(MENAFN- Asia Times) TOKYO – On Wednesday (January 18), the Bank of Japan did what officials in Tokyo do best: take the economic path of least resistance.
The betting that Governor Haruhiko Kuroda would shock markets with bold“tapering” moves became increasingly intense since the BOJ made a minor tweak to bond yield policies.
On December 20, it moved to let 10-year yields drift as high as 0.5%. That convinced hedge funds that the BOJ is ending its 24-year zero rate strategy .
Hardly. On Wednesday, Kuroda left the yield curve control (YCC) program unchanged, sending the yen sharply lower. The BOJ left its negative interest rate at -0.1% and 10-year bond yields around 0%. And in doing so, Kuroda effectively told economists and traders to pay better attention next time.
Ever since December 20, BOJ officials nearly tripped over each other stressing zero rates aren't going anywhere. More importantly, the BOJ put its money where policymakers' mouths are. Since January 1, it's pulled off countless unscheduled – and aggressive – bond purchases to cap yields.
To be sure, Michael Kramer, founder of Mott Capital Management, speaks for many when he says it's“shocking to me the BOJ passed on raising rates when the market gave them the green light.”
Analysts at BofA Securities are correct, meantime, that“the dysfunction in the bond markets that prompted December's YCC modifications have gotten significantly worse.”
But the real clue missed by investors betting on a big boj shift is the“Frankenstein problem” Kuroda's team has on its hands. It's one that's also bedeviling global markets.
For 24 years now, Tokyo has been building a financial monster the likes of which the globe has never seen before. The experiment began in 1999, back when mountains of bad loans in the banking system put Japan on the road toward deflation. Then-BOJ governor Masaru Hayami slashed short-term borrowing costs to zero, a first for an industrialized economy.
In 2000 and 2001, Hayami's team pioneered the quantitative easing (QE) strategy that central banks from Washington to Frankfurt would later emulate. Twenty-plus years of QE saw the BOJ hoarding more than half of all outstanding Japanese government bonds. It became the biggest investor in Japanese stocks via exchange-traded funds.
By 2018, the BOJ's balance sheet topped the size of Japan's entire US$4.9 trillion economy, a first for a Group of Seven nation. Yet over time, Japan Inc became so addicted to history's most aggressive monetary easing that it forgot how to function without it.
The yen was down as much as 30% against the US dollar in 2022. Image: Facebook
With the BOJ acting as an ATM for the government and businesses, there was no need for reform, restructuring or disruption to raise Japan's innovation game. It deadened the animal spirits that the BOJ wanted to reanimate.
Now that Frankenstein is coming back for its BOJ creators. Global markets, too. On December 20, the slightest of boj tweaks spooked investors everywhere.
The ferocity of that reaction now appears to be cowing BOJ officials, some of which are angling for a more rational and independent policy mix.
Economist Lauren Goodwin at New York Life Investments warns of parallels between Japan and last year's UK bond market crisis. As UK yields surged, many pension funds were on the brink of insolvency. That was particularly so of funds relying on derivatives-based strategies. It forced the Bank of England to scramble to the rescue with emergency bond-buying programs.
“For years, due to the challenge low-interest rates pose for meeting future liabilities, Japanese insurers have used derivatives to hedge interest rate risk,” Goodwin says.“Japan's shrinking population has increased the need for future payouts, likely amplifying the use of risky yield-generation strategies and further increasing the fragility of the market.”
It hardly helps, Goodwin says, that Japan's debt market is five times larger than Britain's.
Part of the problem here is the decades-long blame game that's colored BOJ decision-making. Since the 1990s, a succession of Japanese governments pointed fingers at the BOJ anytime gross domestic product (GDP) underperformed.
Things got particularly heated in the latter years of the decade, prompting a more assertive easing response from boj headquarters .
This dynamic flared up again in the mid-2000s, the last time the BOJ tried to normalize ultraloose monetary policy. From 2003 to 2008, then-governor Toshihiko Fukui worked to extract Tokyo from the intensive-care unit.
QE, as Fukui argued, was meant to bring the economy back from a kind of near-death experience. It was never meant to be permanent. First, Fukui ended QE. Then, in July 2006, he oversaw the BOJ's first official rate hike in nearly a decade. Then a second one in early 2007.
Japan Inc struck back, and hard. Loud protests from banks, investors, companies and politicians put the Fukui BOJ on the defensive. The tightening cycle ended.
In 2008, goal No 1 for Fukui's successor Masaaki Shirakawa was returning rates back to zero and making QE great again. Then came Kuroda in 2013 to supersize QE efforts in unprecedented ways.
The BOJ became the biggest investment“whale” in bonds, stocks and other assets. This took the central bank-underwritten corporate welfare of the previous 15 years to entirely new levels.
The Fukui era was quickly forgotten in Tokyo. Yet in the mid-2010s, then-Federal Reserve Chair Janet Yellen experienced her own“Fukui moment.” In late 2015, Yellen ended Lehman Brothers-era QE and began hiking rates.
In 2018, Yellen's successor Jerome Powell stuck with the Fed's rate normalization regimen. Yet Powell reversed course after then-president Donald Trump threatened to fire him. The Powell Fed in 2019 began cutting rates back toward zero before Covid-19 hit.
That limited the Fed's latitude to cut rates as the pandemic savaged growth and investment confidence. It added to froth in asset markets, helping put the US on an inflationary trajectory that Powell's team has frantically tried to reverse.
Adding to the drama in Tokyo is Kuroda's imminent retirement scheduled for March. Though Prime Minister fumio kishida hasn't named a replacement, investors generally think deputy governors Masayoshi Amamiya and Masazumi Wakatabe are the most likely contenders.
Kuroda's successor will be taking the helm just as Japan's annual repatriation trade puts upward pressure on the yen. That's when CEOs ship overseas corporate profits back to Tokyo.
Trouble is, Kuroda leaves his successor with an even bigger Frankenstein monster. Part of the problem is that Kuroda has been betrayed by one Liberal Democratic Party government after another these last 10 years.
Kuroda was brought on in 2013 to set the stage for the financial Big Bang to come. At the time, prime minister Shinzo Abe hired Kuroda to fire the first of three policy“arrows” to end deflation and restore competitiveness as china's influence grows.
After deploying the monetary arrow, Kuroda learned the other two didn't exist. Abe never got around to fiscal retooling to increase the efficiency of growth. Nor did his reform plan leave the quiver to cut bureaucracy, internationalize labor and corporate governance norms, catalyze a startup boom, empower women and attract more foreign talent.
Kuroda has since realized that letting the monetary arrow crash to earth could devastate Japan's economy. The added concern is that 24 years of zero rates morphed Japan into the globe's top creditor nation.
Though Fed rate moves tend to have greater impact, BOJ effects are amplified by the so-called“yen-carry trade.” It's become standard practice for investors and hedge funds everywhere to borrow cheaply in yen to bet on higher-yielding assets from the US to South Africa to India. This means, though, that any sharp move in the yen upends currency, bond, stock and real estate markets around the globe.
That's not to say the BOJ shouldn't be mulling an exit from nearly a quarter century of free money. A key reason Japan is suffering the worst inflation in 40 years is an undervalued yen. Yet the global reaction to December 20 suggests that neither Japan nor global markets are ready for a BOJ U-turn.
Modest tightening moves taken by Bank of Japan Governor Haruhiko Kuroda have been enough to affect US bonds. Photo: AFP / Jiji Press
For now, says economist Takeshi Yamaguchi at Morgan Stanley MUFG,“we think the BOJ intends to stabilize the jgb yield curve via banks by providing them mid-term/long-term funds at lower rates than JGB yields.”
Another area of uncertainty is that“data in coming months will be choppy given the numerous crosscurrents hitting the economy,” says Stefan Angrick, senior economist at Moody's Analytics.
Amid so many headwinds,“Japanese stocks would get crushed if the BOJ abandons YCC, while if they decide to widen the band again that might be the best-case scenario for Japanese stocks,” says analyst Edward Moya at OANDA.
The BOJ's reluctance to do either can be seen in the frantic pace of BOJ bond purchases. As of Tuesday, for example, Kuroda's team had purchased a record amount of government bonds so far this year, roughly $126 billion. Last Friday saw a new single-day record of about $38 billion.
Devising an exit from 24 years of building a financial Frankenstein will fall to Kuroda's successor, whoever that might be. The timing also might rely on how much latitude Kishida's government affords the post-Kuroda BOJ.
On paper, the BOJ is“independent.” In practice, the prevailing political winds in Tokyo often hold great sway over BOJ decisions. Frankenstein, too, it turns out.
Follow William Pesek on Twitter at @WilliamPesek
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