Amid the “epic”/”historic”/[choose your own superlative] relent from developed market central banks that started in January when a procession of Fed speakers swiftly laid the groundwork for what would end up being a pair of exceptionally dovish policy statements aimed at allaying market concerns about overtightening in the face of a decelerating domestic economy, arguably the biggest worry is that policymakers are hamstrung in their capacity to deploy accommodative monetary policy in the service of reflating the global economy.
We’ve been over this on too many occasions to count over the past two months. The bottom line is that with rates still uncomfortably close to the lower bound (at best) and still mired in negative territory (at worst), and with central bank balance sheets still bloated, it’s not clear how much counter-cyclical “ammo” is left to ward off a downturn.
This problem is a bit less vexing for the Fed and there’s an argument to be made that Japan crossed the Rubicon years ago, so being stuck in Neverland (where helicopter money is now virtually inevitable) is just business as usual.
For Europe, though, it looks increasingly likely that the ECB will be forced to admit to having missed its window for normalization and, by extension, to having made a policy mistake by ending net asset purchases in January.
Early last year, when the data started to roll over across the pond, the hope was that the malaise would prove fleeting. Mario Draghi added date-dependent forward guidance to the statement (in addition to the traditional state-dependent language) and in December, he tweaked the language around reinvestments in an effort to calm markets. The data, though, generally refused to cooperate. After inflecting a bit throughout 2018, things have decelerated meaningfully, with Italy falling into recession, Germany barely avoiding a similar fate and the ECB itself acknowledging in January that downside risks have proliferated.
Now, the central bank is staring down the prospect of having to launch another round of TLTROs at minimum and it looks increasingly likely that the forward guidance around the rate path will need to be enhanced (it will be stale by summer anyway and if the data doesn’t improve, any changes will almost surely suggest the first hike has been pushed out, in line with analysts and, to a certain extent, markets). Clearly, political risks in Europe around the EU elections only increase the urgency, as does lingering uncertainty around Brexit.
With that in mind, BofAML’s Barnaby Martin is out with a new note documenting the “eerie similarities” between Europe and Japan.
“In our latest credit survey, we noted plenty of references to ‘Europe is Japan’ given how quickly the ECB appears to have altered its tune [and] while such a debate is clearly more complex, the comments, we think, are nonetheless prescient as 20yrs ago to the month (Feb 12th ‘99) the BoJ first cut interest rates to zero”, Martin writes, before reminding you that “with the exception of a few years in between, Japanese interest rates have barely moved since.”
And while history may not repeat itself, it does often “rhyme”. To illustrate, Martin uses the following chart which “shows that the progression of Japanese and ECB interest rates has been eerily similar when overlapping the two time series to match the point of zero interest rates (ECB deposit rates fell to zero in July ’12).”
The disconcerting read-through from Martin:
A crude extrapolation of chart 1 implies that ECB deposit rates will still be broadly at today’s levels in 2033!
He goes on to say that extrapolating from that chart suggests the ECB will probably make a policy error towards the end of this year by trying to raise rates, only to be forced to cut them again. That too would be consistent with the Japanese experience, he cautions.
“Back in July ‘06, the BoJ raised rates by 25bp after 5 successive quarters of positive growth [when] the feeling was that Japan had moved away from the spectre of deflation”, Martin says, taking a trip down memory lane. Obviously, that was wishful thinking. Following the crisis, the BoJ was ultimately forced to adopt negative rates.
Martin continues, noting that it isn’t just the rate path that’s similar. “We find eerie similarities in many other areas”, he observes. “Other areas” like these, for instance:
- Chart 2, shows the progression (months) in headline inflation rates for Japan and the Eurozone. Again, we overlap them at the point at which interest rates for both countries first hit zero (“Month=0”, in the chart). The correlation of Japanese and Eurozone inflation since then has been 52%.
- Likewise, chart 3 shows the progression of 10yr government bond yields for Japan and the Eurozone. The correlation between the two (from “M=0”) has been a eerily impressive 76%.
- And chart 4 shows the progression of Japanese and Euro high-grade credit spreads. Here, the correlation has been 50%. Note that Japanese high-grade spreads are roughly the same today as they were in February ’99.
Of course there’s more to this discussion than that. BofAML goes on to rehash the demographic story in Japan, which is obligatory whenever one starts to talk about “Japanification.”
Without getting into the weeds on that, Martin goes on to emphasize that BoJ persistence has been critical when it comes to “sustaining” the Japan story. The BoJ, he writes, has no “red lines”, as the central bank’s JGB holdings now clock in at 80% of GDP, versus “just” 20% in Europe (PSPP holdings).
BofAML also notes that tantrums have been a relative rarity in Japan and that policy uncertainty has been comparatively subdued, which obviously helps. “Importantly, there have been no material ‘tantrums’ in the JGB market, unlike with the Eurozone periphery crisis”, Martin says, adding that “this has allowed Japan to manage high debt/GDP levels, thanks to a decline in debt servicing costs.”
Ultimately, BofAML writes that the parallel with Japan will evolve according to the ECB’s willingness to abandon its “red lines” on QE as fiscal policy becomes more expansionary. In other words, it will depend on whether and to what extent the central bank is willing to monetize debt.
“In Europe, just as the first signs of fiscal loosening are emerging (Germany, France and Italy), the extent to which the region heads down the Japan route will end up being a function of how rigorously the ECB stick to their QE ‘red lines’ (33 issuer limit for instance)”, Martin concludes.
Right. And there’s more than a little irony in that in the European context. After all, looser fiscal policy would presumably take some of the burden off the ECB when it comes to reflating, but in Europe, that’s complicated immeasurably by a legacy (i.e., vis-a-vis the 2011 crisis) aversion to fiscal largesse. But when it comes to fiscal stimulus, the die seems to be cast – so to speak. The US, under Trump, set about an experiment in late-cycle stimulus (deficits be damned) and talk of deficits “not mattering” is all the rage right now.
Meanwhile, the realization that QE can never be unwound in full means that the we’re already monetizing debt.
Again, the die appears to be cast on a number of fronts.