Abe's Hollow Victory Makes A Very Loud Virtual Noise


Abe's victory in the House of Councillors elections coincided with the release of data which convincingly showed that Abenomics has failed so far.

Abe with the support of Ben Bernanke framed the election victory as a mandate for economic stimulus including Helicopter Money.

Mr. Market has eased for Abe and the BOJ, but will require them both to deliver soon.

The BOJ is already monetising the deficit with its "stealth weapon".

The BOJ's "stealth weapon" is creating the banana republic economic conditions that require a restructuring of its JGB holdings.

(Source: FT)

On the eve of the House of Councillors elections, the nation was reminded of the abject failure of Abenomics from inception to date. The influential Economic Watchers Survey (EWS) released by the Cabinet Office confirmed that negative sentiment was back at the same level of one month before Abe took office. This diffusion index gauges the mood amongst taxi drivers, retail clerks and others with jobs sensitive to economic conditions; so that it is therefore strongly correlated with the views of the average Japanese voter.

With no credible opposition and general voter apathy, Abe's victory in the House of Councillors election was no surprise. A Japan Times survey commissioned directly after the election result found that 56.4 percent of the respondents said they do not believe Abe's economic policy mix can lift the economy versus 32.0 percent who said they believe the measures will. The survey also found that support for Abe's Cabinet stood at 53.0 percent, down from 55.3 percent in the previous poll conducted in late May, whilst his disapproval rating was 34.7 percent, up from 33.0 points. Against such a negative backdrop, Abe resorted to theatre to change perceptions of Abenomics. Carefully placed comments from his team framed positive expectations of the election result.

Expectations have now risen for a fiscal spending package as a result of the victory and his previous stalling of the sales tax increase. There is also a raised expectation that the election result somehow gives the Ministry of Finance (MOF) the green light to weaken the Yen, but this seems somewhat misplaced and runs the even greater risk of Japan being branded as a currency manipulator by America. The sudden appearance of Ben Bernanke in Japan immediately post-election only served to heighten the sense of expectation that something big is coming. Prime Minister Abe capitalized upon this opportunity by boldly telling Bernanke that Abenomics' job of boosting inflation and growth is only half finished. This implies that there is the remaining 50% more of the same to come.

(Source: Bloomberg)

Abe's adviser Koichi Hamada, who also attended the meeting, then reported on Bernanke's advice. Allegedly Bernanke asked Abe to carry on with his economic policies by supplementing monetary policy with fiscal policy. Bernanke also allegedly said that the Bank of Japan still has the instruments to further ease monetary policy, according to Yoshihide Suga, Japan's top government spokesman. The combination of fiscal and monetary policy easing is yen negative; thus in a roundabout way, Bernanke was being used a tool to weaken the currency in a way that does not appear to be unilateral currency intervention.

Given his sobriquet of Helicopter Ben, it has been assumed by many that Japan is now preparing for Helicopter Money. Bernanke perhaps should also have admitted that he was an unofficial policy guidance instrument to weaken the yen. Presumably Jacob Lew is aware of Bernanke's use as a policy tool and has no issues with it. The Sankei newspaper ran with the story that adviser Etsuro Honda has told Abe that "now is the time to introduce helicopter money" whilst special adviser Koichi Hamada said that it should be restricted to a one-time event.

The retractions swiftly followed. Chief Cabinet Secretary Yoshihide Suga told reporters that the government isn't considering helicopter money, but the cat was out of the bag and market perceptions framed in anticipation of Helicopter Money. The framing was quite positive in terms of market reaction in contrast to the prior reaction to negative interest rates, thus the door is open to Helicopter Money in Japan. The retractions were factually correct in saying that Helicopter Money was not discussed at the recent meetings involving Bernanke. The real bombshell was dropped when it was relayed that discussions pertaining to Helicopter Money had already occurred in April.

Etsuro Honda, the current ambassador to Switzerland, has emerged as the key player in the Helicopter Money issue. He is famous for linking rock star economic advisers with Japanese policy makers. Allegedly his recent April link up with Ben Bernanke has led to the advanced discussions for the application of Helicopter Money. Apparently, this will take the form of perpetual bonds with maturity issued by the government directly to the BOJ.

For the record, Hamada has said that this Helicopter Money initiative would be a "very risky gamble" while Honda allegedly favours expanding bond purchases rather than driving interest rates deeper into negative territory. Honda's envisioned bond purchases should commence immediately.

Following this new script, Abe then ordered economy minister Ishihara to compile a new list of potential government spending by the end of the month. No order on how to finance said list was issued! Construction bonds and definitely not deficit-cutting bonds are apparently already on the list, suggesting that Abe's plan has been cooking for some time before the election. Evidently the attack on the yen will now come through deficit weakening fiscal expansion rather than overt currency intervention. Given the size of the deficit already, scope for a meaningful fiscal policy expansion is limited unless Japan intends to abandon all pretences about addressing its deficit. Bernanke's suggestion that the fiscal expansion be augmented by a monetary expansion hints that the BOJ will directly monetize the debt.

The Cabinet Office was also deployed in the attempts to frame expectations to accept a fiscal and monetary stimulus. Following the election result and all the noise surrounding Bernanke and the potential stimulus, the Cabinet Office released its new growth and inflation forecasts. Had there been no election and no political noise, the data release would have been met with disappointment and the immediate sell-off in Japanese equities and a rise in the Yen.

The growth forecast was lowered to 0.9 percent in the fiscal year that started April compared with a January estimate of 1.7 percent. The consumer price index is forecast to rise 0.4 percent compared with an earlier projection of 1.2 percent. In the absence of the election, such forecasts would have been viewed as a total failure of Abenomics. Post election and post noise, the gloomy forecasts were framed and accepted as justification for fiscal and monetary stimulus. Abenomics lives to fight another day and hence another attempt to weaken the Yen.

Even the Japanese Royal Family was mobilised in the great media spectacle. Apparently Emperor Akihito, whose reign has been confluent with Japan's economic stagnation, wishes to step down to make way for a new head of state. Regional observers will be watching to see if a transition occurs and if it is also symbolic of the switch back towards the militarism that goes along with Abenomics.

More symbolic was the abdication of Bank of Tokyo-Mitsubishi UFG Ltd. from its position as one of the 22 JGB primary dealers. This move has been on the cards for some time, ever since the bank's CEO strongly resisted the BOJ's negative interest rate policy. The bank will not however be dumping its JGB holdings, and it will also continue to play a "significant role" in the primary and secondary JGB markets. It cannot make money out of the JGB auction process, however, it can still make money out of owning them and market making in them. This suggests that a deal has been done between the BOJ and the Japanese banks.

The JGB and the government still need the banks to sit in the middle of the monetization of the Japanese deficit so that it is not overt. The structure of the dealership community is therefore being reorganized to provide the interface for the deficit monetization process whilst making it profitable for the remaining banks involved in it. The dropping out of Bank of Tokyo-Mitsubishi UFG Ltd. from primary dealership also signifies that the BOJ intends to press on with even deeper negative interest rates as it monetizes the nation's deficit.

(Source: Bloomberg)

What is also interesting about the JGB market is the divergence in yields between the 10-year and the 20- to 40-year bonds. 10-year yields have gone negative whilst 20- to 40-year have gone a little more positive. A yield incentive is available to investors who will allow Japan to roll its debts further into the future. This has implications for the potential for the BOJ to restructure the JGBs it owns into long-dated zero coupon bonds. The engineering of a negative to positive yield curve between the 10-year and 20-year plus durations nudges the migration of private investors out along the curve. The BOJ can therefore repackage the JGBs it owns into longer-duration securities that also have secondary market liquidity and value by nature of their positive yields. It will be interesting to see if this yield divergence continues. Should it continue, this supports the thesis that the BOJ will ultimately restructure the JGBs that it is buying.

(Source: Bloomberg)

It seems that Mother Nature is also working on a demographic solution to Japan's deficit problems. The results of the latest demographic survey show the largest decline in the population since records began in 1968. If Japan is dying, there will be nobody to get into debt for and also nobody to finance the debt. The BOJ therefore only has to monetize the existing deficit and let nature do the rest. Unfortunately, the death of debt and credit is not something that will weaken the yen! Every cloud has a silver lining, however, as Abe can use this demographic data as further evidence in support of his economic stimulus plans.

(Source: Bloomberg)

After all the election fireworks, Mr. Market has begun the easing process in anticipation of the Japanese policy makers' actions. Abe's advisor Masahiro Kawai advises that the policy makers should sit back, Bank of England style before delivering again, to see where Mr. Market has eased to for them. Mr. Market has not been patient or forgiving of the Japanese yen in recent times, so it is advisable that Japanese policy maker patience does not become complacency. A recent Citigroup survey found that almost one-third of those surveyed expect Helicopter Money within two weeks. The credibility delta for the BOJ is at negative 30. A move towards negative 50 would represent an at-the-money put option trigger on the loss of credibility. There is thus no room for complacency.

Former BOJ member Hideo Hayakawa also strongly advised the BOJ not to play with Mr. Market's fickle nature. In his opinion, the BOJ is already telling "two big lies." The first lie is the two-year 2% inflation target time frame. The second lie is that it has an unlimited monetary policy arsenal. Since it owns 90% of the outstanding JGB supply, the limits have been reached in this asset class. Hayakawa suggests more QQE ETF buying and even more negative interest rates. He also suggests that the BOJ delivers immediately to satisfy Mr. Market before he turns nasty and it loses all credibility.

As the euphoria over the election result swiftly evaporates, in the absence of action, the IMF has reduced the scope for something overwhelming to happen. In the opinion of its chief economist, Maurice Obstfeld, there is no need for unilateral yen intervention. In addition, he believes that the current volatility in FX markets is a good thing. In fact, he believes that this volatility is a necessary valve in the international imbalances adjustment process. He thus advocates that Japan soldiers on with Abenomics whilst adding an incomes policy.

Having just cancelled its global growth pickup forecast, because of the lack of visibility created by uncertain Brexit outcomes, it would be remiss of the IMF to allow one nation the favourable option to weaken its currency and add to the chaos. The IMF clearly wants to go into the uncertain future with flexibility as the best policy tool to deal with it. Flexible FX rates are therefore the order of the day.

In Obstfeld's opinion there is not and will not be some new Plaza style accord on currencies; so that the free floating FX market will be allowed to perform its imbalance adjustment process. The IMF is therefore firmly in line with Treasury Secretary Jacob Lew, who believes that the FX markets are not behaving in a disorderly fashion. There is therefore no quick fix available for Japan after the elections, and the process of economic reform must slowly continue.

Stepping back from all the noise, it is possible to discern a classic behavioural finance reaction to Japanese monetary policy expansion, which is well understood by psychologists. The process involves denial, anger, negotiation, grief and finally acceptance. Whilst Mr. Market goes through this process, however, there is evidence that the BOJ has been monetising the deficit all along.

It is widely believed that the BOJ is precluded from monetising the deficit by Article 5 of the Public Finance Act. Article 5 prohibits the direct underwriting of newly issued JGBs other than "in exceptional circumstances" which must be authorized by the Diet. A new Credit Suisse research note reports that the BOJ does in fact underwrite JGBs upon their maturity. This is a process known as "BOJ rollover," whereby maturing government bonds owned by the Bank of Japan are retired, the proceeds can be used to underwrite government bills for the purpose of rolling over the government's debt. Credit Suisse also calls the process a "stealth weapon" because the operation has already been preapproved by the Diet - a sort of permanent exception. So it would seem that the BOJ has been monetising the deficit for some time and is in fact literally printing money through facilitating the creation of short term IOUs. Japanese long-term debt is being converted to short-term debt, which is ordinarily a red light signal common in developing nations.

Such a process is common in banana republics, where short-term interest rates spike vertiginously, and there is rampant hyperinflation accompanying a steeply dropping currency. Why hasn't this happened in Japan yet? In answer to the question, one has to look at who owns these bills? Since the BOJ owns them, there is nobody to dump them and drive yields sharply higher. There has been some resistance to negative short-term interest rates from Japanese consumers who now prefer to hold cash. Thus far they have not resorted to abandoning what they esteem to be a source of value in yen cash, even though the BOJ is busy diluting its value. If the BOJ now restructures these short-dated IOUs into long-term perpetual bonds that never get paid back, this confidence trick may not necessarily prompt the holders of yen cash to dump it. The probability of the BOJ restructuring the debt profile of the Japanese deficit away from short-term bills into long-term perpetual bonds in the near future is therefore very high. The BOJ must do this to mitigate the banana republic conditions that it is creating by converting JGBs into short-term bills on maturity. A successful restructuring of Japan's deficit would thus avoid the degeneration into hyperinflation and currency instability that is now threatened as the short-term bills pile up.

BOJ Governor Kuroda appeared to have the final say, when he opined that there is "no need and no possibility for Helicopter Money" and that "at this moment, the Bank of Japan has three options with quantitative and qualitative easing with negative interest rates." The BOJ intends to press on with the policies that have led to the "two big lies." At the same time, it is monetising the deficit into a dangerous accumulation of short-term T-Bill debt. The level of controversy rose when it was leaked that certain BOJ members are uneasy about the sustainability of a process which has thus far only delivered the "two big lies." This unease will tend to favor the outcome, whereby the BOJ restructures the JGBs and bills it owns into perpetual zeros that never get paid.

Mr. Market had expected Helicopter Money, so he is going to be disappointed. The combination of this disappointment and the dangerous short-term T-Bill accumulation will then force the restructuring of Japan's debt profile. A betting man may like to wager that this restructuring will also involve a greater debate about Helicopter Money.

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

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