On September 21st there were two central bank meetings, the Fed and the Bank of Japan, both closely watched but both garnering very little expectations.

The Fed was expected to do nothing and to signal a December rate hike, which it did. The market reaction was positive, not because this was unexpectedly good news but because investors had taken risk off the table, despite having no big expectations for this FOMC. Some of these investors put capital back to work in the anti-climax. The buying, although relatively muted was indiscriminate as investors bought equities, credit, duration, oil and gold.

The BoJ was perhaps even more closely watched and with similarly low expectations. Investors had expected the review to justify current efforts and recommend more negative interest rates. They also expected a targeted effort to steepen the long end of the JPY yield curve. What the BoJ delivered was a promise to raise inflation expectations, perhaps beyond 2%, to be flexible about its bond buying, to maintain a cap on the 10 year JGB yield and an effort to steepen the yield curve. It was a lacklustre package, maybe even a disappointing one. The initial reaction was a rise in equities and a fall in JPY. It is too early to tell where they go from here but if the market was unimpressed by the BoJ’s negative rate debut in January it is hardly going to be impressed this time.

One view is that the BoJ’s lack of determination is a sign that the government should shoulder some of the burden. The Prime Minister has publicly welcomed the “new policy” and will “coordinate closely with the BoJ to accelerate Abenomics.” Quite how new the policy is and how Abenomics is to be accelerated remains to be seen. As long as rates and JPY do not rise too quickly or far, the economy appears to have a chance to muddle on, and there are some signs of material progress in Abenomics’ Third Arrow. Economic immigration, for example, has been growing as regulations have been relaxed and businesses begun to hire foreigners.

On current demographics and reasonable growth forecasts, Japan will not be able to repay its national debt in the foreseeable future. It has already amended its 2016 debt issuance by  3.7% or +60 billion USD, paltry, but a start.

It needs to keep issuing debt. The debt must be bought by private investors, such as the private commercial banks. The BoJ will then buy the seasoned bonds from these private investors. It could buy the bonds directly from the government but this would merely finance the fiscal deficits, which would be direct debt monetization or helicopter money, which is apparently frightening and illegal. Passing through private hands has an advantage. It is Chinook helicopter money, two rotors. First, it still monetizes the national debt, indirectly but effectively. But second, it generates a profit for the initial buyers, and thus puts money in their pockets. Now, if bond yields decline continuously, this generates a capital gain for the investor, but is not sustainable since eventually you get to negative rates at long maturities and undermine the entire savings, banking and insurance industry. A more sustainable strategy is to steepen the yield curve, particularly at long maturities. In February 2016, investors who held on to 20 year JGBs for 5 years say, would have made 1.5% p.a., on top of a 0.5% – 1% coupon just from the rolldown. This ROA is quite substantial given current interest rates. For a bank which can leverage the position, and since JGBs consumer zero capital, the impact on ROE is significant. This works best at long maturities as duration multiplies the roll down which is otherwise too small at shorter maturities. By September the yield curve has flattened so that the same trade would earn 0.95% p.a. This strategy only works with a steep yield curve.

There are a couple of loose ends to this strategy. At some point the national debt will simply get too big. One way of addressing this issue is for a selective debt forgiveness whereby the BoJ converts its holdings of JGBs to zero coupon perpetuals. Or cancels them altogether.

This just leaves the persistent strength of JPY. This is troublesome for an export economy like Japan. When the BoJ cut rates into negative space in January, JPY weakened for less than 24 hours before appreciating some 16% to September. One way would be for the government or the BoJ to buy USD and USD assets such as US treasuries.

This strategy supports the following measures: 

BoJ keeps buying JGBs in secondary market. Check

BoJ keeps the yield curve steep. Check.

BoJ keeps short rates low, perhaps further into negative space. Maybe.

BoJ converts debt to perpetual zeros or cancels its JGBs. Maybe.

Japan government increases issue of JGBs. Check.

One day in the future, the world has nearly depleted its resources. Natural resources have been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth in the developing world has led to over-population and overcrowding in cities, while some areas face neglect and become under-populated. Parts of the world become dumping grounds for industrial and energy (read nuclear) waste. These areas become permanently uninhabitable.

The rise of robotics and artificial intelligence is a significant factor in exacerbating inequality through mass unemployment and a rising share of output accruing to owners of capital. Inequality of wealth within countries gives way to social tensions and domestic secular terrorism and limited civil war. Countries turn inwards and escalate an existing economic and trade war. In some cases, these turn into full martial conflict.

The complete depletion of resources forces some countries to surrender to others in order to survive. Eventually there is peace, but the scarcity problem persists. A united Earth begins to search a new home, a new planet on which to settle. One is found some 200 light years away. Analysis indicates a resource rich world with an atmosphere and gravity similar to Earth’s, not only capable of supporting, but on current evidence, actually supporting life. Unfortunately, this includes intelligent, humanoid life.

An analysis of animal behaviour suggests that the optimal approach is invasion. Spacecraft are built to not only transport the human population of Earth to the new planet but provisions are made for combat and conquest. Fortunately, the evidence is that the population of the new planet, dubbed, KoHo, is relatively technologically primitive and easy prey.

50 years of preparation later, Earth is evacuated and the first transports are launched, destination KoHo. A 400 year journey begins. The period begins in peaceful cooperation but soon, civil strife ensues, on account of inequality and segregation by wealth and social status. A revolutionary, left wing faction develops commanding some 20% of the fleet and population. War erupts lasting 100 years. The war ends in the destruction of the revolutionaries and some 50% of the fleet and population.

The surviving population rebuilds and continues their journey to KoHo. Upon entering the KoHo system, there are initially difficulties in locating the planet KoHo. When the planet is finally identified, landing parties find an abandoned planet devoid of life or resources.

Archaeological studies indicate that a humanoid species lived on KoHo and, similar to humans, ruled the planet at the top of the food chain, using its intelligence and technology to dominate the planet.

One day, this world had nearly depleted its resources. Natural resources had been over-mined, agricultural land over-farmed, the seas over-fished and over-farmed. A surge of population growth had led to over-population and overcrowding in cities, while some areas faced neglect and became under-populated. Parts of the planet became dumping grounds for toxic industrial and energy waste. These areas became permanently uninhabitable…

A solution had to be found. Fortunately, a living, breathing planet was found, a blue planet some 200 light years away…

Inflection:

From the rhetoric it is apparent that the Fed wants to raise rates, the question is not if, but when. The ECB’s recent inaction and signals point to a pause and a possible rethink about QE. The BoJ is currently assessing the efficacy of current QE and has already surprised the market by its hawkish inaction in the face of weak data.

PMI data have been consistently strong globally with the exception of Japan and recently in the US. Japan is slowing but less severely and the US data is a single data point in a robust trend.

Recent musing by the financial elite have been leaning towards fiscal policy.

1. Are the world’s central banks near or at the point of inflection in super low rates?

The Fed is clearly at the inflection point. The question for the Fed is not if, but how quickly rates will be raised. The options are between slow and super slow. The UST market is unlikely to be complacent.

The BoJ is likely to be at an inflection but is it between holding and handing the responsibility to fiscal policy, or is it to accelerate monetary easing towards further unconventional measures such as debt forgiveness? Economic data while indicating continued deterioration are slowing in their descent presenting the risk that the BoJ may maintain status quo or even cut back stimulus. Or, if fiscal policy is expanded, the BoJ may deem it unnecessary to increase its efforts. Interest rates can be cu
t further or QE expanded but current efforts have not been effective and more of the same is unlikely to be helpful. The only shock and awe policy left is to cancel some of its holdings of JGBs effectively monetizing legacy debt. Politically and culturally, this is unlikely.

The ECB is reviewing the effectiveness of its QE program. On recent cyclical data, the ECB may conclude it has done enough. The Eurozone does not have fiscal union and fiscal policy will be decided at the national level although Brussels will have influence though the Maastricht conditions. Politically, Europe has less scope for fiscal policy, and even less for a concerted effort.

2. Has monetary policy reached its limits?

The question is moot in the US for now, although a prudent Fed would at least academically consider its options should the economy slip back into recession.

The BOJ is likely at its limits. It already owns a third of the national debt and is struggling to find assets to buy. It’s NIRP has resulted in a rise in deposits. Economic data remains weak although the pace of decline has slowed. More data are required to be certain but the current evidence is that monetary policy has had limited impact.

The ECB is likely close to limits. Negative interest rates have led to limited cash hoarding, including by corporates. The asset allocation of the QE has been politically constrained resulting in the capital flowing to where it is needed less, Germany and France, instead of the periphery. The ECB is unlike to be able to increase the scale of QE although it could make further progress by moving asset allocation away from the capital key.

3. Will fiscal policy be deployed and to what extent?

In the US this is academic. Politically also, it will depend on the future composition of Congress, the Senate  and who occupies the White House.

In Japan, fiscal policy engaged now will only be another salvo in a series which has seen the national debt swell to 2.5X of GDP. However, given the BoJ’s recent demeanour and Abe’s control of Upper and Lower Houses, fiscal policy cannot be ruled out.

Politics will make fiscal policy difficult to approve in Europe. Germany can afford it but doesn’t need it. France might but probably can’t and peripheral Europe almost certainly cannot afford it but might need it most. The political uncertainty in Europe makes this a difficult call.

4. Asset prices are very sensitive to the base curves. Equities are cheap relative to binds but otherwise expensive. IG spreads are reasonable to cheap and HY spreads are reasonable. The problem reduces to developing a view around base curves.  

USD.

Short end is very sensitive to Fed funds. Long end is more sensitive to inflation. Long end will find less upward pressure from risk of fiscal policy.

JPY.

Japan is already engaged in fiscal policy albeit not in a determined way. This would normally exert upward pressure on yields.  Much will depend on the BoJ’s review of QE due 21 September. The results could be a) mission accomplished, b) QE didn’t work, more needs to be done, and c) QE didn’t work, a new approach is needed. I’d a) then JGB yields will likely rise as will JPY, if b) JGB yields will likely fall as will JPY. The last scenario is the most interesting but unpredictable. A debt cancellation is the most likely strategy left and is one which allows Japan to raise more debt and spend more. On its own, c) should drive yields lower with JPY, however, c) is also an enabler of an acceleration in fiscal policy which would drive JGB yields higher.

EUR.

The system wide PMIs indicate a cyclical recovery in the Eurozone which should signal a success of policy to the ECB. The recovery, however, is not evenly distributed. The recovery in Spain is threatened by politics, the recovery in Italy by politics and specific issues in its banking system. France is in a very slow recovery with high political risk. Germany could do without any monetary or fiscal support. A tailored monetary solution is difficult given the single currency and the adherence to the capital key in QE allocation. A targeted solution would be to get off the capital key or engage national level fiscal policy.

The above would likely be neutral to positive for the EUR. Yields would react at national levels. If the ECB gets off the capital key, peripheral bonds will outperform. If national level fiscal policy is implemented, peripheral and core bonds will likely sell off. If both policies are implemented bunds suffer most.

Bank capital.

Bank capital spreads are mostly impacted by regulation and credit quality. They are, however, not immune to volatility in the base curves.

Rising rates will improve bank profitability. However, banks have significant exposure to sovereign bonds and could face losses if bonds sell off. The first order consequence is an improvement in the profit outlook for banks. Banks are generally more profitable in a higher yield and steeper yield curve environment. This is well highlighted by the relatively high short term correlation between government bond curves, yields and bank stocks

Rising rates may provide some volatility and a buying opportunity.

Loans.

Loans carry very little duration, particularly as LIBOR rises above the LIBOR floor, typically 1%.  Higher rates may put pressure generally on corporate balance sheets through higher debt service and refinancing costs. The inflection point may introduce volatility to the loan market which could be a good buying opportunity.

IG.

IG spreads have compressed considerably in the short term and while in the longer term they may be cheap, in the short term the momentum from a duration sell off will likely carry IG with it. Buying opportunity if duration hedged.

HY.

Same technicals as IG. HY could be more resilient as duration element is smaller and credit fundamentals remain robust.

Monetary policy has likely reached the limits of usefulness, not necessarily the limits of efficacy. The efficacy of monetary policy was questionable in the first place. Multiple QE programs and low interest rates have managed to inflate assets but not to spur the economy as much as was hoped.

Monetary policy is but one class of tools available to encourage growth, fiscal policy being the other. Without fiscal stimulus, monetary policy has to work doubly hard and faces leakage in terms of risk of asset price bubbles, unequal distribution of benefits, disinflation due to increased capacity, and downward pressure on interest rates. Fiscal policy will not mitigate all of these side effects but it could reverse some of the unequal distribution of benefits and put a floor under market interest rates.

Why has fiscal policy not been engaged so far?

• Many countries’ national debt is high in relation to GDP, many on account of financial sector bailouts in the crisis of 2008.
• Austerity followed as economic orthodoxy. The Eurozone, for example, has strict guidelines on state budgets.
• Operating both monetary and fiscal easing carries high inflation risk as output is boosted to potential and could overshoot. By operating monetary policy first, excess capacity is allowed to build before fiscal policy is applied to raise capacity utilization.
• Fiscal policy is politically charged and requires strong government to obtain approvals.
• Cost of debt is another factor. Leading with monetary policy results in lower cost of debt for governments if they subsequently raise spending and seek to finance it in the bond markets.

Are we likely to see a shift towards fiscal policy?

• Japan has periodically engaged in fiscal stimulus which has seen its national debt climb from 0.5X GDP in the 1980s to over 2.5X today. Just days ago, the Abe government announced a 28 trillion JPY fiscal package.
• Japan was able to do this as the Abe government, already with a super-majority in the lower house had recently won a super-majority in the upper house, was unchallenged in the Diet.
• BoJ’s QQE and negative interest rate policy had taken 10 year JGB yields from 1.66% in 2008 to -0.29% just a week ago. Cost of debt is very low.
• Japan needs reflationary policy to revive its economy. Recent data has shown Japan sliding back from the recovery from the first dose of Abenomics.

Does Europe need fiscal stimulus, and if it did, could it become a reality?

• The European economy is still on track with the recovery triggered since the LTRO operations of late 2011. PMI data point to the durability of this recovery.
• The risks to the recovery are Brexit, both directly and indirectly should it trigger more divisions, security, which could embolden nationalists and Eurosceptics seeking to close Europe and restrict freedom of movement, and a long list of local events, such as the impending Italian legislative referendum, which could escalate and spread into more, threatening the integrity of the union.
• Even if there was cause for fiscal stimulus, Europe has strict guidelines regarding budget deficits. While these limits have often been broken, they have not been intentionally breached as part of a deliberate spending campaign. Eurozone national debt to GDP is still elevated having risen from a low 65% in 2007 to 92% in late 2014; it has receded to 90.7%, still a very high level.
• While monetary policy is coordinated by the ECB, the lack of fiscal union would mean that fiscal plans are domestic affairs. Coordination would be difficult and depend significantly on the strength of the individual member states’ governments and their ability to approve such programs. Assuming each member state budgets towards their own situation, they would find monetary policy calibrated to the collective and not to their own circumstances.
• That said, the ECB too has followed a similar path as the BoJ in QE and negative interest rate policy resulting in conditions conducive to debt financing fiscal deficits.

What are the consequences of adding fiscal policy to monetary policy?

• Monetary policy has dual impact on inflation. On the one hand lower rates spur activity, or at least facilitate activity and in that respect spurs inflation. On the other hand, low interest rates encourage over investment and over capacity which have more durable deflationary pressure. Fiscal policy mitigates this by addressing directly the demand deficiency and is therefore inflationary.
• On its own, QE and NIRP lower interest rates across the term structure. The application of fiscal stimulus increases the demand for money and bids up yields across the term structure.
• Fiscal stimulus is likely to cause currency appreciation as interest rates rise. The impact on trade is less predictable given the number of distortionary trade pacts in force and the protectionist biases in the current environment. At this stage it is likely to be neutral.
• Fiscal deficits are a prime example of kicking the can down the road as the expenditure will need to be financed and financed with long term debt. Given that most countries are running historically high debt to GDP ratios, the assumption of more debt could be destabilizing at some point. This could lead to sharper interest rates and weaker currencies.
• The crowding out of the private sector is a particular risk given that monetary policy has already exposed weak private investment and demand.
• The biggest risk is not one resulting directly from fiscal or monetary policy but the slippery slope that all analgesic solutions pose. We have witnessed how easy it is to embark on QE and rate cutting policies and how difficult it is to wean economies off such policies. The same will apply to fiscal policy. What it implies is that governments will continue to apply policies which provide short term relief but which may not treat the underlying cause of slow growth, and that the only way such policies are withdrawn is not when they are no longer needed, but when governments can no longer sustain them.

Observations:

The BoJ’s discount rate, 9% in 1980 has fallen steadily to 0.3%. The 10 year JGB yield has dropped consistently from 8% in 1990 to -0.28%.

The BoJ’s asset purchase programs have seen its balance sheet grow from 110 trillion JPY in 2010 to 436 trillion JPY expanding at 30% per annum.

BoJ ownership of JGBs rose from 9% in 2010 to 34% today. It owns 55% of Japan’s ETFs and about 1.6% of the listed market capitalization. The BoJ’s current plan involves buying 3 trillion JPY of ETFs per year. The GPIF owns about 5% of market cap.

Japan’s national debt to GDP ratio has increased steadily from 50% in 1980 to 251%. The annual rate of increase is only 4.5% but it has been increasingly almost monotonically for the last 36 years.

Inflation is still negative and not showing signs of any revival. Growth has slipped from 1.8% in Q3 2015 to 0.1% Q1 2016. Sentiment and confidence indicators are showing more weakness.

Since the imposition of negative interest rates on excess reserves JPY has strengthened from 120 to 100. It trades at circa 105 today. Also, bank deposits at the central bank have reportedly risen 20% since.

Expectations:

On July 29, the BoJ meets. Various analysts assign a significant probability to some kind of increase in QE in the form of increased asset purchases from the current rate of 80 trillion JPY p.a. as well as a rate cut from the current -0.10%.

On the fiscal front, the government has announced an eagerly awaited 28 trillion JPY stimulus package. The details as to how much will be spent when, how much will be direct (expenditure) and how much indirect (tax), and how much are existing and how much are is additional, are still not available. Rumours suggest that the direct spending portion will be small with the bulk of the package in the form of loans and subsidies.

So far the market has regarded the BoJ and the fiscal package with caution. JPY and JGBs have rallied while the Nikkei has come off.

The BoJ has a track record of disappointing the markets and expectations have become increasingly uncertain. The lack of details in the announcement of the fiscal package have also left the market sceptical.

Thoughts:

While the Prime Minister’s advisers have spoken about ‘helicopter money’, technically Monetized Fiscal Policy (MFP), Mr Kuroda has said that there was “no need or possibility” of doing it. Given that ‘helicopter money’ requires close coordination between the Ministry of Finance and the BoJ, Mr Kuroda’s thoughts should be taken at face value. No ‘helicopter money.’

Monetized Fiscal Policy is likely to be ineffective in the long run and would introduce too many new and innovative problems anyway.

A sizeable fiscal package will in any case need to be financed and given the pace of the BoJ’s QQE, it will effectively be indistinguishable from MFP. The difference is a mere technicality where under QQE the bonds are passed through private sector intermediaries and under MFP the BoJ faces the state directly. Never underestimate the propensity of public servants for pedantry when they practice to obfuscate.

In the long run, the demographics of Japan will likely prove insurmountable. And in any case, the Keynesian view of the long run is probably true. In the short term Japan needs an infusion of confidence which would involve a rising equity market, stable, positive interest rates and bond yields, and a stable currency. A monotonically decreasing currency is too high a price to pay for a rising equity market. A modest recovery in inflation is also necessary.

Adding an outsized fiscal program to the currently loose monetary policy will likely stabilize interest rates and bond yields, put a floor under inflation and give a boost to demand. QQE will be needed not only to moderate any rise in yields but to finance the budget deficit and roll over the national debt. The size of the package will need to surprise the market to be effective.

The above solution is sufficiently conventional for the BoJ and the government. It provides temporary respite, but it will not address the underlying issues in the Japanese economy.

More innovative solutions:

If we are allowed to speculate, we might consider some less conventional cures for the slow growth and weak inflation. More money, debt and spending can boost demand temporarily and even give the economy sufficient momentum for the appearance of escape velocity. However, it results in chronic dependency and ultimately, policy fatigue.

In the long run, amputation could be better than analgesic. Bankruptcy law needs to be upgraded, in particular Corporation Reorganization Law, which prolongs resolution, needs to be aligned to the Civil Rehabilitation Law (equivalent to US chapter 11.) Interest rates need to be normalized and put back up to cull unprofitable enterprise and excess capacity. Negative rates cannot persist for long without detrimental impact on the banking and insurance sector. Japan also needs to encourage immigration and labour mobility to better match labour to land, capital and technology. The stock of national debt held by the BoJ could be written down.