Negative Sentiment On Japanese Banking Sector Likely To Continue

| About: WisdomTree Japan (DXJF)

Summary

The Bank of Japan’s negative interest rate policy is straining bank profitability.

To control for this, the BOJ announced in September that it will undertake a policy of “yield curve control” to use its power to steepen the yield curve.

With all the problems facing Japan from demographics related issues to debt load, pegging the yield curve will be a very expensive and likely unsustainable exercise.

I remain short an index of Japanese financials.

The Bank of Japan's overnight rate currently sits at -0.1% and hasn't been above 0.5% since 1995 in response to a stubbornly persistent low-growth/low-inflation economic environment. Japan has not had managed to have two consecutive quarters or more of 2% year-over-year GDP growth since 1988. Since the late-1990's Japan's inflation rate has been negative as often as it's been positive.

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(Source: Ministry of International Affairs & Communications; modeled by tradingeconomics.com)

The BOJ's prescription of enduringly low interest rates has had the intended effect of spurring business investment and inflating domestic bond and stock markets to increase the wealth in the country. Nonetheless, equity investors have harshly punished the country's financial stocks despite the BOJ's ¥80 trillion per year ($768 billion) asset-purchasing program. The bank's decision to drop rates below zero has prevented these institutions from profiting off the yield spread normally created with respect to paying interest to depositors versus collecting interest via loans.

The eight-year period of ultra-low rates in the EU and US has also disproportionately hurt financial institutions. With Japan at 0.2% year-over-year real GDP growth for Q2 2016 and -0.5% inflation as of August at an overnight interest rate of -0.1%, easing measures are likely to carry on for an indefinite period. My belief is that these easy money policies will continue to be ineffective and that Japanese bank profitability will persistently suffer with the BOJ's experimentation with negative rates. Hence, the country's banking stocks may be prone to further sell off as earnings compress.

As a US-based investor, there are some hurdles to shorting Japanese bank stocks. As a compromise, since May 2015 I have been shorting WisdomTree's Japanese financials fund (NYSEARCA:DXJF). Since August 2015, DXJF has lost 38% of its value. It has rebounded 21% off its July 8 low, but low rates are unlikely to reverse soon and earnings will remain vulnerable.

Despite being a straightforward way of loosening monetary policy further in times of need or crisis, negative deposit rates provide little actual benefit for the Japanese economy. They work to constrict the viability of the banking system, which serves as the conduit by which monetary policy is transmitted in the first place. This, in turn, doesn't shine a positive light on the BOJ's credibility. Nonetheless, with rates and QE essentially the only two policies the bank can legally employ, the failure of its massive asset-purchasing program to bring inflation up to 2% (3-1/2 years later) has forced desperation measures.

With that being said, the BOJ is certainly fully cognizant of its effect on bank profitability and has undertaken a new policy of "yield curve control," announced on September 21. DXJF saw a 5.3% spike in price on that day alone, though has retreated back 6.2% since its September 22 six-month high.

A steeper yield curve helps the banking sector, as it allows long-term borrowers to be charged a higher spread relative to what short-term depositors must be paid in interest, benefiting margins in the process. From the diagram below, one can see that since the April 2013 initiation of QE, the curve has progressively flattened over time, depriving banks of earnings.

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In Japan's case, the back-end of the curve (comprised of distances that are, for example, 10+ years in the future) has shifted down, denoting the sentiment that inflation and/or growth expectations are more muted than they were 3-4 years ago. While the BOJ attempted to dip into negative rate territory under the belief that this would help incentivize businesses to borrow, the country already suffers from a high level of debt overhang. Namely, even as debt becomes cheaper, the high level of indebtedness among households and corporations isn't conducive to motivating further debt uptake regardless of how low the interest might be. Accordingly, the policy has done little outside of throttling bank margins.

The BOJ has attempted to use forward guidance as a means of directing public sentiment, stating that the bank is committed to keeping 10-year Japanese bonds at around 0% and attempting to surpass its aim of 2% inflation. But naturally, with over two decades of policy that has not produced solutions, there is a natural level of public skepticism as to whether its yield curve control policy will achieve its stated ambitions. Inflation has not exceeded the 2% target in over 20 years when controlling for VAT increases given they are not genuine demand-driven inflationary events (it's a basic government-mandated consumption tax increase).

In terms of historical precedents, have yield curve controls worked previously? The answer is yes, but they come at a steep price tag with various other market participants involved in the market as well. In September 2011, the launch of "Operation Twist" represented a policy initiative by the Federal Reserve to flatten the US yield curve. The Fed expanded its balance sheet by $667 billion by selling short-term US debt and purchasing long-term debt, which had the effect of reducing the spread between short-term and long-term US bond yields. This helped bring down the back-end of the curve to incentivize business investment and bring down mortgage rates to stimulate the housing market. Also, from 1942-1951, the Fed capped the yield on long-term bonds to mitigate the expense of government war spending.

Therefore, the BOJ is programming investors to look at the yield curve as follows going forward:

The issue is how sustainable the bank's yield curve control program is going to be. Japan's QE program is already a very expensive endeavor. Manipulating the curve at both the short-term and 10-year rates -- and practically any other area of the curve that might be vulnerable -- will at some point require an even more aggressive bond-purchasing agenda.

In general, I am skeptical about mostly everything Japan is doing on the monetary policy front, given the dubious viability of negative rates, its massive quantitative easing program with no end in sight, and now dipping its hand into controlling the yield curve at any point it sees fit. The BOJ's balance sheet is already at an enormous 80%+ of domestic GDP, compared to 24%-28% for the EU and US, and the country's growth remains anemic.

The bank is attempting to solve a demographic problem with monetary policy, which I do not believe will work (especially with poorly rationalized monetary policy that hasn't worked in the past). The country suffers from a population with 26.3% of its citizens over the age of 65 (median: 17.8%), a fertility rate of 1.4% (median: 1.7%), and has international migrants making up just 1.6% of the population (median: 12.2%).

Moreover, government debt now stands at over $9 trillion or about 220% of GDP (source: Japanese government data). Capital spending is still below levels seen before the financial crisis. Consumption and GDP have dropped since the April 2014 implementation of the VAT hike. And Japanese exports have been hit through the appreciation of the yen relative to the USD, by dropping from 120 yen per dollar to just above 100.

Conclusion

There are plenty of issues facing the Japanese economy, regarding demographics, debt load relative to GDP, business investment despite historically low interest rates, exports becoming strained to the yen's appreciation, and largely dead-end monetary policy initiatives that have never been very effective anywhere. And by attempting to peg the yield curve to specific levels, the BOJ is playing a very expensive and perhaps unsustainable game by interfering with the natural function of a market. An uncertain macroeconomic environment never favors banks and betting against Japan's situation has been fairly straightforward and I believe the risks are still asymmetrically skewed lower. For that reason, I continue to be short the Japanese financials index DXJF.

Disclosure: I am/we are short DXJF.

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.