The Bank of Japan has been engaged in the largest of the DM CB easing campaigns. Its balance sheet is the largest and growing the fastest, its benchmark rate is negative, and its government’s yield curve is the flattest. After initial QQE success via a 40% FX depreciation, the markets lost faith in the inflationary efficacy of monetary base expansion and yield suppression, and finally internalized the importance of monetary endogeneity.
At the same time, the BoJ (along with the ECB) ran into supply constraints for its asset purchases, even moving into equity ETF, REIT, and corporate bond markets. The scarcity of yielding paper amplified the flattening in the JGB curve, offsetting (and in January, overwhelming) the stimulative impact of lower yields. And all the while, the JPY trended higher while inflation trended well below target.
Negative effects of financial repression
Intentional yield suppression can be a useful counterweight to the deflationary impulses from technological globalization and private sector deleveraging. However, they may fail to offset demographic shifts like higher dependency ratios and lower population growth rates. As a population ages, the relationship between interest rates and consumption increasingly turns from inverse to positive, since spending becomes more sensitive to interest income rather than interest expense. Scarcity of yield, to the extent CB-driven bond scarcity drives yields lower than equilibrium, can thus amplify the financial woes of older age cohorts, which can feed back into aggregate deflationary forces if the population skews old like in Japan.
The same dynamic that hurts elderly consumers also hurts banks, insurers, and pensions, whose asset/liability mismatches require steep curves. When the BoJ introduced NIRP in January, financial conditions significantly tightened, mainly driven by concerns within financials. This sparked broader fears of monetary firepower in DMs. What can the Fed/ECB do if the next recession hits before rates can rise much? These effects easily spread globally, given the demand spillovers from European and American pension & insurance funds. If lower rates can lose stimulative efficacy, and even at times become anti-stimulative, then how can a central bank fight low inflation and growth? How can a central bank fight financial repression imported via demand spillovers? Will risk-free collateral scarcity ever be alleviated?
The BoJ’s QQE found strong initial success, so what changed? The problem is that the market works in narratives, which shifted dramatically as understanding of unorthodox monetary policy became clearer and more informed over time. Initially, market practitioners viewed the monetary base expansion as an inherently inflationary dynamic, as the supply of JPY bank reserves ballooned beyond the growth in USD and EUR bank reserves.
Over time, markets increasingly learned of the importance of monetary endogeneity and why money supply growth is more important to inflation than monetary base growth. As the BoJ’s continued asset purchases starting hitting supply constraints in the JGB market, market participants started questioning the efficacy of QQE. The financial shocks over the last two years dampened prospects for the BoJ to meaningfully diverge further from Fed & ECB policy to the dovish side, which was a fundamental pathway for FX weakness. The BoJ finally conceded to the structural constraints to QQE efficacy in January, when it went to negative rates, but the resulting curve flattening damaged FIRE sector profitability expectations so much that financial conditions materially tightened.
This was a major signal to traders that the BoJ had lost any further space to ease, since asset purchases weren’t moving the needle and deeper NIRP was failing to ease financial conditions, leaving exchange rates to the whim of capital flows. The PBoC’s main strategy for fighting USD-driven shocks to RMB vol was to recalibrate its reserves allocation weights, selling billions of USD securities in the process this year. Its main reweighting destination was the Japanese bills market, creating a wave of capital flows that overwhelmed marginal BoJ policy shifts. Combining these dynamics with massive PPP undervaluation created the perfect environment for JPY appreciation.
The BoJ’s answer
In its September monetary policy meeting, the BoJ introduced a new framework for its stimulus campaign. Instead of targeting the quantity of JGB purchases (equivalently, the increase in its monetary base) per month, it now targets the yield of 10yr JGBs. As such, the BoJ eased its constraint on private sector interest income (via quantity of bonds available to the private sector), while regaining the ability to ease monetary policy with rate cuts (as the 10yr peg would force bull steepening).
By abandoning the quantity target, it implicitly admits that monetary base expansion is not necessarily inflationary and that the main impact of QQE is via the yield curve’s level and slope. The hidden message, likely intentionally obfuscated, is that the BoJ may end up slowing down purchases of, and even selling, 10yr JGBs in order to defend the 10yr yield target from below. If the BoJ cuts rates further and market demand attempts to drive the 10yr yield below target, it will have to sell JGBs to defend its target. This scenario can motivate imprecise parallels to the US’s taper tantrum, but below the surface, it is a very positive development.
When a flight to quality occurs that challenges the 10yr peg, the BoJ will be releasing supply of safe assets to the private sector, rather than removing it. It can loosen financial conditions through the rate channel again, preventing the negative flattening impact by keeping the 10yr pegged. With yield pegs, the effective lower bound is lower and the FX channel reopens.
The new monetary policy framework also creates conditions for effective fiscal stimulus. Pegging the 10yr to 0% means any increased deficit spending is effectively helicopter money. It also diminishes concerns about interest expense from deficit hawks, since the central bank is providing very strong clarity for borrowing costs. Thus far, the fiscal stimulus package has underwhelmed market perceptions, but there is room for it to grow during the current Diet session. The BoJ’s yield curve control loosens political obstacles to higher deficits while also helping to amplify its effectiveness and durability. With a 10yr peg, it becomes very difficult for a reflationary stimulus to short-circuit its own recovery through higher yields.
Yield curve control by itself is a solid step in the right direction for monetary easing and the policy framework. But combining it with higher deficit spending would be a potent cocktail of stimulus. As of now, traders mainly ignore the BoJ’s new inflation overshoot commitment, since it is so far below its target inflation level. However, if further stimulus gains traction and/or the BoJ regains success with JPY depreciation, the overshoot commitment will become much more relevant and useful.
The September BoJ meeting crushed JGB vol, which bled through to the rest of DM government bond markets, with MOVE near multi-year lows. From my read, traders overwhelmingly interpreted the new yield curve target as a cap on 10yr yields, rather than a symmetrical target with a floor on yields as well. This sets up for a potential washout in DM bonds, especially if the BoJ’s 10yr peg succeeds in diminishing the negative yielding share of DM government bonds. Exposure to rates volatility, whether via put spreads or straddles, seems to be an attractive trade here.
The BoJ is buying massive amounts of equity ETFs each month, which helped the Nikkei (and now the Topix) remain range-bound this year despite a sharp rally in the JPY. Banks have been the main underperformers, which should ease as the curve now has a floor. The returning fiscal impulse is also very bullish for large-cap revenues, and equities are likely a better expression for Japanese reflation than shorting bonds or JPY given concurrent necessity. This makes me very bullish the TOPIX.
The PBoC’s relentless JPY bid is ending, and with the CNY’s IMF SDR inclusion, China can now rely on global SWFs to help keep the CFETS index stable. This should ease downward pressure on USDJPY. Given that the ECB is running into similar constraints as the BoJ is trying to overcome, and the rebound in European PMIs since July, the ECB is likely next in ending its quantitative monetary regime. This sets up for EURJPY to be an excellent FX expression of the path out of DM financial repression.