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.