Last week, the policy divergence narrative between the Fed and the ECB was underscored when Jerome Powell reinforced the hawkish lean from the FOMC while Mario Draghi, in a surprise, adopted “state-and-date-dependent” forward guidance on rates, essentially pushing the timing of the first ECB hike to at least 9 months after the December end of APP.
There’s an (unnecessarily long) recap of the evolution of the transatlantic policy divergence story here, but suffice to say we’re (roughly) back to where we were at the beginning of 2017, when the market assumed that the ECB would begin to fall further behind.
Lost in the shuffle was the BoJ, which, on Friday, did what it usually does – nothing.
heh. pic.twitter.com/5XAcq0X90s
— Heisenberg Report (@heisenbergrpt) June 15, 2018
That’s not entirely true. They did slash their inflation target, but that’s obviously dovish.
Predictably, Kuroda characterized his monetary easing as “very powerful” despite the fact that the elusiveness of the inflation target is itself evidence (and in some respects the best evidence) that his easing is in fact not all that “powerful”.
The BoJ decision came just a day after Kuroda cut purchases of 3-5Y JGBs by JPY30 billion. That was the second cut in a month.
You might recall that those reductions in purchases have laid bare a rather vexing issue for the BoJ as it ponders how (or even if) it’s possible to exit accommodation. The problem is that despite the fact that part and parcel of YCC is a so-called “stealth taper”, the FX market is still prone to overinterpretation when it comes to these rinban ops.
That manifested itself in outsized moves in the yen earlier this year, a highly undesirable scenario as a stronger yen undermines the inflation targeting effort. In short: the sensitivity of the yen to slight tweaks in bond purchases suggests that any actual effort to normalize would be met with a significant (and potentially dangerous) FX reaction (i.e., yen rally).
That calculus was complicated immeasurably by the reemergence of the Moritomo fiasco, as any threat to Abe is seen as a threat to Abenomics which is in turn seen as a threat to the persistence of the BoJ’s easing efforts and thus yen positive.
Lost in the ongoing debate about the stealth taper in JGB buying and the FX reaction to reduced purchases (last week the reaction was mercifully muted) is the persistence of the bank’s massive ETF buying program. That program has been the subject of merciless ridicule for a variety of reasons, not the least of which is that when you start to game out potential outcomes, you end up coming to a manner of hilarious conclusions that include Kuroda owning the entire free float of some publicly traded companies and/or actually breaking the stock market (and give me some rope on that characterization).
Here are two charts from Goldman that trace the history of BoJ ETF buying:
For what it’s worth (which isn’t a whole lot), here’s what Kuroda said last week about the ETF program:
- KURODA: ETF PURCHASES SHOULD BE GAUGED IN CONTEXT OF STOCK MKT
- KURODA: ETF PURCHASES HAVE LOWERED RISK PREMIUM
- KURODA: ETF HOLDINGS HAVE PLAYED LARGE ROLE
- KURODA: JUDGE ETF POLICY BASED ON ECON CONDITIONS AT TIME
So how does the BoJ go about unwinding this massive experiment?
Well, that’s an interesting (not to mention important) question and Goldman has some suggestions based on historical precedent. In a note dated Friday, the bank begins by laying out the reasons why this needs to be discussed or, more to the point, by laying out the myriad concerns attached to the program. To wit:
First, ETF purchases of ¥6 tn a year have almost certainly acted to support equity prices to a great extent in terms of share supply/demand and thus an exit could be a catalyst for large equity sell-offs depending on the exit strategy. Second, equities do not have a maturity date, so they are not “redeemed” over time like JGBs. Accordingly, it is necessary to come up with a scheme for more proactively disposing of ETFs. Third, the BOJ Act requires the recognition of impairment losses when the market value of shareholdings declines markedly. Such a situation would affect the government’s revenues the following fiscal year through a reduction in treasury payments, and erosion of the central bank’s balance sheet also could have consequences for confidence in the value of the country’s currency.
So basically, these purchases are i) distorting the market and creating considerable uncertainty about what happens if they’re unwound, ii) not going to rolloff by virtue of being equities, and iii) MTM.
As for historical precedent, Goldman flags the HKMA’s efforts to combat speculative bets against both the HKD and the Hang Seng (with the latter bets predicated on the assumption that rising rates to combat currency depreciation would lead to a stock market plunge).
“This is a typical speculative position known as a ‘double play’ [and] it was the main reason for the interbank interest rate surging from time to time and the Hang Seng Index dropping about 60% in August 1998 from the peak reached in the previous year,” Goldman writes, introducing the following visual:
So what did HKMA do? Well, first they bought USD15 billion in shares or, for context, about 6% of HK market cap. Obviously, that drove the Hang Seng up sharply.
Here’s Goldman explaining the exit strategy:
First, the HK government established the Exchange Fund Investment Limited (EFIL) as an organization to manage the shares acquired through the intervention, and EFIL in turn structured an ETF linked to the Hang Seng Index called the Tracker Fund of Hong Kong. The ETF was listed publicly in November 1999 and sold in stages, completing sales for the most part before the end of 2002, with the exception of long-term holdings at HKMA. The HK government generated investment returns of US$11.5 bn in this way. The ETF successfully attracted many investors in part by offering discounts of more than 5% to buyers when it listed. Purchasers were both retail and institutional investors.
Goldman goes on to cite two other historical examples that might inform the BoJ’s strategy (stock purchases by Japan Joint Securities Co., Ltd in the 1960s and BOJ purchases of shares held by financial institutions from 2002-2004 and from 2009 to 2010).
In the interest of brevity and also in preserving the integrity of the full note, we’ll skip those discussions and that works here because as the bank’s Naohiko Baba points out, “the HK government’s exit strategy would seem the most ideal for the BOJ [because] not only did the HK government effectively protect the financial system from excessive speculative moves, but when the shares were eventually sold this was a win-win for both the government and investors.”
So what’s the problem with doing that? Well, as you might imagine, this comes back to the inflation target. Whereas the HKMA’s effort was designed to curb speculation against the market, the BoJ’s program is part of a broader effort to engineer inflation. That, in turn, means that an exit from the ETF program will only occur once the bank is closer to that target and as last week’s BoJ meeting confirmed, that target is getting more elusive by the month.
The question, then, is whether Japanese stocks will be in rally mode (or at the very least not falling) when the inflation target is finally hit. If, for whatever reason, Japanese equities aren’t stable when the BoJ wants to exit, well then it’s not entirely clear there would be demand for what they’re selling and if there is demand, there’s no telling at what price. That sets the stage for the bank (and thereby the government) to suffer losses on the sales and if those sales end up putting pressure on stocks, well then they’d be selling into a falling market and everyone would lose.
You can draw your own conclusions here, but suffice to say this isn’t going to be easy because historical precedent isn’t really historical precedent.
