In its September policy update, the Bank of Japan (BOJ) announced that it’s tweaking its framework to “Quantitative & Qualitative Easing with Yield Curve Control”, with 2 major components:
- Yield curve control: “the bank will control short-term and long-term interest rates”
- Inflation-overshooting commitment: “the bank commits itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of 2 percent and stays above the target in a stable manner.”
In keeping to its mandate and this adjusted framework, the BOJ will also adjust short-term policy rates (cut lower) should it deem necessary. This means the Japanese central bank can bring its policy-rate below the current -0.1% should it be deemed necessary. The BOJ has also stated that it would target a rate of 0% on 10-year Japanese Government Bonds (JGBs).
The main takeaway by the consensus is that Kuroda-san is hoping to influence the yield curve in a way that would steepen its slope on the long-end, increasing the spread between short-term rates and their long-term counterparts. This is done with the objective of alleviating profitability concerns among Japanese banks and insurers, since these institutions’ earnings are sensitive to the slope of the interest rate curve. With rates on the short-end at negative levels, a flattening effect on the long-end would squeeze margins of banks and various financial institutions. Consequently, there was a brief rally in the share prices of banks post-BOJ announcement last month, reflecting the market’s agreement with the BOJ’s latest move.
However, there could be further implications of this new announcement, and the markets are slowly waking up to this reality: Kuroda-san may also be setting the stage for outright debt-monetisation!
In free-markets, you could only either set the price of an asset or the quantity but not both. With the BOJ now setting the target price for 10-year JGBs, the central bank is essentially saying that it would adjust the quantity of its purchases in order to make sure rates are at desired level (expand or contract its balance sheet) accordingly).
Thus, the BOJ is backstopping the Japanese bond market with this new framework as well as its inflation-overshooting commitment. With its target, the central bank is also allowing the government to employ any amount of fiscal stimulus without causing an implosion in the sovereign debt market that would lead to a surge in interest rates and borrowing costs. The BOJ simply allows the government to spend without cost as the central bank will just buy whatever JGBs are available. In essence, outright monetary financing. This may support the fixed income and even the equity markets but the Yen would be massively devalued.
Perpetual bonds could be utilised by the Japanese Treasury by this purpose, and this has been proposed by ex-Fed chair Ben Bernanke earlier in the year. It is also unclear if there would be write-offs because the entire debt burden of the government could possibly be bought out by the BOJ. With high total debt-to-GDP levels, there seems to be little choice going forward if productivity and economic growth remains sluggish as the deleveraging phase in Japan continues.
Additionally, in its policy statement, the BOJ stated that it can cut the target level of a long-term interest rate as well, which means that it will expand asset purchases accordingly as the situation demands for it in order to bring yields to a new desired target. This marks a radical move and has implications for the global financial markets going forward.
With this change in the fundamental backdrop, I’ll be looking out for signs that Japanese policy-makers will go all in with a Hail-Mary plan in order to push the country out of its deflationary malaise. As explained in an earlier post, we could easily imagine a scenario where the amount of pressure and pain is too much and policy-makers are then given the necessary legal bandwidths and authorisations needed in order to enact fully-unconventional measures.
One could structure a trade that involves going short the Yen against a currency that is widely used in global trade (like the USD), and hedging the short position with a long in the JGB market. A Yen short could also be hedged with a long in Japanese bank stocks.
Some day, the Yen could be the next Zimbabwean Dollar…
*images taken from the WSJ*
Kean Chan 