Japan continues to test traditional economic theory. Recent data showed that the amount of cash in circulation has doubled over the last twenty years. Traditional economic thinking would suggest that there is an inflation risk, especially as the economy has stagnated over this period creating a reduction of goods and services to chase with physical cash. The reality is that a strong secular deflationary trend over this period has caused an increased liquidity preference; that has not so far been reflected in a propensity to either consume more or pay up for goods and services consumed.
There is also a growing consensus view that BOJ policy action to encourage consumption, with zero and now negative interest rates, has in fact boosted the liquidity preference of consumers even further beyond their enhanced consumption power. Japan's aging demographics have only exacerbated this liquidity preference, as the greying population stoically accepts genteel poverty enabled by their savings that now earn nothing at the bank. The textbooks explain this monetary phenomenon by saying that velocity of money has decreased, even though its volume has risen.
There is also a growing consensus view that BOJ policy action to encourage consumption, with zero and now negative interest rates, has in fact boosted the liquidity preference of consumers even further beyond their enhanced consumption power. Japan's aging demographics have only exacerbated this liquidity preference, as the greying population stoically accepts genteel poverty enabled by their savings that now earn nothing at the bank. The textbooks explain this monetary phenomenon by saying that velocity of money has decreased, even though its volume has risen. Abenomics and the BOJ's experiments with unconventional monetary policy were just beginning to be accepted as having failed, when an external political shock occurred that may now be a catalyst which rejuvenates them or at least the belief in their properties.
Recently, some analysts have started to believe that the election victory of Donald Trump may finally change the status quo in Japan. Prime Minister Abe's failure to do so has swiftly been erased from the memories of this analyst group, after the two gentlemen were seen golfing together. The clichéd view that most business deals are done over a round of golf has thus been extended to geopolitics. President Trump has thus become the vector in Japanese capital markets that is relegating the influence of both Prime Minister Abe and the BOJ to the side-lines. Whilst his influence is benevolent in terms of promoting the Japanese reflation all is well. The problem for both the Prime Minister and the BOJ is that they have effectively lost political and economic control of the Japanese economy respectively. Japan has thus become an emerging market beta derivative tail that is wagged by Donald Trump's dog.
The last report admired the tenacity and negotiating skills evinced by under pressure BOJ Governor Kuroda. He was observed throwing the burden of economic heavy lifting back onto the government, when he declined to ease monetary policy further and suggested that a fiscal stimulus was now in order. His skills were on show again, as he swiftly moved to avoid being compromised, when he evaded demands to expand municipal bond buying with the excuse that the supply is insufficient to merit serious consideration. What this does however do is open up the potential for municipal bond issuance. This would then act as a proxy for a fiscal stimulus, which could then be enabled by QQE muni-bond buying by the BOJ. Far from thwarting Abe's reflationist agenda, Kuroda is practically and methodically pointing out how it can be achieved and enabled by him.
Former BOJ board member Sayuri Shirai is making quite a career out of being the go-to person on BOJ commentary. In the last report she framed the BOJ's latest yield curve targeting and unchanged bond buying as a taper. Building on this theme she recently opined upon what may happen in the event that the taper is viewed as a tightening ,with the resultant violent strengthening of the yen. If this indeed occurs, then Shirai believes that this will trigger a further easing of monetary policy.
The latest report from the BOJ was fairly unequivocal by BOJ standards. It is apparently done with its current phase of monetary policy expansion, until the Government can deliver on a fiscal expansion that will create the JGB's for the BOJ to buy. The report therefore confirms that the BOJ and Ministry of Finance are one and the same. Monetary and fiscal policy in Japan are therefore one and the same, in the absence of private sector agents of economic influence. Perhaps this is what populism is all about. It increasingly resembles the kind corporate capitalism found in Fascist states of recent history. Japan is no stranger to this environment. The return of militarism may be just another confirmation signal.
Into the unequivocal on hold message from the latest BOJ report Governor Kuroda injected some equivocation. Whilst conceding that inflation is on its way to meet target, he outlined that global risks could prevent this. Presumably he was alluding to the risks of populism and trade wars, which have risen since the Brexit vote. Trade wars are however often US Dollar positive, so Kuroda may actually be quite happy about life with President Trump. Perhaps hoping to leverage further off the populist theme being driven by President Trump, Kuroda then called upon Japan Inc. to raise wages.
The BOJ was also forced to follow up Kuroda's equivocation with some action, just to make the message clear. Former BOJ executive Hideo Hayakawa is of the view that the Trump election victory and subsequent US Dollar strength has taken the pressure off the BOJ to ease. This perspective seems somewhat simplistic given the more nuanced reaction of the capital markets to the Trump victory. The recent rise in bond yields post-Trump victory is playing havoc with the BOJ's yield curve targeting agenda. It was thus obliged to arrest the rise in yields in the maturities which it is targeting; by making an unlimited offer to purchase JGB's in this 2 to 5 year maturity range in order to steepen the curve which had experienced a flattening-shift higher in yield. The BOJ Governor then strongly opined that he does not have to "accept" Mr Market's opinion on the yield curve, based on what President Trump's victory is being discounted as meaning for bond yields in general. The BOJ Governor however has no such issue with what Mr Market is doing to weaken the yen.
The weakening of the yen in tandem with this curve flattening, has been seen by some as indicating that the BOJ is done with easing now that President Trump can be relied upon to weaken the Japanese currency. A flatter curve is the last thing that the policy makers need now, as they wish to see the banks making longer term loans and bond purchases. Flat curves are also bad for the banks' margins and hence their ability to lend. President Trump is therefore not the ideal solution that Japan desires, despite his ability to weaken the yen. A weak yen is of little benefit in a world where trade barriers are being erected in any case.
Having just re-steepened the yield curve, the BOJ was then faced with the next distorting shock courtesy of the Abe administration. Draft 2017 budget plans, with no numbers, were leaked to the press. These plans suggest that a fiscal stimulus is desired by Abe and that he wishes to test the reaction of the markets and the BOJ in advance. A fiscal stimulus would be expected to push up yields and weaken the yen. It would also steepen the yield curve if the BOJ were to respond by delaying any tapering.
By nature of the fact that the BOJ is the buyer of JGB's of both first and last resort, any contemplated fiscal stimulus cannot occur without BOJ enabling, if it is to be financed by the issue of government debt. The BOJ can therefore deploy its yield curve targeting resources on the maturities of the new government debt that is issued as part of Abe's flagged fiscal stimulus. This neat symmetry however needs a trigger and justification, in order to avoid being called what it is namely deficit monetization. In preparation for this event, the BOJ has begun to articulate the litany of threats to the Japanese economy which will act as a cover story for the next monetary policy expansion.
Board member Takako Masai recently kicked off the list by identifying uncertainty about the economic policies that Trump will apply and slowing overseas economies hurting sentiment in Japan. Additions to the list are expected to follow as the Japanese government announces details of its new fiscal stimulus and hence borrowing requirements.
The latest solvency report from the BOJ , illustrated the corner that it has backed itself into; from where escape is conditional upon external global forces beyond its control. The central bank turned in its first loss in four years. This loss was driven by the mark-to-market of the purchases of JGB's at negative interest rates that then accrete to par at maturity. It was also exacerbated by the rise in the yen, earlier in the year, which created a mark to market loss on foreign securities held. There is an alarming conclusion to be drawn from these numbers.
The BOJ cannot monetize the fiscal deficit through negative interest rates successfully unless the yen falls in value. Unfortunately, negative interest rates have increased the propensity for the yen to strengthen. On its own BOJ is therefore incapable of further unconventional monetary policy, involving simultaneous QQE and negative interest rates, since the two processes are self-defeating. The BOJ must therefore incrementally rotate these two processes in sequence, to manage the weakening of the yen through QQE followed by monetizing the deficit with negative interest rates. This is evidently the solution that has been chosen, which is reflected in the current policy stance of targeting the yield curve.
The arrival of US Dollar strength courtesy of President-elect Trump, has provided a windfall opportunity to monetize the deficit more aggressively; yet for some reason the BOJ has not availed itself of this windfall. The trump election victory and the US Dollar strength have however demonstrated that Japan is not in control of its reflation story. Indeed, renewed trade hostilities created by Trump's protectionist policies may suddenly deliver a period of yen strength which puts the BOJ back in an insolvent position. This risk should not be underestimated.
President Trump's impact throughout the Asia-Pacific region was initially felt through his commitment to scrap the TPP. What will replace it is something for conjecture. Prime Minister Abe's signals may provide more clarity to this conjecture. After playing golf with President Trump, the Prime Minister stated that the TPP without America was meaningless; thus scrapping the deal on behalf of his golfing partner. He then signaled that the TPP may be replaced with a free trade zone based around the realpolitik of America's umbrella missile defense shield, under which Japan is now safely positioned. Japan has no choice other than to sign up to any American sponsored regional trade deal, if it wishes to reflate its economy and inflate away its fiscal deficit under the umbrella of a strong US Dollar and US Dollar based foreign exchange system.
In the past Prime Minister Abe has signaled that he may seek a new mandate at the polls in the near future. President Trump's victory and the recent game of golf may have galvanized this plan and provided some issues to talk about during his campaigning phase. His proximity to his golfing partner can have done his re-election chances no harm, if they are framed in the foreign policy terms of relations with Trump's America. As with the BOJ, Prime Minister Abe has thus accepted that he is hostage to Donald Trump.
An interesting divergence is developing amongst the analyst community, based on which side of the Trump impact fence they come down on. Those believing in the strong US Dollar story, also favor a return of fiscal spending and animal spirits in Japan to sustain further rises in Japanese equities.
Those who see the initial Trump euphoria as a bubble are more circumspect. When the euphoria evaporates, they see the yen strengthening against the US Dollar back to 98; at which point the BOJ is facing insolvency again and Japanese equities sell-off also.
If it transpires that the BOJ is indeed playing the game, of sequential monetization and negative interest rates, then in fact both views are right and there will be a very dynamic trading range to trade ahead.
What is in no doubt, is the fact that Japanese core inflation continues to fall. October core consumer prices fell 0.4% making it the eight straight month of annual declines. Those who believe that the Trump euphoria is a bubble, therefore think that they still have got the edge at the moment. Going forward, the sudden rise in crude oil prices in US Dollars combined with the weakening yen is going to test their convictions to the limit, once this feeds into the Japanese inflation data. It is therefore hard to fall in love with either argument, but the idea of the range trade seems to have merit.
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