Quarterly Investment Strategy
Japan: Alone at the forefront
In a nutshell:
September saw the surprise decision by the Bank of Japan (BoJ) to adopt yield targeting, intending to anchor the 10-year government bond rate around 0% and retaining the option to cut the policy rate further into negative territory.
The hope is that a steeper yield curve will improve the banking sector’s ability to extend credit, while allievating the increasing shortage of government bonds.
Ultimately, though, only supply-side reform could sustainably boost Japanese growth.
One of the most astonishing takeaways from the International Monetary Fund’s August report on Japan was the projection that the Japanese government – the ultimate symbol of public indebtedness – should actually receive more interest income (1.6% of GDP) in 2017 than be charged interest expense (1.3% of GDP). Despite the BoJ’s best efforts to reduce the appeal of Japanese government bonds (JGBs), investors continue to snap up or hold onto such negative-yielding paper instead of putting their precious capital to work elsewhere. This only serves to push the yield curve lower and increasingly goad the entire market into the position of subsidizing the Japanese government.
Worried that this odd dynamic could exacerbate the perceived limits of its monetary policy and impair the domestic banking sector’s ability to extend credit, the BoJ unexpectedly announced, at its September policy meeting, the first yield target since the US ended a similar repressive practice in 1951. By promising to anchor the 10-year JGB yield around 0% and retaining the option to cut the policy rate further into negative territory, the BoJ pushed against the idea that additional monetary easing could end up merely boosting the financial position of the entire public sector, encompassing the BoJ itself. Steepening the yield curve through a “reverse operation twist” (reducing long-term bonds in favour of their short-term alternatives) could, it argued, provide a better incentive structure for the banking sector to make the most of BoJ easing while also neatly resolving the increasing shortage of JGBs.
But it that really so? Thus far, the market’s verdict seems to be that the Japanese policy framework has become even more convoluted, not least because it also promised to deliver an “overshooting” of the BoJ’s inflation target that has never been achieved since the launch of Abenomics. In the absence of underlying inflation that would put some upward pressure on JGB yields, the BoJ’s efforts are akin to leaning against a door that opens outwards. In other terms, the BoJ could be selling long-term bonds precisely at a time when bad external shocks warrant opposite action in order to ensure balance sheet stability.
The adoption of yield curve targeting cements the BoJ’s position at the forefront of the global fight against deflation. It is far from certain, however, that this target and the other various financial policy innovations since 2013 will matter much in the end. Only structural reforms, opening up the Japanese fortress to foreign labour and capital, could permanently improve the country’s growth trajectory. Unfortunately, current supply-side constraints could instead be intensified by the end of the Trans-Pacific Partnership talks and a potential Trump presidency.
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