

Macro Wrap-Up: A Monetary Policy Mechagodzilla

August 3, 2018

Japan hasn’t played a large role in market moves this year. It’s been an afterthought in discussions about trade, with Europe, China and the U.S. getting most of the attention. Back in the 1980s and 1990s, even minor financial news stories from Japan could have major repercussions for currency, fixed income and equity markets, but now it seems Godzilla could attack Tokyo and global bond markets wouldn’t move a bp. That was until two weeks ago, when rumors of a Bank of Japan (BOJ) move began to spread. 1By Tuesday, trading desks in New York and London were left scrambling to find accurate translations of a BOJ press conference, and Japan suddenly seemed like the most relevant market in the world.

Since the BOJ instituted its Yield Curve Control (YCC) policy in 2016, ten-year JGB yields have been in a very narrow range around 0 bps. The reason the BOJ moved from traditional quantitative easing to yield targeting was simply that its balance sheet had expanded so much that it seemed like it might run out of bonds to buy. 2YCC has solved that problem and kept ten-year rates pegged near zero, but it has also left volatility so low that some tactical investors have reduced their exposures to JGBs. Volumes in the market have declined.3

However, this complacency about Japan, on the part of international investors, may make global markets even more vulnerable to future moves in JGBs. Some strategists have suggested the low yields in Japan (and perhaps Germany) have dragged down global yields via the substitution effect. Investors may be repositioning their portfolios toward countries with higher-yielding bonds. 4There is also a sense that with the Fed raising rates and the ECB announcing tapering, the BOJ is the last major central bank without any sort of timetable for exiting zero-rate policy. If it were ever to move rates, then we could see a meaningful rethinking of global yield levels.

The YCC policy was really an extension of Abenomics. Recall that Abenomics promised the three arrows of loose monetary policy, expansionary fiscal policy, and structural reform to revive the economy. It was like summoning Godzilla, Mothra and Rodan to team up to fight Ghidorah, the three-headed deflation monster. 5Many economists believe that, in practice, much of the work of Abenomics is being done via monetary policy, which is why Bank of Japan Governor Kuroda’s job is so difficult. Almost five years into his term, Kuroda can point to success in the form of positive growth and inflation, but the BOJ’s 2% inflation target is a ways from being reached.6

So what do you do when you’ve tried everything, but still haven’t achieved your primary goal? 7Some news reports prior to the meeting suggested that Kuroda might try to do less. Speculation was that he would begin the process of unwinding the stimulus. The BOJ’s aggressive easing policy has not been without side effects. Low long-term yields may be hurting banks by flattening the yield curve and narrowing the spread between their short-term borrowing and long-term lending. Kuroda himself expressed concern that the policy might be discouraging lending. There was talk about how the BOJ might tweak its policy to help banks by moving the yield target or targeting a shorter-term rate instead of the ten-year.8

The BOJ did make some changes, but they were not totally what had been expected. It took steps toward ending its unpopular negative rate policy and changed the mix of ETFs that it will buy. 9It also said it could increase or decrease its ETF purchases. But the more important change is the BOJ’s new approach to communication.

Two weeks ago we wrote about how Fed Chair Powell wanted to speak more clearly and stop using “communication” as a monetary policy tool. Kuroda is moving in the opposite direction – the BOJ is adding forward guidance as a monetary policy tool. The statement said that the BOJ would keep both short- and long-term rates low “for an extended period.”1 0While it didn’t specify how long that was, it specifically mentioned the consumption tax hike in 2019 as a source of economic uncertainty. This would seem to affirm a commitment to stimulus for at least another year. But then in the introductory statement to the press conference, Kuroda said that the BOJ would widen the band around the yield target, meaning that rates could go as high as 20bps, 10 bps higher than the previous implied ceiling.

This seems muddled, which may be the intent.1 1Kuroda faces a difficult task: he is trying to achieve several contradictory outcomes. He wants to maintain stimulus by keeping rates low and stable, but also wants markets to be liquid and volatile enough to function normally. He also wants banks to be healthy and lend more, but doesn’t want borrowers to pay more for loans. There is no simple way to express a policy that does all of that, so Kuroda needs to channel Alan Greenspan instead of Jay Powell.12

Markets seem to be confused by the statement. Initially JGBs rallied, but later sold off with a bigger move coming a full day after the announcement. Economists can’t seem to agree whether the statement was hawkish or dovish, whether it means the BOJ is tapering or maintaining policy. A few even claim that there is nothing new in the statement. So it seems Kuroda was successful in his “communication.”

The higher JGB yields may be part of the reason that yields are up in Europe and the U.S. this week as well. This is a reminder that 1 investors shouldn’t ignore Japanese markets, even if they have been boring recently. If JGB yields do start to come up from the depths, it could disturb fixed income and currency markets around the world. But if it does happen don’t worry, investors might feel market tremors but probably nothing like a sludge monster wrecking everything.

What We Are Watching

U.S. CPI (Friday) Higher gasoline prices pushed CPI inflation to 2.9% YoY in June, the highest reading since 2012.1 3Core CPI, which excludes energy and food prices, has also accelerated in recent months, although last month’s reading of 2.3% was still within the fairly tight range that has prevailed in recent years. The outlook for core inflation remains a key area of uncertainty for policymakers and market participants. Low levels of unemployment and a modest uptrend in wage growth may put upward pressure on prices over time.1 4However, this dynamic has been slow to emerge thus far, to the surprise of many economists. In recent months, another source of potential inflationary pressure has emerged as the U.S. government has implemented tariffs on a range of raw materials and manufactured products. Anecdotal sources, such as the Federal Reserve’s Beige Book, suggest that tariffs are contributing to higher input prices for many businesses.1 5If data begins to show that rising costs for labor and other inputs are passing through to consumer prices, investors and policymakers could grow more concerned about upside risks to inflation.

Canada Employment Data (Friday) Trade with the U.S. plays a major role in the Canadian economy, and recent moves towards more protectionist trade policies pose a significant risk to the outlook for Canadian growth. However, recent data releases suggest the Canadian economy has so far remained reasonably healthy, with slightly above-trend growth and low levels of unemployment.1 6The Bank of Canada decided to raise rates at its most recent meeting, and stated that it “expects that higher interest rates will be warranted to keep inflation near target.”1 7If incoming data continues to show a healthy labor market and strengthening wage growth, the Bank of Canada may proceed with plans to keep raising rates despite the risks posed by trade actions.

U.K. GDP (Friday) U.K. growth slowed notably in early 2018, with GDP up only 1.2% YoY in the first quarter.1 8While severe winter weather in February and March appeared to play a role in the slowdown, it was nonetheless unclear whether the underlying pace of growth had also deteriorated to some extent. Over the last few months, business surveys such as the PMIs published by Markit have bounced back, and official data releases have also improved. If the initial estimate of second quarter GDP from the Office of National Statistics (ONS) confirms that growth has recovered, it will likely help to assuage concerns about the strength of the U.K. economy.

[1 ] The following article from Reuters and a Jiji News report on the same day started a stream of reports that suggested the BOJ was considering altering its policy at its upcoming meeting: Reuters: “Exclusive: BOJ to debate policy change in July to make its stimulus sustainable: sources,” 7/20/18.

[2 ] Its balance sheet is almost 100% of GDP. That is really big. Source: Bloomberg.

[3 ] There was even a day with no trades. Source: Wall Street Journal: “Nobody’s Trading 10-Year Japanese Government Bonds,” 3/15/18.

[4 ] This is for unhedged investors. For investors who currency hedge their bonds it is a bit more complicated. In some cases they can earn more carry by buying lower-yielding bonds. It’s weird.

[5 ] Rumor is that the new Godzilla movie will be a remake of the 1964 classic Ghidorah, the three-headed monster. I haven’t seen any of the new Godzilla movies (meaning any made since 1970), but this might be a good one to start with.

[6 ] The BOJ’s preferred inflation gauge, the Nationwide CPI ex-Fresh Food measure, was at 0.8% YoY as of June 2018. Source: Ministry of Internal Affairs and Communications.

[7 ] You could listen to Coldplay.

[8 ] The BOJ could also build a monetary policy Mechagodzilla.

[9 ] Bank of Japan: “Strengthening the Framework for Continuous Powerful Monetary Easing,” 7/31/18.

[10 ] Ibid. The Fed had used that exact language, “extended period,” in numerous statements post-crisis.

[11 ] The confusion is not lost in translation.

[12 ] Greenspan famously said, “If I’ve made myself too clear, you must have misunderstood me.” Source: The Independent: “’If I’ve made myself too clear, you must have misunderstood me,’” 7/14/96.

[13 ] Bureau of Labor Statistics (BLS).

[14 ] BLS data has shown unemployment at or below 4% in recent months for the first time in almost two decades.

[15 ] The most recent edition of the Beige Book, published on 7/18/18, noted that “the prices of key inputs rose further” and that “a few Districts described these input price pressures as elevated or strong. Tariffs contributed to the increases for metals and lumber.”

2 [16 ] Data from Statistics Canada showed GDP growth of 2.6% YoY in May and an unemployment rate of 6% in June.

[17 ] Bank of Canada Monetary Policy Statement, 7/11/18.

[18 ] Office of National Statistics.

This material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision.

Past performance is not a guarantee of future performance.

This document is not research and should not be treated as research. This document does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only.

The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

3