SEPTEMBER 16, 2016, 17:30 JST

BoJ Tapped to Taper

For a printable version of the report, please click here.

In our view, the policy meeting on September 20-21 will be the turning point for the Bank of Japan (BoJ) since it started its current form of monetary easing in 2013. The BoJ will try its best to sugarcoat the message, but they will essentially be admitting that they will no longer pursue 2% inflation rate target as ardently as they have been. The bank will maintain its 2% inflation target, but it will become a medium term objective, rather than a target they are obliged to meet in a set duration of 2 years.

In our view, the change is overdue. As we wrote in September 2015, the BoJ has been modifying the nature of its pledge since late 2015. The change is also inevitable, as we believe the BoJ has nearly exhausted its means to ease the monetary condition in Japan. While there are still measures the BoJ could implement, the cost of adopting these measures outweigh their benefits for now. In our view, the decision the bank made last July to expand its ETF purchase was already a step too far.

A stock market crash in 2018 will wipe out BoJ’s capital

At the new pace of the equity ETF purchase, 6 trillion yen per year, the exposure of the BoJ to equity market will quickly grow to such an extent that a severe negative shock could wipe out the banks' capital by early 2018. For more details on our view on the limitation the BoJ faces, please see our report, Time for Damage Control.

How will the market react to the news? 

While we think the retraction of the time limit was inevitable, the financial market will probably react negatively as it perceives the change as a step back in the BoJ’s eagerness to ease further. In order to soften the negative reaction, the BoJ may throw in a monetary easing measure to accompany the news. Offering a negative interest loans to private sector banks could be such a measure. Opening a possibility to reach an accord with the government to encourage larger fiscal stimulus could be another. However, we think it will be difficult, if not impossible, for the BoJ to find an easing measure powerful enough to compensate for the news that the BoJ is admitting that it does not have tools to effectively reflate the economy.  

With “taper” comes a “taper tantrum”

Even when the BoJ succeed in partially softening the impact, we would expect the admission of its limitation to give rise to a modicum of market volatility. In our view, the result could be similar to what we observed in the US “taper tantrum” in 2013, in response to the Fed’s own signaling (after it had achieved its target).

Following the Fed’s signal in May 2013, we might observe that US 10-year yields moved higher (and remained higher through mid-2014), while the shorter end of the US curve was afflicted by increased volatility (see below chart). The curve steepened following the “tantrum” and remained steep.

Meanwhile, by mid-2014 (one year following the “tantrum”), the positive inflection of the “belly” returned.  We contrast this move with the ongoing negatively inflected JGB curve (proxied by the average of 10 and 2-year minus 5-year yield).

There emerged some evidence of a liquidity squeeze in the longer end of the Treasury curve, which is a clear warning signal for the JGB market, from its larger, more liquid counterpart.

Dollar-yen on the other hand saw immediate gains, alongside a spike in volatility in both EURUSD and USDJPY, breaking with the more recent tendency for dollar-yen to dive in volatile conditions, as markets take risk off the table.  Instead, this market-specific shock led, albeit temporarily, to a shift in market behavior.

In Japan’s case however (with the BOJ rather than the Fed signaling the end for QQE is nigh), it would be reasonable to expect the yen initially to strengthen, assuming of course, a no capital flight situation, where domestic investors continue to hoard JPY as liquidity recedes.

What if it’s more than a “tantrum”?

Conversely, one market where the “taper vs cold turkey” argument and its impact on liquidity become extremely relevant is the cross-currency basis swap market.  Assuming no capital flight or loss of BOJ credibility, it seems reasonable to assume that lower expectations of extremely negative yen carry should reduce the negative premium on the dollar-yen basis swap.   However, taking a lesson from the Euro-dollar basis swap’s volatile swing into negative territory at the time of the European crisis (as dollar funding dried up), we would watch this market closely for signaling on BOJ credibility.  Expectations of “Japan selling” could easily push the basis swap into even more negative territory. 

Using a rolling 1-month indicator of “Japan selling” (simultaneous daily declines in yen vs dollar, stock and JGB’s), we can see that the negative basis swap premium tends to deepen a markets fall subject to “Japan Selling”. 

While this is not our central scenario, we would pay especial attention to this market as an early warning indicator that the tantrum may be turning into a full-scale behavioral disorder.