- The central banks of most developed economies joined the Federal Reserve in taking the first steps toward normalizing monetary policy in 2017.
- The Bank of Japan at first glance appears to be playing along by engaging in "stealth tapering" with its yield suppression policy.
- Yen strength and rising bond yields may yet force the BoJ to resist normalization, or even buck the trend by reverting back to increasingly stimulative monetary policies.
- Having historically been accused of currency manipulation by trading partners, actions by the BoJ in the next 12 months could present yet another set of challenges for international trade.
The next 12 months suggest continued monetary tightening from the developed world's central banks. Now, it can be argued that the term "normalizing" is preferable to "tightening" given the extraordinarily abnormal monetary policies observed since the Great Financial Crisis (GFC). Whichever term you use, however, there is no denying the relatively hawkish moves made by the Federal Reserve, Bank of England, and Bank of Canada in the last year or more. There have also been hints from the European Central Bank (ECB) and the Bank of Japan regarding less accommodative policies, too. Ultimately, I expect the ECB to essentially follow through with its stated, albeit incremental, normalization plans. However, the Bank of Japan is a most interesting wildcard.
There are several macro factors which cause me to believe that the Bank of Japan (BoJ) will not be able to normalize policy over the next 12 months, or for perhaps much longer. Most glaring is the continued weakness of the US dollar. The Japanese economy has benefited from increased exports recently, but manufacturers are already worried that Yen strength may spoil the party. Also of importance is the BoJ's commitment to yield suppression, and its stated intent to keep the yield of the 10-year Japanese Government Bond at essentially zero. These factors, in combination with an inflation rate that remains stubbornly unmoved, suggest that normalization is unlikely. It seems at least as likely, especially given recent volatility in bond markets, that the BoJ's recent reduction in annual bond-buying may be quite temporary.
The bigger question will then come down to how her trading partners will react if Japan stands apart as the sole developed nation unwilling (or unable) to normalize monetary policy. Presumably, the current US administration will not take lightly to what can easily be interpreted as currency manipulation. Nor is it likely China will see things much differently, either. Indeed, countries as far removed as Germany and Brazil have historically been frequent critics of Japan's monetary policies. It seems that even more dark clouds are gathering over global trade.
Starting in October of 2014 the Federal Reserve formally ended its most recent asset purchase program (QE3). While that represented a "tightening" of sorts it was at the time by no means an international trend. No sooner had the Fed ended its bond-buying program than the ECB announced an asset buying program of its own, while the BoJ's QQE policy, which had been in place since 2013, was just gaining momentum. As recently as 2015, the Bank of Canada surprised many by lowering its overnight rate twice, and in 2016 the Bank of England would cut its Official Bank Rate another quarter point. However, 2016 seemed to indicate the high-point (or the low-point, perhaps) of extreme central bank accommodation.
Of course, "tightening" is a relative term, evidenced by the fact that we now have a Fed Funds Rate of only 1.75% following six consecutive rate hikes since December 2015! Yet, it is an increase nonetheless, and other central banks have since at least made outward moves to… let's say "normalize." In 2017 the Bank of England raised its Official Rate a quarter point, while the Bank of Canada raised its overnight rate by a full half point. Meanwhile, the ECB in October 2017 announced its intentions to cut its asset purchases in half in September of the following year. Less explicit, however, was what the Bank of Japan was proposing.
In 2016 the Bank of Japan tweaked the QQE policy which had been in place for over three years. It introduced a "yield suppression" strategy, the intent of which was to manage the market rate of Japanese Government Bonds (JGBs), essentially keeping the 10-year at a rate of roughly zero while keeping short-term rates just below zero. This would be accomplished by conducting as many (or as few) bond-buying interventions as needed to achieve this goal. This was a subtle change from the previous policy whereby the BoJ was committed to a preordained target of purchasing ¥80 trillion in JGBs annually. The initial assumption was that this would require a lower amount of annual bond purchases by roughly 20%. If true, then that would mean the BoJ was in effect tapering its highly accommodative monetary policy, a sort of "stealth tapering". 2017 did in fact see the BoJ reduce its purchases. However, as we shall see, this is not necessarily as clear-cut a normalization as we are seeing from the other developed nations' central banks.
Questions remain as to whether yield suppression can actually provide a true segue to a normalization process, or whether the BoJ will be forced to become more accommodative yet again even as its trading partners scale back their own accommodative policies, or even outright tighten them as now seems to be the case.
The Yen Versus The Dollar
The Yen has baffled currency traders and economists alike for well over two decades. It has been the "widow-maker" of short sellers and has confounded its humbled skeptics. Japan continues to amass mind-boggling amounts of government debt, with a total currently approaching 260% of GDP, but while the currency has its ups and downs it still remains a safe haven in the eyes of many, defying all predictions to the contrary. A recent article, for example, from MarketWatch, makes compelling arguments for the Yen to weaken against the dollar. In what has become a routine development, almost from the date said article was published the Yen defied all detractors yet again, and has steadily gained strength against the greenback. Widow-maker, indeed.
If one looks beyond the government of Japan's colossal debt-load there are reasons for the Yen's strength. Most obvious is the fact that as the US dollar has recently weakened, resulting in inevitable gains for the Yen, relatively speaking. With fiscal policy in the US pointing towards not only increased budget deficits, but massively increased budget deficits, the dollar has come under steady pressure against most other major currencies.
Trade-Weighted US Dollar Index (Major Currencies):
Source: St. Louis Federal Reserve
This trend is equally evident vis-a-vis the Yen. From the beginning of 2017 you can see a similar downward trajectory versus the Japanese currency.
US Dollar-Japanese Yen Exchange:
Source: St. Louis Federal Reserve
This brings us to yet another reason for the Yen's seemingly inexplicable strength. Starting in 2017 Japan's balance of trade returned to surplus after roughly six years of deficit. As reported in the Japan Times this occurred largely as a result in higher exports in autos and semiconductors. Perhaps surprisingly, Japan's trade surplus with the US continues to increase at a faster rate than its global average, even in light of the greenback's decline.
Another factor that needs to be addressed is Japan's status as the world's largest creditor nation. That sounds strange for a country with a federal debt to GPD ratio of 260%, but it's true. The fact is, that between the government, business interests, and individuals Japanese currently hold approximately US $3.12 trillion in foreign assets, making it not only the largest creditor nation on earth, but also the holder of that title for 26 years straight.
Given these facts, the Yen is not only considered a safe-haven currency, but amid the recent volatile environment it has performed better than all competitors.
Japan Can Allow Neither Higher Rates Nor A Stronger Yen
The BoJ has made a commitment to yield suppression, and clearly this policy has replaced the less maneuverable ¥80 trillion annual purchase approach previously pursued. This essentially means the BoJ will continue to buy JGBs, but only as many as is necessary to keep the interest rate of the 10 year bond at essentially zero. As a result purchases of JGBs have declined noticeably in the most recent year.
Nevertheless, during the same year the BoJ has been forced to undertake emergency large-scale JGB purchases to hold yields down amid periods of broad weakness in global bond markets, as seen in July 2017 and most recently in late January 2018. Clearly, what we are seeing is not really tapering in a strict sense, even though bond purchases fell to ¥45 trillion in 2018. That is because, theoretically, just as the bond purchases are no longer required to rise to ¥80 trillion per annum, nor are they limited from exceeding that number, either, should circumstances demand it.
Circumstances just might demand it. As recently reported in the Financial Times, Deutsche Bank, among others, believes recent Yen strength may be "systemic" and could last several years. If so, the BoJ may have to undertake even more drastic interventions like those observed in July and January for a sustained period of time in order to arrest upward pressure on the Yen. In March of this year Bank of Japan Governor, Kuroda, seemed to backtrack on his intention to taper bond-buying, noting that the bank is only opening the door to "consider and debate" tapering in 2019 - and only if progress is made in the inflation rate. The risk of a higher yen on exports will weigh on that decision. Currently, Japanese business confidence dropped for the first time in two years, specifically on fears of a rising Yen. An unexpected fall in Japan's February trade surplus may signal that the Yen's strength is beginning to show up in trade numbers.
Of course, nothing is guaranteed. Any of the following circumstances could allow the BoJ to avoid greater monetary accommodation:
- If the recent drop in Japan's trade balance is temporary, due for example, to the Chinese New Year, as some have suggested.
- If the US cannot get a stimulus bill passed, rendering higher US deficits less likely.
- If current weakness in bond yields reverses for any number of reasons.
I don't believe any of these scenarios is more likely than continued strength in the Yen, larger US deficits, and heightened volatility in bond markets.
Stimulus or Manipulation
We have to watch what the BoJ does. If it allows the Yen to rise, and if this occurs without disruption in exports, then some normalization may still take place. However, if we see more examples of Japan backtracking or delaying tightening then it is reasonable to assume that resistance to normalization will continue indefinitely. Moreover, unlike the ECB, for example, whose tapering represents a more-or-less formal commitment to reduce its bond purchases by one half starting in September 2018, the BoJ has made no explicit commitment. 2018 may be another year in which it buys fewer than ¥80 trillion in bonds, or it may buy exactly ¥80 trillion in bonds; on the other hand, it may even buy more than ¥80 trillion in bonds should the 10 year stubbornly hover above zero, should inflation continue to defy the 2% target, or if Yen strength begins to strangle exports.
It is not at all clear how Japan's trading partners will react to a more accommodative BoJ. As I've written before, whether market interventions are formally carried out for reasons of stimulus or overt currency manipulation is largely irrelevant in the eyes of competitors when said actions ultimately result in a weaker currency regardless of the stated reason. The BoJ came under fire from Germany over its current stimulative monetary policies right from the outset. In the present climate it's easy to forget that there was widespread concern over the BoJ's decision to engage in this most recent QQE program well before the current US administration took office. That said, the current US administration, as recently as this year, has outwardly accused Japan of currency manipulation, and this atmosphere would presumably only get more heated should Japan take additional monetary steps to fight a rising Yen. Even beyond accusations of currency manipulation is the very interesting problem of the growing US trade rift with China. If the US reduces its purchases of goods from China it will have to obtain many of those goods from elsewhere, and Japan would be among the most likely candidates to assume that role. This would further exacerbate the US's trade deficit with Japan and could potentially shift protectionist attention away from China right onto the land of the rising sun.
In a world in which the major central banks are normalizing in unison how much patience will they have for a BoJ that may be forced to go full steam ahead with further - perhaps even permanent - accommodation? Investors should closely observe what the BoJ does over the next 12 months, as its actions should provide hints as to whether the dark clouds presently gathering over global trade are destined to intensify.
This article was written by
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