Much ado about nothing – Bank of Japan stands pat as yen rises

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In Shakespeare’s time, the “Nothing” in his Much Ado About Nothing play title would have been pronounced “Noting,” which referred to the characters actions of observing, listening, and writing or noting.

During the last week of April 2016, market participants were heavily engaged in this “noting” behaviour in an attempt to determine the next moves from the Federal Reserve (Fed), the Bank of Japan (BoJ), and the Reserve Bank of New Zealand (RBNZ). By the end of the week, market participants were mildly disappointed when all three central banks actually did nothing. As a result, global yields and credit spreads remained in relatively tight ranges while global equities weakened modestly due in part to the lack of further global central bank easing.

Arguably, the most important central bank inaction of the week came from the BoJ. Following deteriorating growth including -0.3% quarter-on-quarter GDP growth and a -0.1% National CPI release earlier in the week, market participants expected additional easing measures ranging from increased exchange-traded funds purchases and Japanese government bond purchases to a more negative deposit rate or an expanded loan support program at negative rates. We expected that they would embrace a domestic credit easing strategy along the lines of the European Central Bank’s (ECB) recent actions and refrain from focusing on lower risk free real rates to avoid currency weakness. An increase in equity, corporate bond and Real Estate Investment Trust (REIT) purchases along with a more aggressive lending facility would have eased domestic financial conditions and likely had little impact on the yen. While we believe some yen weakness would help boost inflation, central banks have generally shied away from competitive devaluations since the apparent G20 detente agreement in mid-February. Moreover, if the BoJ acts to weaken the yen, Japan risks losing US Congressional ratification of the Trans-Pacific Partnership trade deal, a key lever for Prime Minister Abe’s third arrow structural reform.

Exhibit 1: The Japanese yen has continued to rally against the US dollar despite the introduction of a negative policy rate by the BoJ on 29/01/16 (the graph shows the exchange rate – number of Japanese yen for one US dollar – for the period from 01/10/15 through 04/05/16).

USD JPY

Source: Bloomberg, as at 4 May 2016.

The BoJ was in a difficult situation; however, the decision to do nothing may prove to be a policy error with serious consequences, particularly if perceptions that the BoJ and perhaps central banks more broadly, have lost either the will or means to act. The theme of diminished central bank effectiveness played an important role in the first quarter volatility spike and a re-emergence of this theme would destabilise financial assets and economic activity. We believe that continued yen strength or further declines in inflation expectations will reinforce these perceptions. In the near term, Japan must rely on fiscal policy in the form of supplementary budgets and wide speculation regarding a delay of the upcoming consumption tax increase. However, fiscal multipliers are typically low and raising debt to GDP from 250% to 260% is unlikely to spur growth in our opinion. Moreover, a move away from Ministry of Finance’s medium term fiscal framework could exacerbate debt dynamic concerns and possibly put upward pressure on the currency.

The Federal Open Market Committee (FOMC) indicated less concern about financial market volatility and weakness in global growth in this week’s statement, leaving open the possibility of a rate hike in June. Despite a considerable easing of financial conditions since the March meeting and marginal improvement in high frequency data, we expected the Committee to retain the sentence noting that “global economic and financial developments continue to pose risks”, given the structural challenges in many emerging markets, Europe and Japan. While they removed it, they expanded the sentence on monitoring inflation to read, “The Committee continues to closely monitor inflation indicators and global economic and financial developments.” In our view, the change is subtle and reflects a modest upgrade in their assessment, reflecting reduced market volatility and the impact of easier ECB policy while recognising that global growth remains fragile and financial conditions could again tighten.

As expected, they did mark down their characterisation of economic activity. The preliminary first quarter U.S. GDP data released this week provided more detail on the recent economic weakness. GDP growth fell from 1.4% in fourth quarter to 0.5% in first quarter. Non-residential private fixed investment contracted by 5.9% (quarter-over-quarter seasonally adjusted annual rate) with much of weakness concentrated in non-residential structures and equipment. While the contraction in structures was largely energy related the contraction in equipment investment continues to be broad-based. Moreover, despite ongoing labour market strength, personal consumption expenditure growth has now decelerated for three straight quarters.

The plot of Much Ado About Nothing is based upon deliberate deceptions, some malevolent and others benign. While we do not believe any central bank would deliberately deceive the markets, it is inevitable that their actions will either be interpreted as constructive, benign, and at times harmful. One need only observe the currency strength in Japan and New Zealand as well as the decline in global equities to conclude this week’s collective inaction was not constructive. It is too soon to tell but given the structural impediments to growth and inflation, we anticipate more easing from the RBNZ and the BOJ this year and a rate increase from the FOMC in September or December.

Timothy Johnson

Head of Global Sovereign Fixed Income at FFTW

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