to G20 with a stronger Yen and asks for permission to weaken it, he will have to explain that QQE is going to be expanded.
The recently released minutes of the meeting, at which the negative interest rate strategy was announced, show heated debate and a total lack of consensus support. Members were particularly concerned about the mixed message that this would send; and the ensuing chaos it would create. No doubt this view has now persuaded Governor Kuroda to be clearer with his guidance going forward, rather than to surprise and contradict.
As the BOJ pauses to watch the outcome of its move into negative interest rate territory, the first changes in the landscape of capital markets have appeared. After a respectful period of apparent deliberation, the trust banks have decided to prioritize their short term margins over the loss of long term customers and hence ultimate survival.
Mitsubishi UFJ and Sumitomo Mitsui have started to inform their customers that they will be imposing negative interest rates on cash balances held with them by asset managers and pension funds. Observers are now watching to see if this is the tip of an iceberg or an isolated occurrence. The suspicion is that this move will now ripple through the banking industry.
Acting as a spokesman for the banking sector, Nobuyuki Hirano, president of Mitsubishi UFJ Financial Group Inc. issued the strongest warning over the health of the banking sector so far. In his opinion: "Both households and businesses have become skeptical about the effectiveness of policy measures to address the current economic problems." The weakening fundamentals in the sector suggest that the ripple is now being transmitted through the system as the banks evolve their business model to preserve their profitability.
The resistance from the banking sector was reinforced by a former Abe advisor and one-time acknowledged cheerleader for Abenomics. Nobuchika Mori stated unequivocally that negative interest rates are bad for the banking sector and hence for the economy by nature of weakening the credit creation process. When former true believers desert the cause of Abenomics and criticise the BOJ, people in Japan start to take notice.
In the inflation linked government bond market, the Japanese landscape is diverging from that of its developed nation peers. American TIPS investors are now in search of inflation protection, whilst their European counterparts remain a little more circumspect. Japanese inflation linked investors are avoiding this asset class altogether. Negative interest rates have therefore failed to raise inflation expectations.
The knee jerk reaction from retail investors to negative interest rates has also manifested itself strongly. Tanaka Kikinzoku Kogyo K.K., the country's biggest bullion retailer, reports that bullion sales soared 35% during the first quarter. The BOJ will now be watching carefully to see if this flow is sustained, and how it negatively impacts the banking sector and also consumption.
Abenomics and the BOJ both received a major setback from the latest wage bargaining round. Wage increases from the large companies were lower than last year. The 2% inflation target now looks like an even more distant goal. In addition, the Japanese worker with his consumer hat on, is in even worse condition to sustain another sales tax increase. With a lower incremental increase, the tax yield from income taxes is also under pressure. The deflation and fiscal situation are therefore deteriorating. Kuroda must already be penning his dear G20 leaders' note, in anticipation of persuading them to let him weaken the Yen.
Prime Minister Abe had been exploring the opportunity to seek a new mandate for constitutional reform, by calling early general elections. The last report concluded that this was a risky gamble; as voters may confuse the elections with a referendum on Abenomics in general. Abe's political position was weakened further when his junior coalition partners insisted that he press on with the sales tax hike, which has been increasingly viewed as bad for his electoral standing and the economy in general.
Abe's electoral position was further weakened by the broadening significance of the Japanese Communist Party as a player in any future coalition government. Out of political expediency the Communists have now dropped their strict pacifism, in order to make them attractive as a coalition partner.
After deciding to press on with the consumption tax hike, Abe came under immediate pressure from the government's advisers to reduce the force of the economic headwind that this will create. A recent Yomiuri Shimbun poll found that 65% of those surveyed wanted the proposed 2017 tax hike postponed. Assuming that this poll is representative, the economic headwind from this sales tax hike is going to be significant. The only respite for Abe in this regard, came from the OECD, which advised that the sales tax must rise by at least 15% in 2017.
In light of the anticipated shock from the sales tax hike, the Council for Economic and Fiscal Policy (CEFP), recommended that the government take on remedial measures to boost consumer spending. These measures could include raising the minimum wage and narrowing the pay gap between regular and contract employees doing the same work.
No doubt these suggestions will meet equal and opposing forces from Japan Inc. since they will erode its profitability. The latest Tankan survey showed that businesses expect inflation to reach 1.3% over the next five years, down from the 1.6% level forecast previously. Business does not expect the BOJ to hit its inflation target. The degree of certainty in this view holds out little hope that businesses will engage in the CEFP's proposals on consumer stimulus through wage increases.
The IMF swiftly moved to ease the BOJ's pain. Christine Lagarde is full of praise for the BOJ and also the ECB, for taking interest rates negative. In her opinion, had they not done so things would now be even worse on the growth and inflation fronts. By doing so she has lent even greater credibility to the developing thesis that there was in fact a "Shanghai Accord" at the last G20 summit.
The Japanese lower house also gave Kuroda (and Abe) some much needed support by approving the reflationist nominee Makoto Sakurai to the existing space on the divided BOJ policy board. Incremental progress has been made towards getting Kuroda the board that he needs in order to administer some radical monetary stimulus.
The reflationist momentum continued, as existing board member Hiroshi Nakaso began to test the waters again to see if attitudes towards the BOJ's negative interest rate strategy could be manipulated. Nakaso's opening gambit probed to see if the acceptance was there when he stated that interest rates could go more negative than the -0.1% level but that he was not sure where. He hopes to shift the debate away from the principal of negative interest rates, towards debating the limit of the level of negative interest rates.
BOJ board member Yukitoshi Funo then started the groundwork to justify the next monetary policy expansion. Funo opined that the BOJ will not hesitate to act again if the recovery is threatened. He also undermined the strict G20 criteria that future policy moves, which may weaken the Yen, should be referred to and consulted upon with other G20 members.
Funo dodged the need for a G20 consultation by asserting that the BOJ cannot and does not target currency levels, when making policy moves. The inference therefore is that the next BOJ easing of policy will be explained as not specifically targeting the Yen. Having circumvented the G20 obstacle, Funo then articulated exactly how policy will be expanded. This will be accomplished through an increase in quantity, diversification in quality and most importantly with a deeper move into negative interest rate territory.
Whilst appearing to be in sync with Funo, new BOJ Board Member Makoto Sakurai is going to be less easy to read. Initially he seemed to be a clear advocate for an expansion of QE when he opined support for more aggressive policy. He was however very careful to clarify this support, by saying that he does not advocate a slavish resort to expanding monetary policy recklessly to hit the 2% inflation target at all costs.
He then followed up his mixed message with a signal that he is a believer in bold policy action rather than incremental moves. Evidently Sakurai will be in favour of shock and awe from the BOJ, when he deems that its timing will produce the maximum impact.
After the way had been paved for him by his two colleagues, BOJ Governor Kuroda then addressed the topic of the next monetary easing from Japan. According to him, this will be very much conditional upon the behaviour of capital markets. This is code for a strengthening Yen and falling Japanese equities. Since both indicators are giving warning signals, Kuroda must be getting nearer to pulling the trigger. Unfortunately, he undermined himself by saying that negative interest rates can get more negative.
Markets will accept an expansion of QQE, but thus far have signaled total rejection of negative interest rates. Going forward, Kuroda will have to expand QQE if he does not intend to have another abject failure. It is important to note that he offered two policy solutions, expanding QQE and making interest rates more negative. Having tried and failed with QQE it is logical to assume that the next move will be a QQE expansion.
This logic however runs into technical difficulties in relation to the QQE process. These technical problems were recently highlighted by former BOJ Governor Kazumasa Iwata. According to him the BOJ will soon run out of available bonds to purchase. He therefore advocates that the BOJ takes the risky plunge of moving interest rates from negative 0.1% to negative 0.7% in one massive move. He does not rule out negative 1% interest rates ultimately.
Iwata's suggestion can be seen as introducing the negative 1% baseline into market perceptions, in order to frame expectations to accept it. This will not be easy. Clearly Iwata thinks it will be difficult also as he recommends that Kuroda remains sidelined for some time in order to assess the feedback from the first move into negative interest rates. Presumably, during this period of pause the case for the massive move to negative 0.7% or 1% interest rates can be forced onto market perceptions.
Pressure on the BOJ to do the heavy lifting increased after Prime Minister Abe appeared to pull in his horns. In a recent address to lawmakers, Abe ruled out both a supplementary budget and also the calling of elections this summer.
In addition, he reiterated his intention to proceed with the proposed sales tax increase. The only hint of any fiscal stimulus came from his announcement that existing budget spending will be front-loaded. This front-loading was confirmed by Finance Minister Taro Aso. Abe has therefore taken future stimulus into the present with the front-loading. The lack of future fiscal support will be negatively reinforced by the sales tax increase. In the absence of sustained fiscal support, it will be left to the BOJ to provide a monetary stimulus once the fiscal front-loading has worn off.
Taro Aso and Economic and Fiscal Policy Minister Nobuteru Ishihara then ratcheted up the rhetoric and pressure on the BOJ to react as the Yen strengthened in the face of relaxed attitudes to the Fed's tightening and ECB's reaffirmed commitment to "whatever is needed".
Being careful to conform, with the G20 ban on unilateral currency devaluation, both individuals implied that a unilateral revaluation had been forced onto the Yen by the Fed and ECB. In response to this unilateral action by G20 partners, the BOJ is therefore obliged to respond without breaking the rules in their opinion.
Chief Cabinet Secretary Yoshihide Suga spoke on the behalf of Prime Minister Abe, to avoid making him look even more desperate than he already appears. Allegedly Japanese Prime Minister Shinzo Abe's comment to the Wall Street Journal last week, that countries should avoid "arbitrary intervention," was totally misunderstood as ruling out intervention for Japan, according to Suga. He then applied a semantic tautology to justify future Japanese currency intervention. "What the G20 is talking about is arbitrary intervention, which is different from responding to a one-sided move," according to Suga.
Unilateral currency devaluation is evidently in the eye of the "devaluer" and not the G20 "beholder" and one man's "one-sided move" is another man's unilateral devaluation. Suga's comments should be seen as more of signal of intentions and capabilities, than a serious attempt at trying to justify future attempts to weaken the Yen.
The preparation for the response by the BOJ is being carefully framed. Further evidence of this careful preparation was to be found in the BOJ's recently released regional survey. The consistent theme running through all the regions is that the slowdown in regional economies and the strengthening Yen are increasing headwinds.
The BOJ has taken a leaf out of the Fed's playbook and is now using regional and global threats as the basis for monetary policy decisions, rather than the stock answer of failing to hit the mandated inflation target.
The problem with all this rhetoric and preparation is that it may lead to a complacent reaction from the markets. The need to justify actions to weaken the Yen also creates the risk that Mr. Market discounts the news without significantly adjusting the value of the Yen lower. This risk is greater, the longer the rhetoric and signaling continue without a discernible impact on spot prices. Just to make this situation a reality, OECD Secretary General Angel Gurria opined that any action taken to weaken the Yen will not alter its primary strengthening long-term trend. The BOJ has lost the element of surprise and is now losing the initiative.
The financial media is already preparing the markets to expect a significant response from the BOJ. The strengthening of the Yen and fall in equities serves to increase the level of expectations. The risk for Kuroda will come in satisfying observers that whatever he does next is commensurate with these high expectations.
To test the magnitude of these expectations, Abe's trusted adviser sent up a smoke signal and observed the market's response. Under the disguise of a policy suggestion, Kozo Yamamoto signalled a combined fiscal and monetary policy expansion. He suggested that the government should assemble a 10 trillion yen ($92 billion) fiscal package, and the BOJ should add the same amount to its already unprecedented easing program.
This suggestion halted the Yen's rally against the US Dollar at the 108 level. Japanese equities loved it, as speculators front-ran the BOJ. The plan therefore stops the rot temporarily, but does not demonstrably reverse the Yen's long-term rally. In addition, speculators have now bought the rumour in anticipation of selling the fact. This is just more of the same, so something more comprehensive is needed.
Speaking in response to Yamamoto, for the global markets, the IMF's Japan country head Luc Everaert opined that there is currently no need for currency intervention. This implies that any attempt to stem the rise in the Yen would be short-lived, without the buy-in of Japan's trade partners. The IMF and G20 are therefore looking for Japan to do more in the way of supply side economic reform, before they will acquiesce to the blunt tool of currency devaluation.
In response to the conflicting domestic and international forces it faces, BOJ board member Yutaka Harada carved out an independent niche in which the central bank can operate. In doing so, he also gave the BOJ room to ease at its next meeting at the end of April along with the agenda for this easing. In his opinion it would be "natural" for the BOJ to ease if it does not believe that recent Yen gains are reflected in the domestic economy. To finesse his point, he also noted that said recent Yen gains will be a headwind for growth. The BOJ can therefore claim motive and opportunity, should it wish to ease at its next meeting later this month.
BOJ Deputy Managing Director Mitsuhiro Furusawa bolstered the dimensions of the niche with some cryptic remarks at the IMF's Washington meeting, which heightened the level of market anticipation. According to him, the BOJ still has an ample array of unconventional tools available. When he was pinned down about the recent strengthening of the Yen, he hinted that this could be interpreted as "broadly in line with (economic) fundamentals"; but then issued a disclaimer that : "All I(he) can say is that there's a consensus among nations that authorities can take necessary action against rapid and disorderly exchange-rate moves."
Governor Kuroda swiftly occupied the niche created by Harada and Furusawa. Based on the negative feedback from all sides, on his negative interest rate strategy, Kuroda blinked and promoted the case for QQE. Apparently, just because the BOJ has adopted a negative interest rate policy, this does not imply that it has lost its focus on QQE. Kuroda like Yellen and Draghi, is now trying to give the market what it wants in order to weaken his currency. He has thereby become yet another head of a central bank who has subcontracted monetary policy out to Mr. Market.
Kuroda also tried to exonerate himself, whilst drawing a line under the current negative interest rate level and keeping this tool on the table for use later. In an attempt to frame market perceptions and future acceptance of further application of negative interest rates, he opined that Japanese markets would be in a much worse position had negative interest rates not been combined with QQE.
By adopting this tactic, Kuroda tries to associate negative interest rates as being part of the wider QQE process. This is a tough sell at this point in time. If however he continues to use this mantra, when the Yen has risen enough to justify Mr. Market's acceptance of his words, a window of opportunity for the application of negative interest rates may ultimately open for the BOJ.
All the verbal casuistry and sophistry, employed by Japanese officials, has fallen on the deaf ears of their G20 partners at the IMF conference. During discussions with US Treasury Secretary Jacob Lew, Finance Minister Taro Aso was reverted back to the G20 baseline that nations should not seek to unilaterally devalue. Aso has therefore at least followed the G20 directive of discussing policy options, that may weaken the Yen, with his G20 partners. It would seem that they have told him to engage in supply side reforms and fiscal stimulus, as all G20 members are doing, in order to stimulate growth.
Ironically, if Japan does nothing and its G20 partners all engage in economic stimulus the Yen may actually weaken. Such a perverse incentive, whilst amusing may actually fit Japan's broken policy making process. Even more ironically, any attempt at fiscal stimulus by Japan may also weaken the Yen because Japan's poor public finances cannot sustain such a stimulus. Japan faces Hobson's Choice.
Having taken the measure of the IMF's Washington gathering, Governor Kuroda tactically retreated. He framed the recent price action, which has halted the Yen's rise, as cover under which to retreat. As noted above, this Yen weakening was a consequence of Kozo Yamamoto's signal about the magnitude of a combined fiscal and monetary stimulus. Kuroda chose to frame the price action as an un-attributable correction to the Yen's "excessive" rise of late; whilst acknowledging that all of this "excessive" rise had not been unwound. In the absence of said package from Yamamoto, the Yen's rise will continue therefore, and Governor Kuroda will once again have to get Finance Minister Aso to ask Jacob Lew if his central bank can have the green light to intervene.
Japan needs to get a credible fiscal reform and growth plan up and running fast, so that Mr. Aso has something to show Mr. Lew to convince him (and other G20 members) to give Japan the green light to weaken the Yen.
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