The Jupiter Merlin team discuss the continuing efforts of central banks to play monetary policy Whack-a-Mole, as this time it’s Japan’s turn to shock markets.
We hoped that last week’s was the final update before Christmas. But we had bargained without the Bank of Japan (BoJ) throwing a small cat among the pigeons.
The Bank of Japan’s lonely path…
It has been some time since the BoJ troubled the scorers. Many acres of trees have been expended by commentators, including us, on central bank policy and speculating about the future path of interest rates at the Federal Reserve, the European Central Bank (ECB) and the Bank of England. However, ever since the BoJ several years ago moved unilaterally towards a policy of actively managing its 10-year sovereign bond to a ceiling yield of 0.25%, there has been little to write about Japan. Largely because the others are forbidden under their mandates actively to manipulate the yield curve (i.e., fix the cost of government borrowing, whatever the duration, in what is an open market), the BoJ is allowed to do so and has actively pursued it. The means by which it has done it is through the active use of its balance sheet, to the extent that as at the beginning of December and for the first time, the BoJ has crossed the 50% threshold and directly owns half of all Japanese government bonds (in the UK the Bank of England owns roughly 35% of UK Gilts, while the Fed directly owns less than a quarter of total US Treasuries).
…and a mugging of the yen
We have discussed on several occasions the extent to which the tensions in currencies this year have largely been a factor of the dollar’s strength, the flip side of which is all other currencies being weak against it. However, a stand-out has been the weakness of the yen against all other major currencies. While a weak currency helps Japanese exports, it also helps fuel domestic inflation notably through Japan’s reliance on imported energy. As its major competitors, and especially the Fed, have rapidly increased interest rates this year, so the pressure on the yen has intensified: investors dumped it. There has been considerable speculation as to when the BoJ would have to react, particularly as the inflation rate now approaches 4% (a mere 4%, we hear you say! Child’s play compared with the UK and the eurozone, but Japan has been actively fighting deflation and its debilitating effect on economic growth for three decades; suddenly to find the rate at twice the BoJ’s target and likely to go higher is prompting soul-searching). However, it was widely assumed that under BoJ governor Mr Kuroda, an unswerving devotee of the late Prime Minister Abe’s radical (for Japan) governance and economic reform (‘Abenomics’), of which a fixed yield curve was Kuroda’s creation, however great the pressure to change tack, nothing would change until after the end of his final term in office in March. In the event, not so!
Kuroda announced that while not deviating from the strategy of managing the yield curve, the ceiling would be doubled to 0.5%. With other central banks having already been smoked out of their entrenched positions on interest rates and forced into a fighting retreat away from the notion that inflation was transitory, speculation is that Japan could also be forced to take further action and that the ceiling will be raised again. It’s a familiar story. Coming completely out of the blue, inevitably all major sovereign yields reacted in sympathy, rising sharply (the corollary of which is prices falling).
Italian jitters. Again.
In several instances, especially in the eurozone and including fiscally conservative countries such as Germany, Holland, Finland and Austria, 10-year bond yields today are at or within a whisker of the heightened levels seen a few weeks ago when the broader financial system was under stress in the aftermath of the failed experiment with the UK’s Trussonomics. Why?
While digesting Japan’s news, investors took a closer look at the fine print of the ECB’s announcement last week when it too joined the Fed in the “higher for longer” interest rate club. Monetary conservatism is reasserting itself in Europe with the German representatives on the ECB leading the way. As the ECB steers a new course, markets are looking at the potential points of tension, much of which predictably focuses on countries with too much debt. At the forefront is the fragility of Italy. We have discussed this subject many times. Under the microscope again is the extent to which its banking system in particular is propped up by a plethora of artificial structures (with pithy, trip-off-the-tongue titles such as Targeted Long Term Refinancing Obligations) created by the ECB to give the illusion those banks have a secure capital base capable of withstanding the liquidity pressures inherent in a looming recession. Italian bond yields blew out again, and now match those of the eurozone’s traditional economic basket case that is Greece at 4.5% (incidentally, it is only a month since the UK was being compared unfavourably with Italy; our 10-year Gilt yield is now a full point lower than Italy’s).
The Italian banks will not fall over; the ECB will ensure it does not happen. But as we highlighted last week, in a financial system with all the design logic of Heath Robinson, eurozone monetary policy is a near-permanent game of Whack-a-Mole.
The death of negative-yielding debt
However, as we round off 2022, it is worth standing back from the detail and looking down from 30,000 feet at just how much has changed in exactly two years since quantitative easing (QE) reached its zenith. In December 2020 when the world’s central banks and its governments were hosing money prodigiously to contain the economic melt-down amid the pandemic, $18.3 trillion (that’s 18.3 with 12 zeros) of global investment grade debt, 27% of all investment grade debt in issue in the world, carried a negative yield. For most of 2020, even Germany’s 30-year government bond had a negative yield (and to rub in the point of calling out the market’s obtuse and negligent attitude that there was less than zero risk, last month Germany nearly suffered a political coup). As a reminder, a negative yield represents the borrower being paid to borrow and the lender paying to lend. That $18.3 trillion has since been reduced by 96%, to $800 billion now (and most of what is left is a decreasing stock of very short-dated Japanese government bonds).
Rational behaviour is being restored. What concentrates the mind (or should do) is the realisation of how much debt was allowed to build up unchallenged when it was essentially free, forgetting that one day it might again carry a cost (and as we have argued forcefully in other columns, it certainly should carry a cost—debt is an obligation, not an entitlement); and given a decade of mediocre growth together with the significant fiscal drag and falling real earnings as unintended consequences of QE, what did it achieve? Monetarists, followers of Thatcherism and Reaganomics, might have long ago lost the argument of their cause, but the lazy consensus of liberal Keynesian economics has much to answer for!
On that provocative note, that really is it for this year. Happy Christmas!
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