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The Mystery of the Bank of Japan

Having led the way in unconventional policies, the BoJ is reluctant to get out of it. She will probably have no choice. A strong movement would be felt far beyond Japan.

Wednesday, January 4, 2023 was, for the financial world, a historic date. It marked the end of negative rates around the world.At that time, no debt security, whatever its maturity, had zero or lower yield. A first since 2016.

The progress made in just two years is spectacular.In December 2020 debt with negative rates reached a peak of more than 18,000 billion dollars. By the end of 2021, the climate had abruptly changed. From almost 14,000 billion dollars at negative rates in December 2021, the stock had shrunk, in just over a month, to 4 billion at the end of January 2022. Eleven months later, here comes the end of this road

The events of last year, from soaring inflation to energy and geopolitical shocks, by prompting the major Central Banks to brutally tighten financial conditions to combat rising prices, have therefore put an end to this financial aberration, which mechanically enriched borrowers to the detriment of creditors, by giving a negative price to risk and time.

The end of free money obviously represents a major shock for the financial and economic sphere:

  • There is what was seen in 2022, with the 19% decline in the value of global equities and a 16% decline for bonds in 2022, an unprecedented configuration.
  • There is also what is beginning such as the impact on households, companies or indebted States of this increase in financing costs.
  • And there is what is less visible such as the leverage effect built into some pension and endowment funds, used to improve the return needed to pay the benefits owed by these funds.

Last October, British pension funds were strangled by the sudden rise in interest rates and the fall of the pound, forcing the Bank of England to intervene urgently and the government of Liz Truss to resign.

Now all institutions and all countries are warned: the quality of balance sheets must be monitored everywhere to avoid financial accidents because easy money is over. Only Japan seems to be resisting monetary normalization.

For a long time, the Japanese were the pioneers of monetary experiments.After having initiated the “unconventional” mass policies as early as 1997 (it was the purchase of commercial debt securities from banks, not yet called “Quantitative Easing” but the first direct injections of liquidity to the entire banking system), they enthusiastically followed the ECB, which had initiated the movement in June 2014, with the implementation of negative key rates in January 2016.

Even stronger, Japan is almost alone in the world – only the Bank of Australia timidly followed their example in March 2020 by targeting only the 3-year rate – was the first from September 2016 to make operations aimed at controlling the entire yield curve. She even went so far as to buy stock trackers!

Our Japanese Economic Growth Momentum indicator fell to 7 in 2020 and rose to 75 in 2021. It hovers around 37 currently.

Source: Bloomberg / Montpensier Finance as of January 6, 2023

The reason for this adventurism was simple: since the monumental financial and real estate crisis of the 90s, Japan was in the grip of hyper-resistant deflation and all monetary – and fiscal – efforts to remedy it seemed futile. Japanese debts were thus the last at negative rates in December 2022. But now it’s over, inflation is picking up and it could change everything.

Indeed, the first cracks are appearing: on December 20, the Bank of Japan announced that it was giving more “flexibility” to its yield curve control policy.

Since then, it is the vigil of arms: the BoJ defends itself from any sudden evolution, continues to buy government bonds on the market, but the pressure is immense because inflation is rising, it is now at the highest since 1982!

A change in policy should be very gradual so as not to rush the market.However, it could be clearly materialized on April 1st when the emblematic President Haruhiko Kuroda, in office since March 2013, leaves. The former vice-president of the institution, Yutaka Yamaguchi could then succeed him. However, after his departure in 2013, the latter was very critical of Abenomics and especially its monetary aspect.

A reversal of Japan’s ultra-accommodative policy would have several significant consequences for markets:

  • First, by accelerating the broad-based withdrawal of central banks, this “pivot” would increase upward pressure on global rates and accelerate the gradual decline in liquidity.
  • Then, Japanese commercial banks will be asked to replace the central bank and refinance – at a higher cost to the Japanese Treasury – the 260% debt to GDP of the state, which would encourage them to sell securities in foreign currencies, and in the first place the dollar, to buy Japanese securities, which would weigh on the greenback.
  • And above all, it increases the risk of a financial accident: Japanese institutions and funds have been living with negative rates and constant support from the central bank for more than 35 years. Investors were alerted last October by the turmoil around the UK and its pension funds. They will therefore be very vigilant with the world’s third largest economy and its colossal stock of debt.

The BoJ is aware of the risks of a too abrupt exit from its heterodox monetary policy. It will probably be very cautious, even if it means coordinating closely with other central banks to avoid storms. But it could also be a sign of Japan’s exit from a long period of deflationary hibernation. Japan will then contribute more to global growth.

By Wilfrid Galand, Chief Strategist of Montpensier Finance

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