The Connecting Link To The Next BOJ Easing

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Includes: EWJ, FXY
by: Adam Whitehead

Summary

Resistance to the next BOJ easing is declining as the Yen strengthens and the Japanese data weakens.

Resistance to negative Japanese interest rates has yet to be fully overcome.

JGB risk has been transferred from private holders to the BOJ.

The transfer of JGB risk to the BOJ is implicit debt monetization.

The transfer of JGB risk to the BOJ is an essential precursor to a debt write-off and/or rescheduling.

Resistance to the BOJ expanding monetary policy has declined again, however there is still significant resistance to some aspects of its policy. The last report observed that the BOJ still had a lot of work to do to overcome the resistance at home and abroad to negative interest rates. BOJ Deputy Governor Nakaso signaled that the resistance may be a little closer to home within the BOJ itself.

Speaking at the 150th anniversary of Italian-Japanese relations he opined that: "I (Nakaso) can't deny that some aspects of this policy may be counterintuitive to the public." Nakaso has never been a strong believer in negative interest rates, so using the cover of "the public", he passive aggressively signaled his continued resistance. It should be clear however that if the public were ever to buy into the idea, that he would swiftly change his opinion. Governor Kuroda thus has to sell "the public" on negative interest rates as his first priority; and then the dissenting BOJ board members will follow.

Bank of Tokyo Mitsubishi UFJ signaled that the domestic resistance to negative interest rates within the banking system is becoming more vociferous. The bank has threatened to quit being a dealer in the JGB market. Liquidity in the JGB market has become by appointment only; with the appointments being monopolized by the BOJ. Dropping out of the illiquid JGB market therefore makes sense to a dealer. The risk for the BOJ is that it requires the façade of primary dealers to interface between it and the Ministry of Finance, in order to keep up the feeble pretense that it is not monetizing the deficit. If more dealers drop out, then the charade becomes difficult to maintain. The BOJ therefore needs to come to some kind of agreement with the dealers, to protect their margins, in order to enable the mechanics of its QE process to continue.

(Source: Bloomberg)

The international resistance to any unilateral action to weaken the Yen was palpable at the recent G7 finance ministers' meeting, especially from America. The skirmishing continued after the meeting broke up. Finance Minister Taro Aso insisted on defining what he believes is a disorderly appreciation of the Yen. By his definition this is a 2-day move of five Yen. Treasury Secretary Lew gave this definition short shrift. If Japan therefore reacts to such a 2-day move, it will get called out as a unilateral currency manipulator by America.

The follow up G7 heads of state meeting failed to move beyond the stalemate conditions of the finance ministers. Prime Minister Abe tried to get the wording of the final communique to frame a more negative risky outcome for the global economy, as it goes into the expected FOMC tightening phase just as global economic conditions weaken. His insertion read; " the risk of the global economy exceeding the normal economic cycle and falling into a crisis if we did not take appropriate policy responses in a timely manner"; and looked suspiciously like an amber light for more weakening of the Yen. He failed in his bid to have his insertion included in the final communique.

The best that the heads of state could do was to allow each nation to interpret the general consensus to adopt economic reform and fiscal stimulus where appropriate. Japan will therefore have to juggle its sales tax hikes, whilst coming up with structural reform and fiscal stimulus elsewhere.

The signals from sources close to Abe suggested that the sales tax hike would be delayed, whilst a $ 91 billion supplementary budget was applied in the meantime to stimulate growth in the absence of G7 consent to weaken the yen. Taro Aso also signaled that his position has changed to now supporting a delay in the sales tax hike. It came as no surprise when Prime Minister Abe then announced that the sales tax increase will be postponed until 2019. The Opposition's no confidence vote in response was easily defeated. Whilst supportive of the economy in the short term, the delayed increase undermines the fiscal position considerably. This outcome was also concluded by Fitch, who lowered its outlook on Japan whilst retaining the same credit rating.

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(Source: Bloomberg)

Said fiscal position is one in which the budget deficit continues to balloon. The risk of this ballooning deficit is however being shifted from the private holders of Japanese government debt to the BOJ, as the central bank becomes the major creditor of the Abe government. Adair Turner a doyen of the untested policy known as Helicopter Money, suggests that the Government should make the population aware of the fact that its debt is being monetized; so that they are no longer worried about being on the hook to pay for it through taxes. The implication is that the BOJ will write off the Government's debt, or at least convert it to some kind of perpetual zero coupon bond that never gets paid; rather like the British Government War Consols.

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(Source: Bloomberg)

Allegedly once assured that they are off the hook for their debts, the people of Japan will get out there; consuming and procreating their economy back to an economic growth demographic… or so the story goes.

The fear of a spike in interest rates and/or a massive slide in the Yen, as the government's credit rating is downgraded to junk status in the event of such a debt write off, is apparently holding back progress towards this solution. It is also highly likely that no Japanese politician or central banker is willing to live with the shame and opprobrium that such a strategy would create; possibly involving a period of time for the nation on an IMF stabilization program.

The singular failure of the BOJ to inflate the country out of its debts to date, suggests that there is no way out of Japan's debt crisis without a strategic default or write off. Conveniently transferring the debt to the BOJ facilitates both the strategic default and write off process. If foreign investors don't get hit, then the IMF can be less draconian as the Japanese people will stoically wear the debt burden on the Consols.

After the savaging at the hands of G7, the IMF started to rebuild the bridges between Japan and its economic partners; in order to pave the way for the ultimate acceptance of action to weaken the Yen by Japan after it has endured another trial by fire and water of a strong currency. The reconciliatory step involved the publication of IMF research, for the edification of the G7 attendees; which showed that the monetary stimulus by Japan, that has weakened the Yen, has benefited its Asian trade partners' economies and equity markets also. Could this research be the first step towards the official great BOJ government debt monetization?

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(Source: Bloomberg)

Columbia Threadneedle's Toby Nangle believes that the BOJ (and other developed central banks) have already dropped Helicopter Money. He rationalizes this by saying that the combination of the expansion of fiscal policy combined with central bank government bond buying is de facto Helicopter Money. This author would say that he is correct, only if the alleged temporary expansion of QE liquidity is made permanent; which now seems to be the case in all of the developed nations. If Nangle is correct, then the next process in central bank communications will involve explaining how the Helicopter has already landed in stealth mode. The ensuing volatility and chaos may make the BOJ's relatively overt expansion of monetary policy to weaken the Yen look very transparent and judicious in comparison to the dark arts practiced by the ECB, Bank of England and the Fed.

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(Source: Business Insider)

Thus far, the Japanese recipients of this ex ante Helicopter Money are stashing it in the safe and not the bank. The message has either not got through to them; or if it has they no longer trust a government that intends to Welch on its debts.

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(Source: Markit)

The first piece of the collateral puzzle, to solve for G7 acceptance of Japanese unilateral currency weakening, came in the form of the latest PMI data. The third consecutive declining sub-50 number, indicative of recession, was also the weakest in the over three years; about the same period of time that the BOJ has expanded its most recent QE program over.

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(Source: Bloomberg)

The second piece evidence came from the latest CPI data; which fell even further than the previous month's drop.

BOJ Governor Kuroda began to move through the low gears of rhetoric, as he builds momentum for his ultimate monetary easing. He began by acknowledging that consumption is weak and also refusing to drop his 2% inflation target. To ease his progression through the gears, his adviser Yutaka Harada drew attention to the mitigating global economic circumstances that some FOMC members are opining as hurdles to the resumption of the tightening process. Such circumstances, like the Brexit and Chinese slowdown are risk-off and hence Yen positive. Governor Kuroda may then have global macro collateral in addition to domestic economic data to justify his future actions.

Negative interest rate dissenting BOJ board member Takehiro Sato remains critical of BOJ action, but only in its practical execution and not its spirit. In a recent speech, he appeared to hunker down for the long term; and to abandon the political expediency enforced by Abe for a swift economic solution.

In his view it will take ages to reach the inflation target and the current economic situation is very weak. He believes that the BOJ should become more flexible in its long dated JGB purchases in order to prevent a yield spike, as it did in 2003. The BOJ should therefore tailor its JGB purchases to reflect the lack of liquidity in this market, that it is exacerbating by taking out floating JGB supply. In the long run however, he remains committed to the JGB buying process and sees no limits for it at this point in time. Sato would seem to be a definite debt monetizer, despite his contempt for negative interest rates which he believes just inhibit the credit creation process and thus undermine QE.

Post Janet Yellen's Dovish comments about the US economy and the prospect for rate hikes, the Yen began strengthen again. This strengthening is one more piece of collateral required by the BOJ to justify a monetary policy expansion.

Deputy Governor Nakaso swiftly changed his position on negative interest rates, in light of the Yen's new found strength, when he said that: "We must of course be mindful of various side effects of negative interest rates, such as the effect on market liquidity, in guiding policy. Even so, the positive effects (of negative rates) are big." His sudden conversion to negative interest rates is a little to coincident with the Yen's latest strength.

Prime Minister Abe's adviser and former BOJ godfather of QQE Nobuyuki Nakahara moved for an immediate resumption and increase of JGB buying. In his opinion, this is required to augment the lack of fiscal tightening that the postponement of sales tax hike will create. Lack of fiscal tightening plus monetary expansion should net-net be an economic stimulus.

In a move which suggests that the BOJ is closely watching and copying the ECB, he also suggested that the BOJ should buy corporate bonds and even junk after the next wave of JGB purchases. Signaling that the BOJ has learned that what is good for the ECB is not necessarily good for it, he strongly advocated leaving negative interest rate policy unchanged.

Nakahara's views are important, because just before the last BOJ meeting he was resistant to the BOJ expanding monetary policy. Evidently, the sudden Yen surge has shaken him out of his monetary policy inertia. Since the strong Yen has been associated with the failed attempt at negative interest rates in the past, this time around only an expansion of JGB buying will be deployed to make sure that the currency is weakened.

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The analyst community is now satisfied that the BOJ has endured enough yen strength and weak economic data to justify a further monetary expansion. In a bizarre mirror image of the debate over the FOMC's tightening, BOJ watchers agonize over whether it will go in June or July. The Fed's procrastination devalues the impact of any BOJ easing, therefore the BOJ's easing decision seems conditional upon the Fed tightening first.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.