1. BoJ’s monetary policy could be harming Japan

BoJ’s monetary policy could be harming Japan

Two major central bank monetary policy meetings were scheduled last week, US Fed and then the Bank of Japan. Though Fed proved to be non-eventful but the Bank of Japan monetary policy meeting had all the fireworks.

By: | Updated: May 2, 2016 9:05 AM
Post-BoJ, Yen rallied by over 4-6% in two sessions against various currencies, one of the sharpest rise in some time. (Reuters) Post-BoJ, Yen rallied by over 4-6% in two sessions against various currencies, one of the sharpest rise in some time. (Reuters)

Two major central bank monetary policy meetings were scheduled last week, US Fed and then the Bank of Japan.  Though Fed proved to be non-eventful but the Bank of Japan monetary policy meeting had all the fireworks. Interestingly the outcome in both the meetings were status-quo decision but the effect on the currency markets, commodity markets, bond markets and stock markets were very different. Market participants were expecting US Fed to sound a little more sanguine about hiking rates later this year but what came out was a non-committed central bank. At the same time, consensus was for Bank of Japan to announce more steps to ease monetary policy, through a hike in the monthly purchases of government bonds and exchange traded funds. BoJ was not expected to lower rates further. However, we were less sanguine about an easing from the Bank of Japan after comments from the economic aide to Japan’s PM, Shinzo Abe, Mr. Honda, that he does not expect BoJ to move in this meeting. Possibly Mr. Honda tried to manage market expectation before BoJ meeting so that there was not too much reaction post decision, but that strategy has failed.

Post-BoJ, Yen rallied by over 4-6% in two sessions against various currencies, one of the sharpest rise in some time. The gains were not just limited to Yen, it was broad based, as most of the currencies appreciated against the US Dollar. Market took the uncommitted Fed’s language as call that rates may not be hiked before September-December period and as a result, US Dollar lost between 3-5% against various currencies.  Nevertheless, the gains were stunted against Rupee, as sell-off in stocks and then demand from the central bank, did not allow the currency to break below 66.30 levels on spot. Over the past month or so, Rupee has been caught within a narrow range of 66.10 and 66.85 on spot. Historically, April has been a quite month but volatility tends to remain high between May-August time period.

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Japanese Yen and Euro are currencies which are borrowed by global hedge funds to fund leveraged bets on speculative assets world-wide. The reason these currencies are chosen because their central banks are pulling all stops to devalue them. The three major risks such bets face, carry trade, are:

1) Strong Yen and Strong Euro
2) Rising interest cost in Yen and Euro
3) Loss of capital in the assets they invested the borrowed funds

The end result is that these carry currencies, Euro and Yen, end up moving inversely to the risky financial assets like Equities and high yield bonds. It is to be noted that not only are the hedge funds who do such carry trades affect this relationship between financial assets and the carry currencies, but also other speculators who are not engaged in such trades but bet on only one side of the carry trade. For example, seeing Euro and Yen rise, some ground of computer based speculative funds may start selling the equity indices around the world, vice-versa. These kinds of trades are known as reflexive trades and they accentuate the impact of currencies on financial assets and vice versa.

Last week what transpired was the illustration of the above described phenomenon, unwinding of the carry trade and reflexive trades. In a world where narratives, well connected story, are major driver of asset prices and currency markets and also those dominant narratives revolve around central bank control over markets, a central bank surprise, positive or negative is bound to have exaggerated impact on prices. As Bank of Japan shocked markets first by not doing anything new and then by not dropping any hints of any future action in the subsequent monetary policy briefing, market decided to punish the authorities by doing what is most painful for them, make the Yen stronger and cause Japanese stocks to tumble. We can the trend continue for a week or two, as monetary policy meetings of the three key central banks are over and there is not much scope for a change in narrative of a weaker US Dollar in the interim.

JAPAN’S HOUSEHOLD CONSUMPTION EXPENDITURE GROWTH (Y/Y-%)

What puzzles us is the Bank of Japan’s overt policy of weakening the Yen over the past 3 years in the name of Abenomics. Let me throw some light on who drives Japan’s economy, is it production or is consumption. According to World Bank data available till 2014, household consumption comprises nearly 61% of the economy that is up from 53% in 1980’s. Compare this with China, where household consumption was 53% in 1980s but has fallen to around 35% by 2015. An economy which is driven by domestic consumption would benefit from a strong to stable currency as cost of living remains stable and disposable income increase. Instead, what they have pursued since end 2012 was a weak exchange rate policy. The effect on real disposable income of households has been pretty bad and which in turn has led to sustained weakness in household consumption. It is fool hardy for Japan, with an ageing population to try and hammer the economy with weaker exchange rate and negative interest rates. According to Bank of Japan, 9.7% of household wealth is in the form of equities, whereas it is 34.2% for US and nearly 17% for Euro area. Currency and deposits comprise nearly 52% of household wealth in Japan compared with nearly 14% for US and 34.4% for the Euro area citizens. Consumption driven economy with large import dependence for raw materials and food, ageing population and high proportion of interest bearing securities in savings can never be allowed to face the engineered menace of negative interest rates and weak currency.

Japanese household debt to GDP is just around 70% which means the over leveraged sector of the economy is government, which is bloated with debt. Therefore, the whole obsession to create inflation so that household can see their debt servicing costs fall in real terms is also not going to work for Japan as the household debt is not high enough. All in all, Japan is pursuing a policy where it will inadvertently trying to weaken the structural support for the economy.

Before I conclude, let me touch upon the key events for the next week. US jobs data for the month of April will be keenly watched as it will have an impact on the US Dollar. A strong jobs data can provide support to ailing US Dollar and also the local USD/INR pair. Apart from the US jobs data, traders will keep a close eye on the bunch of economic survey releases, PMI, from India, Euro zone and US. USD/INR is expected to trade within a range of 66.00 and 67.50 over the medium term. Demand for US Dollars from the central bank should provide support the pair. However, market technicians need to keep an eye on the 65.70/80 zone, incase it fails to hold, then risk a major breakdown will arise.

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