Click to enlarge (Source: Bloomberg)
There are many moving parts determining the probability and timing of the next Japanese monetary expansion. Observers and commentators are struggling to see how they fit and even if they fit together at all.
The last report observed the conditionality of the BOJ's next easing move upon the Fed resuming its tightening program. The Fed's decision to stay on hold, followed by the lowering of its growth projections and assumptions about the number of future rate hikes were dismally summarized by Chairman Yellen at her FOMC press conference. This event further served to strengthen the Yen, however, it at least provided the BOJ with the collateral evidence it needs to justify its next monetary expansion.
To add to the list of catalysts that could then trigger the Yen strength, that would then justify the move, the Brexit moved to the top of the list of risk-off elements in the table. Coincidentally, the timing of the UK referendum vote also served to keep the BOJ on hold. It was thus no surprise when the BOJ declined the opportunity to expand its bond buying program at its latest meeting. Slightly lower on the list, are the upcoming Upper House elections on July 10th.
This election has been framed as the opportunity to present an alternative to Abenomics. Liberals are framing the election as an opportunity to prevent Abe militarizing the country. There is however a growing feeling that Abenomics rather than the Constitution is the real focus of voters. Abenomics has been given the convincing thumbs down. Abe came in to office promising to stimulate the economy and inflation with his policies. What he actually did was a quick fix by betting that the BOJ could weaken the Yen. In a global economy of slow economic growth rates, where every nation has been trying to make the same currency bet, this quick fix was never going to work in the long run. Perhaps he had hoped that it would get him as far as re-election.
Despite his failure, however, the Japanese are so disengaged in the political process that there is no obvious opposition and a significant minority of voters just don't even care. A recent survey found that his LDP party is set to maintain its majority in the Upper Chamber, receiving support from 31 percent of voters, far more than the 9 percent support for the main opposition Democrats. Growing apathy is also clear, with 23 percent of the respondents saying they support no party and 26 percent not knowing who to vote for. Abe therefore will win by default and call this a mandate to continue with his policies.
In practice this victory is meaningless, because his great Yen weakening strategy does not work in the medium to long term; and he has nothing else to play with. In fact, as we will see later, it is quite possible that time is being called on the great Yen weakening strategy by the BOJ in any case. Abe may therefore try and dazzle with constitutional reform and nationalist rhetoric, to divert attention away from his economic policy failings. Since he may win by default in any case, there is actually no real pressure on him to deliver on either the economic or political front at all!
If the opposition is to be successful, it must go beyond framing the election as a referendum on Abenomics. To say that Abenomics is failing is not enough, since this is self-evident. A credible alternative must be presented by anyone wishing to seriously challenge Abenomics. This alternative must not only stimulate economic growth, but must also reduce the fiscal deficit. Boosting growth at the expense of the deficit is not a credible solution, given the size of Japan's debts. Cutting the deficit without a credible growth plan is not credible either. Many will argue that there is no credible solution at this point in time. It thus remains for the BOJ to either muddle along on the margins, as it has done so far, or to go for the big one and monetise away the fiscal deficit. As time passes, this latter solution increasingly becomes the only option available. Lacking in global credibility this option therefore comes at great risk... unless other nations are going to try as well.
In a previous report entitled "The BOJ is 'Worried' By G7" Japanese posturing over the strengthening Yen was viewed in the context of G7 and G20 obligations not to unilaterally intervene. The recent abrupt Yen strengthening has forced Japanese officials to revisit this issue. Finance Minister Taro Aso had stated that the speed of the Yen strengthening is justification enough for Japan to move unilaterally. He recently fired another warning shot, to remind his G7 and G20 partners of his alleged intentions and capabilities to act. Abe's adviser Koichi Hamada signalled that the line in the sand, for unilateral Japanese currency weakening, is somewhere between 90 and 95 Yen to the US Dollar. The FX market will now converge on this target range to see if and where the trigger level is. To help it on its way, Mr Yen stated that his target is 100 by year end. Post Brexit vote, it may be at this level within days.
Christine Lagarde notified Japanese policy makers of the conditionality that trading partners will attach to the ultimate expansion of monetary policy. Assuming that the last one has been a failure, which Lagarde did not say directly, she implied that the next one must be accompanied by structural economic reforms and an incomes policy if it is to have a chance of success. If the Japanese thought that they could just weaken the Yen, then they have been disabused by Lagarde.
Perhaps in acknowledgement, that things will have to be different for the next easing, BOJ Governor Kuroda abandoned his unpredictable maverick style and began to speak candidly for the first time. He openly admitted his failure to hit his 2% inflation target, in the 2 year timeframe, for the first time officially on record. This admission of failure, is however necessary to give the BOJ the motive and opportunity to have another go. His admission was therefore tactical positioning.
He also directly stated the "unprecedentedly difficult challenge" of hitting his inflation target as the reason to respond with greater monetary force. In relation to changing his style of operation, away from being overtly unpredictable, he added a subtle wrinkle in the form of guidance. Presumably this new tweak is intended to frame market perceptions of his actions to provide the desired optimal outcome that he intends. To frame market perceptions better, he will now indicate the tripwires that will elicit a monetary expansion response; without saying specifically what this will be or when it will come. By default therefore, any policy move that follows after the hitting of the tripwire should be blindly accepted as being consistent with his objective. The BOJ does not want to be second guessed and then overruled any more. Governor Kuroda thinks that he has found a way with words to achieve this objective. Evidently, his prior failure to get negative interest rates accepted has caused him to realize the error of his ways in being unpredictable.
The release of the latest BOJ meeting minutes is also consistent with Kuroda's change in guidance style. The minutes were very clear that the BOJ does not want its decision to stay on hold interpreted as meaning that it has changed its attitude towards easing or given up. According to the minutes, it could ease any time that the data and conditions dictate this behavior. The minutes also emphasize the global threats as being key risks that may trigger another monetary policy expansion.
Janet Yellen's latest FOMC press conference, touched on the issue of Helicopter Money, so the topic is being projected onto the BOJ by default. Analysts' thoughts are immediately turning to the possibility of Japan making the leap to Helicopter Money; since its experiments with QQE and negative interest rates are viewed as having failed. The last report discussed how some analysts actually believe that the BOJ is actively monetising the budget deficit already, through buying up all the JGB supply to write-off the debt or convert it to a long-dated perpetual bond. With such controversy in the minds of observers, BOJ Governor Kuroda sought to retain some semblance of orthodoxy.
Whilst ruling out Helicopter Money under the current legislation, he did however elucidate how it could be legislated in the future. Japanese law prohibits the BOJ's direct purchase of JGBs from the Ministry of Finance (MOF). It does, however, stipulate that the BOJ is allowed to buy the bonds under special circumstances and within limits set by a vote in the Diet. Japanese lawmakers therefore will ultimately decide on whether Helicopter Money is applied not the BOJ. Prime Minister Abe's majority and mandate may soon be put to this end.
The Brexit vote and the resulting Yen strength provided a potential catalyst for the BOJ to act. The strength in the Yen versus Sterling whilst unprecedented, was also seen in other currencies so there was no opportunity for the BOJ there. The strengthening of the Yen versus the US Dollar and the Euro certainly provided more motive and opportunity for the BOJ to act. Since the Brexit was heralded as the demise of the EU and the Eurozone, the BOJ has to be careful not to act prematurely as the Euro can swiftly collapse against the Yen even more.
Sensing an opportunity, Prime Minister Abe instructed Finance Minister Abe to watch the situation and intervene in the Yen at his own discretion. Treasury Secretary Lew then did his best to destroy any notions about intervention, that the Japanese may have entertained after the Brexit vote. In an authoritarian ruling, he stated that the currency markets were acting in an orderly fashion; thus negating the need for any unilateral action in response their price action. This was evidently enough to deter Finance Minister Aso, who then agreed that market conditions after the Brexit vote were not as bad as the Japanese government had anticipated. Japan must continue to wait for its opportunity.
BOJ newbie Takako Masai was thrust into this stalemate. Since she is a foreign exchange specialist by training, this is the opportunity for her to earn her pay by nudging the foreign exchange market to demand unilateral action to weaken the Yen. Her initial behavior and communication was predictable. She chose to frame the large moves in foreign exchange rates, in the aftermath of the Brexit, as a headwind for the global economy. Given that Treasury Secretary Lew has already framed perceptions of this, as not being disorderly, Masai is going to struggle with her line of reasoning.
Despite Masai's enthusiasm for her mission, to weaken the Yen, there appears to be declining enthusiasm for the BOJ to persist with its two year timeline for achieving its 2% inflation target. In the last report Governor Kuroda was noted for adhering to the target, whilst acknowledging that it will be difficult to hit it within the two year timeframe. In this report he has admitted his failure to achieve it. Something is changing at the BOJ. A new level of pessimism seems to be pervasive, with other board members now pushing for the dropping of the two year time horizon. The market has already assumed that this timeframe is pointless in any case, so the BOJ's credibility has already been lost in this respect. Japan Inc. officially revised its inflation forecasts lower, signaling that it thinks that the 2% inflation target will not even be met within five years.
The dropping of the two-year timeframe will have to be handled delicately if it occurs. If it is framed as the BOJ giving up on its 2% inflation target, this would be disastrous. If Kuroda is smart, he will use the excuse of the Brexit for dropping the time-horizon; whilst simultaneously saying that this event will force the BOJ to take stronger deflation fighting action. He must do this soon, however, whilst the Brexit memory is fresh in the market's mind and still associated with headwind conditions. If Secretary Lew's benign currency market analysis becomes the default association with the Brexit, then Kuroda will have lost the initiative.
The two year timeframe is the least of Kuroda's hurdles. A far larger one is looming in relation to changing perceptions of what the BOJ will do in relation to its massive JGB holdings. Recent commentary, from both Deputy Governor Nakaso and Governor Kuroda, suggested that they are concerned about the lack of liquidity in the JGB market that QE purchases have created. A dissenting consensus group on continued QE has found an advocate, in the form of former BOJ board member Shirai. According to him: "Monetary policy has done more than enough" and "I (Shirai) can't see why the BOJ needs to ease more when the effects of its existing steps are distorting the yield curve." Some commentators have attributed these comments to Mitsubishi-UFJ's threats to quit being a primary dealer. Others believe that they have detected a change in BOJ attitude and policy in relation to JGB purchases. Some have even suggested that this signals the end of BOJ easing altogether. This wide view of probabilistic outcomes shows that the BOJ is losing the initiative and its credibility.
There are also those who suggest that the JGB will now start buying a different asset class. The crowding out of the private investors in ETFs, by the BOJ's QQE buying, however, suggests that the buying of securities is rapidly running out of effectiveness and also securities to buy. Those who see the end of the easing process have been encouraged by this observation in relation to JGBs and ETFs.
There is also a growing technical obstacle to QQE that the BOJ finds itself running into in its ETF buying. The recent creation of equity ETFs linked to companies that boost capital expenditure and hiring has been a failure with private investors. Private investors have rightly concluded that these ETFs were created specifically for the BOJ to have a new asset to buy. Private investor participation has therefore been muted. This then produces a problem for the BOJ, because it is limited to only owning 50% of this QQE eligible asset class. The BOJ is literally running out of assets that it can now buy, which endangers future QQE.
One could conclude that the BOJ does have something up its sleeve. This could be Helicopter Money, but as has been stated previously this is conditional upon the politicians. This something up its sleeve, could also be the endgame whereby it restructures the JGBs it owns into something like British War Consols. The restructured debt would be a zero coupon bond that would never get paid. Since its duration is unlimited, it would then be the most attractive asset to own in the Japanese sector of the NIRP/ZIRP universe. The BOJ could thus unload it on the duration buyers. The something could even be the endgame whereby the BOJ simply writes off the governments debts, without even playing the charade of restructuring them into zeros.
The uncertainty over the BOJ's new course of action is growing. What seems to be certain is that QE and QQE are not working, so that it is time for something else. In the meantime the Yen strengthens and builds up expectation for that something else, whatever it may be.
Perhaps related to the question mark over the BOJ's attitude towards continued unconventional monetary policy is the controversy surrounding the huge losses at the Government Pension Investment Fund (GPIF). The fund allegedly lost $48.7 billion in fiscal 2015. In October 2014, the fund lowered the ratio of domestic government bonds in its portfolio from 60 percent to 35 percent, and doubled the ratio of stocks to 50 percent. At the time, this was viewed as a switch that confirmed the veracity and success of the BOJ's QQE process. The market front-running of this telegraphed portfolio switch also boosted equity prices, so that the fund destroyed its own entry levels and liquidity. A switch into overseas equities by the fund, was also framed as vindicating the success of the BOJ's attempts to weaken the Yen.
Since then the Yen has strengthened and Japanese equities have fallen, exposing the failure of the portfolio rebalancing move. Since the BOJ has willingly bought the JGBs that the fund has sold out of, there is also an element of collusion and conflicted interest to answer for. JGBs are scarce, so the fund's selling has made the BOJ's buying that much easier. An opposition politician could argue with some success, that the GPIF has been used to facilitate BOJ QE and hence Abenomics. The cost to the fund fiduciaries has therefore been a transfer of wealth to the BOJ and then on to the government. What makes this reasoning so seductive, is the way that the loss will not be officially reported until after the July 10th House of Councilors elections. The boasting by Prime Minister Abe that the fund has generated 37.8 trillion Yen of profits, approximately eight times the recent loss, simply adds to the controversy. There is a nasty aroma developing around this issue, that will motivate pensioners and voters to rebel against Abenomics with dangerous consequences for Prime Minister Abe and BOJ Governor Kuroda.
In his first opportunity to speak, since the Brexit vote, Kuroda was giving nothing away. Whilst stating that he will act again if the conditions require this, he injected a positive note into his commentary. His refusal to mention the Brexit and his adherence to the positive rhetoric about growth and inflation only added to the dissonance. It is possible that he is trying to soothe volatility by talking positively. For those who believe that the BOJ is finished with QE, his words will only have strengthened their conviction.
The fallout from Japan is contagious and wide ranging at the global level. The economic landscape in Japan is a microcosm of the wider problems of the developed nations. If it fails in its attempts to stimulate growth and inflation, this would set a dangerous precedent for the developed economies. Negative interest rates have undermined the ability of pension funds and insurance companies to meet their liabilities. At the same time, the growing central bank QE appetite has crowded these funds out of sovereign bonds and driven interest rates even more negative. The criticism that can be leveled at the BOJ can also be leveled at the Fed, ECB and Bank of England. The only solution available is for these central banks to start the QQE process; so that they too can take credit risk and drive up equity prices through buying ETFs as the BOJ has done. The case of the BOJ and its current ETF stalemate however shows that there are limits to QQE also. As the central banks run out things to buy, Helicopter Money gets closer to take-off. This however requires a political consensus, which appears to be sadly lacking in the developed economies at present. As a bribe to potential populist voters, it does have considerable merit for the established policy makers though.
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