Is The 'Reversal Rate' Normalization By Another Name?

by: Adam Whitehead

The BOJ and MOF are on the same page about current monetary policy but Abe’s cabinet office is on the next reflation page.

Kuroda will do (what he is currently doing) for as long as it takes as opposed to Mario Draghi’s “do whatever it takes”.

Kuroda’s hint about the “Reversal Rate” will trigger calls that the BOJ normalization has begun.

Prime Minister Abe “hopes” that the BOJ will cap therise in JGB yields from a deteriorating fiscal situation.

The BOJ may target yields higher to support thebanking sector and debate normalization in 2018.

(Source: BIS)

The Bank for International Settlements' (NASDAQ:BIS) prescience is once again in focus, as it warns the developed nations' central banks about the perils of prolonging QE. Japan has signaled that it is a special case that does not need to follow the global imperative to normalize. BOJ Governor Kuroda may however be second guessing this view. His recent revisiting of the "Reversal Rate" hypothesis may be an early signal that the BOJ will join the global normalization party later. Since this recent revisit has been inconclusive, the BOJ still has the flexibility to rule that the "Reversal Rate" does not apply; so that Japan is still a unique case justifying continued QQE.

The last report observed BOJ Governor Kuroda flattering to deceive, with mixed messages about whether he will respond positively to Prime Minister Abe's request to help reflate the economy with more monetary policy easing. Kuroda's latest domestic speech to business leaders in Nagoya, sent the message that he will not pre-empt the situation; and will wait for them to pass on inflationary labor and input prices to their consumers as he expects. As he said: "Under the current framework of 'QQE with Yield Curve Control,' the Bank will continue to persistently pursue powerful monetary easing."

Kuroda's Nagoya speech was coincident and consistent with the release of the September BOJ Monetary Policy Meeting minutes. The minutes were themselves full of the consistently repeated words about "virtuous cycle" and "moderate" or "moderately" expanding economic activity. Interestingly, the minutes recorded attendance by government representatives who presented the intended fiscal stimulus, based around education and social welfare, promised pre-election by Prime Minister Abe. Perhaps by way of response, the BOJ Board members then noted that they expected economic activity to improve based on fiscal expenditure; thus signaling an initial refusal to accommodate a demand for further monetary policy expansion to support the reflation.

The minuted comments on BOJ policy by the government attendees were also of interest. The MOF representatives opined their satisfaction with current monetary policy steps, including yield curve targeting.

The Cabinet Office representative was less satisfied than his MOF colleagues, only opining an expectation that the government expects the BOJ to do whatever it takes to hit its inflation target rather than satisfaction with current attempts.

Crucially, the MOF and BOJ are on the same page in that monetary policy should remain the same for now. Abe's Cabinet Office is however applying subtle pressure for things to be eased further.

Close adviser to Abe and current ambassador to Switzerland Etsuro Honda was far less subtle in his application of pressure to the BOJ. He recently stated that it is inappropriate to retain Governor Kuroda and that a new BOJ Governor (namely himself) is needed to hit the inflation target.

Governor Kuroda's latest international speech, at the University of Zurich, was more explanatory of his actions and thinking in contrast to the speech made in Nagoya. Kuroda framed his explanations with the qualifying observation that when the Credit Crunch came, Japan was bereft of conventional monetary policy tools to deal with the crisis because it had expending most of these to fight the lost decades of economic activity beginning in the 1990's. Dealing with the Credit Crunch was therefore a bold experiment that is still unfinished, yet in his opinion is working. Along the way, he has learned some valuable lessons and found a new tool to implement his unconventional experiments with QQE. What he has found is that it is important to give bold and explicit guidance, whilst backing this up with bold actions. He has also found that there is an immovable object called a negative price shock which, is exogenous and often related to energy prices and, can then entrench disinflationary expectations. His reaction to this negative price shock has been to develop Yield Curve Targeting. Whilst viewed by some as a Taper, it is in fact anything but that.

Yield Curve Targeting is an exercise in creating the appropriate term structure of interest rates for specific agents in the real economy. For example, the household sector is driven by the intermediate term structure and the capital investment sector is driven by longer term interest rates. Kuroda also explained that this strategy does not have a free lunch and that there are trade-offs between sectors and term periods on the curve. The banks have been crushed by negative interest rates which have been employed to stimulate consumption drive inflation, as an example of such a trade-off. Yield Curve Targeting is therefore an economic policy management tool, created out of necessity by the absence of a conventional monetary policy cushion. It must be carefully administered since it has associated costs and negative externalities associated with it, that must be factored in and re-balanced periodically to maintain the overall integrity of the economy.

Looking ahead, Kuroda sees nothing radical on the agenda in relation to unconventional policy, other than changing the shape of the yield curve and maintaining QQE until the negative price shocks have been overcome by perceptions that the BOJ will stay in the game for as long as it takes. He and the BOJ are hunkered down for a long war of attrition against falling inflation expectations. Kuroda's as long as it takes should be compared with Mario Draghi's commitment to "do whatever it takes". The BOJ has reached the bottom of the barrel and can now only prolong its current set of policies, until it runs out of assets to buy or inflation hits its target. The BOJ is where the ECB (and the Fed and the Bank of England) may end up one day, when their normalizations run into the next economic slowdown or disinflationary negative price shock.

The corollary negative price impact on the banking sector, from the BOJ's adherence to current policies, is however causing debate over the need for remedial action in support of the banks. There are signals from the banking sector that it is giving up all hope of higher interest rates and wider margins. Setting out their stall for the ZIRP/NIRP banking environment the megabanks, who merged and scaled as Japan entered the lost decade of growth in the 1990's, have now begun to cut staff and other fixed costs. This move is also a tacit acceptance that the BOJ has prioritized the space on its balance sheet for the nation's fiscal deficit, rather than to provide a normal capital markets environment that allows the banks to be the sources of private credit for economic growth. The Japanese banking sector has thus become a marginal growth driver in a nation that continues its slow death spiral.

Governor Kuroda has himself noted these signals of capitulation from the banking sector and responded with one of his famous early signals of recognition that may translate into policy action. During his international speech, Kuroda noted something called the "Reversal Rate". This is broadly speaking a point at which the negative impact of diminished credit creation appears, as a central bank pushes on the string of ZIRP/NIRP.

BOJ Deputy Governor Hiroshi Nakaso has suggested that the banks should push this day of reckoning further into the future, by consolidating to create the economies of scale required to weather an extended period of ZIRP/NIRP. His recent speech entitled "New Frontier of Macroprudential Policy: Addressing Financial Institutions' Low Profitability and Intensified Competition" was nothing short of a practical guide for the perplexed on the subject matter of the "Reversal Rate". Unfortunately for the banks, Nakaso came down on the side of the debate which agrees that the pain in the banking system from ZIRP/NIRP is justified, for the greater good of serving economic growth, in a country where demographics make demand for credit and banking services look like a vanishing pastime.

Whilst Kuroda may be hoping for further consolidation and restructuring in the banking sector, to make it more efficient and robust, he has signaled that this next phase of evolution in the banking sector may also have reached the limit of the "Reversal Rate". What this means for Yield Curve Targeting is that the attrition in the banking sector must now be given more emphasis in policy making. A phase of targeting higher yields, in order to support the banks may be just around the corner. The higher yields that this will involve on the specific part of the yield curve being targeted, may be viewed as the beginning of the normalization. This would be an observational error, but it is still something that will occur and get discounted until it is understood to be an incorrect assumption.

Having put a question mark over Governor Kuroda's future as BOJ Governor and then doubled up the pressure by forging ahead with a deficit increasing fiscal policy that requires BOJ monetization, Prime Minister Abe recently signalled a change of heart. Addressing Parliament he stated that he had every confidence in Governor Kuroda and his policies, to achieve the inflation target. He did however leave some lingering more subtle pressure, with his "hope" that the BOJ can work together with the government to beat inflation. Could it be that after his recent meeting with President Trump, Prime Minister Abe understands that it would be reckless to do anything unilateral to weaken the Yen and stimulate the economy without allowing President Trump first dibs on such a move? Also after being re-elected there is less pressure on Abe to deliver on his pre-election promises and radical speeches; so that he can fall back into line behind the BOJ's dogged yet gradual pursuit of its inflation target. For now the pressure may be off the BOJ, but if the economy starts to slow down Abe will doubtless turn up the pressure again.

A further sign that the Prime Minister is constructing a carefully laid trap for the BOJ emerged recently from sources within the Government. Said sources suggest that the Government will lower both its future inflation and growth estimates, in line with the current trajectories of both. Ostensibly, this takes all pressure off the BOJ and suggests that the Government has fallen into line with BOJ strategy and execution. The real reason for the Government to appear to fall into line, is that its own somewhat rosy fiscal projections have been made based on optimistic growth and inflation scenarios. Since said rosy scenarios are in fact fantasies, the fiscal deterioration is much worse than the optimists predict. The Government is in fact signaling that it accepts the deteriorating fiscal picture. In the absence of structural economic reform, the fiscal deterioration will pressure government bond yields higher. The BOJ will then come under pressure to put a lid on these rising yields through its yield curve targeted buying.

In tandem with the leak from sources close to the Government, about the scrapping of the growth and inflation forecasts, related sources signaled that a supplementary fiscal package to the tune of $20 billion is being prepared. Deficit financing construction bonds are under consideration as a financing option for this fiscal spending. The deteriorating fiscal picture is about to get another nudge, from increased borrowing side, in addition to the deteriorating tax revenue side.

When Prime Minister Abe says that he "hopes" the BOJ will work with him, he is in fact saying that he "hopes" that it will put a cap on rising JGB yields by monetizing the deteriorating fiscal deficit.

Unfortunately, the rise in deficit funding may coincide with a time when the BOJ is also snugging up the area of the yield curve where the bankers need margin support. The combined impact will be a parallel shift of the yield curve upwards. This will definitely get the speculators thinking that the normalization is occurring. This may then be the dip in Japanese risk assets that should get bought and the rise in the Yen that should get sold. The normalizers will provide liquidity and good pricing to get these trades on.

In its recent market bond buying operation, the BOJ trimmed its purchases of super long maturities. Observers have another dot to join to create an emerging tighter liquidity picture. They can add this dot to another one penciled in recently by BOJ Board member Hitoshi Suzuki. It should be noted that Suzuki was a former commercial bank executive; so when he speaks it is the banking lobby speaking ultimately. His recent comments suggest that the yield curve may be adjusted in the near future to support the banking sector. "If the health of financial institutions is in trouble, it's possible monetary policy won't function well," Suzuki stated for the record; and "I'm carefully watching how our policy of controlling the yield curve affects the economy, and whether or not it is creating any distortions," he followed.

Suzuki however, went even further than talking for the banking sector and addressed the issue of monetary policy, in the context of the current global phenomenon of strong economic growth with no inflation. In his view: "It's inappropriate for interest rates to show no changes until the 2 percent inflation target is hit, and then jump abruptly once the target is achieved …… There is room to debate a fine-tuning of YCC (yield curve control) once inflation heads near 2 percent, so that markets can gradually accept the changes." These specific comments seem to confirm the view that the BOJ is preparing the market for a general discussion which may lead to some signals about a normalization of monetary policy.

The vocal resistance to any notion of normalizing, from the new dissenting BOJ Board member Goushi Kataoka, is further evidence that there are some Board members who are pushing for it. Speaking after Suzuki, Kataoka opined that the BOJ should target the yields on the 15 year part of the curve and drag them down to 0.2%. He is also in favor of increasing the monetary stimulus now, so that it can be ended sooner and thus be prevented from undermining the integrity of the financial system over a longer period of time. He also sees absolutely no reason to consider normalizing at this point in time or in the near future. As an Abe appointment, it is clear that Kataoka is trying to nudge the BOJ towards monetizing the fiscal expansion that Abe is promoting.

BOJ Board member Yutaka Harada provided a more nuanced justification for continuing with the current phase of QE, whilst refraining from expanding it. He does not see "Reversal Rate" stress conditions in the banking system, nor does he see any excessive Yen weakness that may be viewed as predatory currency manipulation. Since inflation currently lacks the momentum to become self-sustaining to and go beyond the 2% inflation target, he also sees no reason to follow the global central banks that are normalizing their own monetary policies.

Following his previous international speech, Governor Kuroda provided clarity and a guide for the perplexed on the "Reversal Rate"; in order to put observers on watch for a potential normalization signal but did not give it just yet. Speaking to parliament on this subject, he stated that academic study of this phenomenon is useful in gauging the limits of Yield Curve Targeting; but he was quick to disclaim that there are any signals yet that the banking sector has reached this inflexion point. He has laid down his marker, for future reference when it could be time to trigger the BOJ's own reversal from QQE. That point however remains some way off.

(Source: Bloomberg)

As the BOJ reconsiders the dubious benefits of pushing on a string in the banking sector, with ZIRP/NIRP, Japan's Byzantine corporate governance structure in industry is also fighting back. Japan Inc. has continued to hoard cash and increase non-fulltime lower compensated employment. Abe's pro-reform agenda combined with some activist shareholder behavior had been nudging some companies towards increased capex and paying higher worker salaries. There are now signs that Japan Inc. is resisting Abe's reform agenda with greater tenacity and purpose.

The clever work-around strategy that some companies are deploying involves buying back their own shares, then transferring them to a charitable foundation that is loyal to the executive management. Ownership and management become aligned, in favor of management rather than shareholders. The maneuver enables the companies to avoid the business reform agenda. This also makes the companies who deploy this degenerate form of capitalist behavior into zombies. The zombie behavior is in fact the antithesis of the reforms that Abe is promoting and that the BOJ is betting on to deliver its inflation target.

The BOJ's equity ETF buying as part of its QQE strategy, risks supporting this degenerate behavior by taking equity that could be used to vote for structural reform off the market. To implement reform, the BOJ may therefore have to ultimately become the uber-activist investor and drive reform through its balance sheet holdings. This may sound bizarre, but one should not rule anything out in Japan's desperate attempts to restructure its economy.

The OECD is also starting to voice its misgivings about BOJ policy a little more vociferously. In its latest warning it suggested that the BOJ may soon need to rethink its massive bond buying operations if inflation continues to undershoot. Warnings are fine, but alternative suggestions would be more helpful at this point in time.

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.