Japan kicks off big 'hard data' day, US and Eurozone to follow
- Inflation updates are due out from the big three economies/blocs today
- Japan’s CPI is barely above zero, but the Bank of Japan persists with its policies
- The limits of the effectiveness of monetary policy are being exposed in Japan
Over the last few weeks markets have been trading on sentiment rather than substance; “soft” data rather than “hard”; surveys rather than numbers.
But today analysts have something they can get their teeth into: a triple-header of inflation updates from the US, Eurozone and Japan. The Federal Reserve, European Central Bank and Bank of Japan all have 2% inflation as their prime objective, so these hard numbers are the ultimate test of whether they are on track.
The first cab off the rank was Japan with the latest read on inflation showing an annual rate of 0.2%. The core rate, excluding food and energy, was only 0.1%.
The major concern for the Bank of Japan is that such low numbers reinforce the notion that inflation expectations have become “backward looking”. That is, after a couple of decades of close to zero price increases, consumers and business expect more of the same. This is not an ideal backdrop to the annual spring wage negotiations between unions and big business just getting under way.
The BoJ wants consumers to become “forward looking” and conduct their affairs on the basis that inflation will reach and stabilise around 2%. But you can’t blame Mr and Mrs Sato for being dubious. After all, the price of a ticket on the Tokyo subway is the same in 2017 as it was in 1995 (excluding taxes).
The limits to the effectiveness of monetary policy in the real world – as opposed to the theoretical – are being exposed in Japan, and many economists are coming to the conclusion the rate of inflation is linked to the economy’s potential growth rate, something monetary policy can have little impact on.
Adverse demographic trends mean the potential growth rate in Japan is 1% per annum at best, making 2% inflation a pipe dream. In contrast, trend economic growth in the US is about 2%, matching the Fed’s inflation target. In the eurozone potential growth is around 1.5%, giving the European Central Bank some hope inflation might be able to match their “below, but close to, 2%” objective.
Market based inflation expectation rates concur with these assessments, as shown in the following chart.
Inflation expectation rates comparison
Source: Bank of Japan
Nevertheless, the BoJ is as determined as ever to stick with its 2% target, In fact it upped the ante recently by announcing an “inflation-overshooting commitment” based on expanding the monetary base until the CPI exceeds 2% and stays above that level in a stable manner. This is a “unique” approach, according to BoJ governor Haruhiko Kuroda in a recent speech, because central banks are supposed to conduct monetary policy in a forward looking manner, taking their foot off the accelerator in anticipation of reaching a target, not waiting until it gets there. But the BoJ is prepared to let the genie out of the bottle and worry about containing it later on.
Commenting on the present situation Kuroda said “there is still a long way to go to achieve the price stability target of 2%”, and it is “obvious” the bank should maintain yield curve control, centred around keeping the overnight deposit rate at -0.10% and standing in the market to buy government bonds so that the yield on the 10-year maturity holds “around zero percent”.
FX traders should note his additional comment that “the bank will not raise the target level of the long term interest rates just because of a rise in such rates in other countries”. Over recent time there has been a close correlation between USDJPY and the US versus Japan 10-year government bond yield spread. But with the BoJ anchoring the Japanese leg, USDJPY is effectively trading in line with movements in the US bond, as shown in this chart (please click to enlarge)
USDJPY and US 10 year bond yield
The BoJ has not had everything its own way. At one stage its aggressive bond buying had flattened the yield curve right out, so that even the 40-year maturity was trading close to zero. This raised concerns that the process of “financial intermediation” whereby banks borrow short and lend long, was being impaired. Margins were squeezed. Furthermore, pension funds and insurance companies need an upward sloping yield curve to earn a return on their assets.
In In the end, pressure from the financial sector caused the BoJ to change tack by relinquishing control of the long end of the curve and instead concentrating its efforts on maturities out to 10-years, as demonstrated here.
Japan's quantitative and qualitative monetary easing chart
Source: Bank of Japan
When the BOJ squeezed them out of the local market, Japanese institutional investors turned to the US. They’ve long been significant investors in foreign bonds after decades of low rates in the home market. But they tend to back off when rising interest rates produce book losses on their holdings.
So it was after Donald Trump won the US election and US bond yields climbed (prices dropped). At the same time the USDJPY cross currency basis swap had risen to 90 basis points. (the basis is the extra cost of hedging FX exposure on top of the interest rate differential). This made hedging currency exposure expensive, giving the Japanese institutions another reason to hold back.
But recently, as the demand for US dollars has diminished the basis has narrowed significantly.
With the cost of hedging coming down, US bonds are becoming attractive again. As the chart below shows, a Japanese investor can now buy a 10-year US Treasury, hedge the FX risk, and end up with a yield of around 0.90%, a lot higher than the 0.05% available on Japanese government bonds.
Source: Bloomberg. Create your own charts with SaxoTrader; click here to learn more.
The Bank of Japan appears to have backed itself into a corner. The latest numbers show inflation barely above zero and many analysts have concluded the 2% target is a pipe-dream, given Japan’s potential growth rate is only half that. Yet still the BoJ presses on, seemingly out of ideas.
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– Edited by Robert Ryan
Max McKegg is managing director of Technical Research Limited. Follow Max here or post your comment below to engage with Saxo Bank's social trading platform.