The Japanese Negative Feedback Loop To Restore Dynamic Equilibrium

Includes: EWJ, FXY
by: Adam Whitehead


Negative interest rates have introduced a limit to monetary policy stimulus from the BOJ via the banking system.

Negative interest rates have introduced a correction mechanism to violently restore dynamic equilibrium in the Japanese capital markets and real economy.

G20 has set limits on BOJ policy going forward.

Governor Kuroda has acknowledged the limits placed upon him.

Prime Minister Abe has responded to the limits placed upon him by gambling.

(Source: Feedback Loops)

The BOJ appears to have confused a positive feedback loop with a negative one. Ironically, this is in relation to the subject matter of negative interest rates. Lenders have been punished for their attempts to form capital. The corollary effect is the production of a positive feedback loop for the government, which is being paid to borrow. The BOJ has been compromised, by serving the government at the expense of lenders to the government.

The negative feedback loop however sets its own internal limit to the extent of the positive feedback loop. By definition negative feedback loops promote stability, whilst positive feedback loops are inherently unstable. By sincerely trying to engineer a positive feedback loop of economic activity, with negative interest rates, the BOJ may therefore have unwittingly restored equilibrium to the system. The return to this equilibrium position may not however be a smooth one.

(Source: Bloomberg)

Recent estimates put the financial gain to the Japanese government through negative interest rates at around $464 million so far. This gain comes from the holders of JGB's. Since individuals are moving out of JGB's into cash, this gain is now coming from the BOJ and institutional investors. Should Japanese savers withdraw their savings from institutions that invest in JGB's, then it will fall to the BOJ to solely provide the income for the government.

The BOJ can finance the government, as long as it is able to fund its own JGB holdings at more negative interest rates than it pays to the government. The BOJ therefore requires the banks to finance its own financing of the government. If the banks cannot fund themselves, with negative deposit rates or negative wholesale funding rates, then their ability to enable the BOJ to finance the government will end.

(Source: Seeking Alpha)

The flight of savers into physical cash, suggests that the banks must be feeling the pressure on their ability to enable the BOJ's government debt monetization. The accumulation of physical cash holdings is impeding the BOJ's ability to monetize the government's budget deficit. The banks are close to reaching a tipping point. At this tipping point the banks will no longer be able to fund the BOJ's monetizing of the budget deficit.

At this tipping point, the BOJ will have to resort to the printing press rather than the collateral markets to finance the government. At this point the safes in which the Japanese savers are holding their cash will be opened; and a more traditional process of hyperinflation will ensue. This hyperinflation phase still shows no sign of breaking out, despite all warnings that it is imminent.

Currently the flight to cash squeezes banks on the deposit side. On the other side, the move towards more negative interest rates squeezes their margins. These two convergent forces have not yet met, with the collapse of a Japanese lender yet. At such a convergence point, the printing press hyperinflationary outcome will become a significant probability.

The last report observed the revolt of Japanese savers, against the BOJ's attempt to confiscate their wealth, through the hoarding cash as an asset class. Thus far the Japanese consumer has chosen to hold yen as cash rather than foreign currency, so the BOJ's desire for a weaker yen has been frustrated. The last report observed the revolt of Japanese savers, against the BOJ's attempt to confiscate their wealth, through the hoarding cash as an asset class. Thus far the Japanese consumer has chosen to hold yen as cash rather than hold foreign currency, so the BOJ's desire for a weaker yen has been frustrated. A desire to hold foreign currency as cash (or precious metals) however, will be another signal to support the hyperinflationary outcome.

(Source: Bloomberg)

The signals from the interbank lending market, after the move into the negative interest rate environment, are ominous. Although the benchmark interest rate charged on reserves is at minus 0.1%, the overnight interbank lending rate has only fallen to minus 0.01%. Even at this token move into negative interest rates, the interbank market has dried up.

This may not be a tipping point, but it is certainly creating a wobble. The conclusion being drawn, is that negative interest rates have actually tightened rather than increased liquidity in the banking system. The BOJ has therefore tipped the interbank market into instability; and hence the whole banking system in general. Why banks would then increase their lending activity, based on a situation in which they cannot fund these lending assets, begs the question. Why the BOJ never considered this outcome begs an even more fundamental question about the BOJ's understanding of monetary policy and the creation of credit.

(Source: The Daily Shot)

Just to nudge the tipping point a little closer in time, the Japanese demographic time bomb's time lapse dynamics began to accelerate. Officially, the population has declined for the first time since the 1920's. The per capita debt burden is therefore now under attack from the denominator, in addition from the outright numerator.

With a dwindling pool of taxpayers and Japanese allocating to physical cash outside the banking system, this debt burden is more extreme. Attempts to confiscate wealth through negative interest rates or otherwise, in addition to monetary inflation initiatives, will now be framed by this demographic risk.

The tipping point therefore looks set to be one at which attitudes to the yen will change. Foreigners currently abandoning the yen find a plentiful demand from Japanese asset allocators into cash. Policy makers continued assaults on these cash holders will however ultimately cause them to abandon the yen for foreign currencies and precious metals.

Apparently unfazed by the evidence of strong resistance to his negative interest rate strategy, Governor Kuroda pressed on with this failed agenda. Indulging in what appears to be his common practice of misleading an audience, he prepared for his showdown with G20 by telling his parliament that his strategy is working.

Having practiced on his own lawmakers he could then look his G20 partners in the eyes and say with all sincerity that his strategy is not to weaken the yen. He could even use the strength of the yen since interest rates went negative as evidence of this! He would then be following another one of his common practices of framing a failure as a success.

Governor Kuroda then reported back to his own parliament, that his G20 partners accepted that his negative interest rate strategy was an attempt to create inflation and not to weaken the yen. Evidently his G20 partners weren't totally buying into his rhetoric. In addition to the standard G20 affirmation that competitive devaluation is forbidden, Jeroen Dijsselbloem signaled that a new tripwire has been installed to materially prevent this.

G20 nations will now be obliged to consult with each other and inform if a policy move could potentially weaken their currencies. In addition, the IMF will also be involved in this communication process. Dijsselbloem strongly hinted that this new communication tool was aimed at Japan and China. Whilst falling short of an accord, a new mechanism has been established which moves G20 towards an informal accord.

In the short term the ability of the BOJ to weaken the yen is weakened and now becomes conditional upon its G20 partners' acceptance. A period of yen strength can therefore be expected until there is consensus within G20 to allow Japan to arrest and reverse its strengthening.

(Source: Bloomberg)

BOJ Deputy Governor Hiroshi Nakaso reflected the new position post G20. According to him, the BOJ can potentially take interest rates more negative but does not currently intend to do so. In many ways the G20 summit did the BOJ a massive favor. After the negative market reaction to the BOJ's negative interest rate move, the BOJ was on the rocks. G20 has ostensibly put its plans to go even more negative on hold, as this is viewed as an attempt to weaken the yen even though it in fact has strengthened it. The BOJ now has time on its hands, during which it can't go more negative on interest rates without tipping off its G20 partners and hence the markets.

Fickle observers and speculators will now lose their focus on Japan and its problems; and move to other P&L driving stories. During this period the negative image of the BOJ and Japan will be replaced with a new whipping boy. The BOJ can therefore prepare the ground for more negative interest rates with rhetoric and analysis, so that it will not be a surprise next time occurs. This would be inadvisable, since it will lead to a more violent contraction in the banking sector.

Alternatively, the BOJ can quietly drop negative interest rates and do something else, such as buying other assets. In order to help move out of the spotlight, BOJ Deputy Governor Nakaso opined that the central bank is prepared to move interest rates even more negative but not right now. He then underlined this position by calling upon the government to accelerate reform of the economy, after the BOJ has done its bit with negative interest rates.

Stimulus through reform was the key G20 theme. This G20 theme seems to have been inculcated into the thinking of Abe's adviser Masahiro Shibayama despite his protests to the contrary. After openly stating that G20 places no limits on the BOJ, Shibayama then opined that economic reform should be accelerated in Japan as a form of stimulus.

It is reasonable to say that the G20 outcome has therefore constrained Kuroda's ability to weaken the yen; which means by default that his policy making ability in general has been constrained. This fundamental signal was enough to confirm the technical yen strengthening signal, for the big Japanese banks to make their call that the four year weakening of the yen is over.

The perception in the market, is that Kuroda is constrained by the backlash against his negative interest rate policy. The additional G20 constraint has yet to be fully factored in. Observers are now looking through Kuroda's existing policy tools, to find one that can be used without inviting criticism that it will deliberately weaken the yen. Asset buying in the form of ETFs is the market's current favored default policy tool. This assumption is flawed.

(Source: Seeking Alpha)

In a previous report entitled "Monkey Business At The BOJ" it was reported that the BOJ's ETF buying intentions are running way ahead of the ETF product in the market. The BOJ can either wait for the investment banks to create more ETF product, or it can buy something else. What that something else will be remains a subject of conjecture.

Governor Kuroda then confirmed that he has in fact been constrained; either by G20 or the market reaction to his negative interest rate policy. In a speech to lawmakers he reported that he is not considering a further decrease in interest rates , to make them more negative. The yen then immediately weakened, because speculators concluded that liquidity preference for the currency will decline if interest rates are not going to become more negative. Ironically, the message to Kuroda now is that if he wishes to weaken the yen, he must raise interest rates!

Kuroda's backstroking on further plumbing the depths, with negative interest rates, then took a quantum leap. Under deepening scrutiny and hostility from lawmakers he opined that the negative growth impacts, from the next proposed sales tax increase, will not be as severe as the last one in 2014. He expects that less consumption will be pulled from the future into the present as consumers move in anticipation of the tax increase. Consequently, there is less pressure upon the BOJ to mitigate the negative impacts of the next sales tax increase. In addition the fiscal position of the nation will improve, as sales tax revenues increase, so that fiscal stimulus rather than a monetary stimulus can be considered as the next growth option.

Under hostile cross examination, Governor Kuroda was also forced to admit that he could not "deny" that negative interest rate policy "has an adverse effect on financial institutions' earnings." This implies that the ability of the banks to support economic recovery through the credit transmission process has also been adversely affected. Kuroda's enthusiasm for taking interest rates to new negative levels has evidently been tempered.

Governor Kuroda received a welcome break, from retiring dissenting board member Sayuri Shirai. She will be replaced by the far more accommodating septuagenarian Makoto Sakurai. He should have less trouble and embarrassment forming that all important consensus going forward.

The G20 outcome has forced Prime Minister Abe to behave even more perversely than usual. Despite advice to the contrary he has decided to press on with the next sales tax hike. Experience to date shows that the inflation boost from this is fleeting; likewise the consumption jump in anticipation of the tax falling due. Some rational observers therefore concluded that the debt situation must be truly more horrific than was currently assumed. Other observers were certain that this spells the end of Abenomics.

When looked at through the prism of G20, there is logic in Abe's apparent irrationality. There was a common agreement at G20 to adhere to previously agreed policies. Abe is therefore obliged to press on with his sales tax increases to meet this obligation. There is also a strict preclusion of overt currency devaluation. Abe thus cannot rely on the BOJ to do anything that shifts the dynamics of the yen. There is also an agreement to stimulate growth at the G20 level, through fiscal reform and expansion. Abe is therefore trying to use Japan's G20 growth and reform commitments to overcome the G20 shackles on the BOJ.

In addition Abe is also gambling, because there is now nothing more to lose than he already can do with the failure of Abenomics. In fact, there is every chance that the new sales taxes will push the Japanese economy into deeper recession, because frugal Japanese consumers will respond by retrenching even further. Combining the next wave of consumer retrenchment, with their asset allocation to physical cash, could push the economy over the tipping point that has been suggested previously. Since he has been advised not to go ahead with this move, it can only be concluded that Abe is deliberately pressing the destruct button. He will then have a scenario on his hands, that he can take back to G20 for consultation to ultimately receive the blessing to go ahead with further inherent monetary inflation policies that will undermine the yen.

Abe is also placing a bet on the fact that the G20 is becoming too large and too conflicted to coordinate global policy initiatives any more. A previous report suggested that G20 has become a sub-optimal vehicle for global policy coordination, because many of its members are conflicted. It was speculated that policy making would degenerate into smaller groupings with aligned interests.

Abe is now focusing on G7, to see if greater alignment of interest can be attained there; that will allow him to pursue policies that would be conflicted at the G20 level. In anticipation of the next G7 meeting in late May, he will set up a special panel to create Japanese issues to be put on the G7 agenda. This panel will include himself, BOJ Governor Kuroda and Finance Minister Taro Aso. The developed nations of G7 can now be seen as turning against their less developed challengers at the G20 level.

To confirm that he is in gambling mode, a close aide to the prime minister leaked that a general election may be called this year rather than as mandated in 2018. With the wheels coming off Abenomics, the prime minister is judging that it may be wiser to go to the country to renew his mandate earlier; rather than later when things are much worse. In addition, Abe has set himself the ambition of reforming the constitution to make the country more engaged with the current geostrategic issues and the regional threat from China. It would be easier to achieve this political reform with a new mandate.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.