Article / 28 July 2016 at 1:19 GMT

Shock and awe expected from Japan after timid Fed

Managing Director / Technical Research Limited
New Zealand
  • USDJPY likely to be the focus of traders after yesterday's timid FOMC statement
  • Many expect everything to be thrown at Japan's deflationary mindset
  • Rumours hint of a Japanese government fiscal injection of around 5% of GDP
  • Bank of Japan is issuing a post-meeting monetary policy statement this Friday

By Max McKegg

By the end of trading in the New York session today, markets had concluded the mid-afternoon statement from the Federal Open Market Committee was neither here nor there or much ado about nothing (choose your Shakespearism). In comparison, many are expecting the double act of Bank of Japan Governor Haruhiko Kuroda and Prime Minister Shinzo Abe to throw everything but the kitchen sink at Japan’s “deflationary mindset” in the next few days, making USDJPY the focus for FX traders.

 Plenty of rabbits ... but markets won't be reacting until either the BoJ governor or
Japan's Prime Minister pulls one out of a hat. Photo: iStock
The Federal Reserve continued with its first, do no harm approach to monetary policy, noting that “near-term risks to the economic outlook have diminished” and economic conditions are likely to evolve in a manner that will warrant “only gradual increases in the federal funds rate”. No forward guidance was given. 

This contrasts with the October 2015 statement, which clearly signalled the rate hike that was subsequently delivered last December. Hence market pricing suggests only a 25% chance the Fed will move at its next meeting on September 20-21. Of course, a lot of water will go under the bridge before then and Federal Open Market Committee Chair Janet Yellen will have an opportunity to update markets on the situation in her Jackson Hole speech scheduled for August 29.
A key data point ahead will be next Tuesday’s update to the price index of Personal Consumption Expenditures, the Fed’s inflation benchmark. Today’s statement said: “Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further." 

But the proof will be in the pudding. This chart shows the current situation: both headline and core PCE drifting along well below target. Not much change is expected this time either. Base effects (last year’s oil price declines dropping out of the annual calculation) will start kicking in from now on, but the Fed will be hoping the recent decline in spot oil doesn’t send things back to square one.

Shock and awe in Japan
And what of the bold monetary/fiscal announcements apparently in store for Japan? The first of these could come Friday afternoon local time (an hour or so before European markets open for the day) when the Bank of Japan issues a post-meeting monetary policy statement. 

Kuroda, inscrutable as always, has given nothing away ahead of time, leaving USDJPY to gyrate on rumour mongering. The capacity to increase the size of the central bank’s balance sheet must surely be diminishing as it approaches 100% of GDP (see chart below). The US Federal Reserve’s balance sheet topped out at 25% of GDP and the European Central Bank is only getting to that level now.
The only other viable option would appear to be cutting the deposit rate again, from minus 0.10% to minus 0.20% or more, but that course of action creates problems for Japan’s private sector banking system.
Source: Bloomberg. Create your own charts with SaxoTrader; click here to learn more 
More likely Kuroda will gratefully pass the buck to Prime Minister Abe, recently emboldened by a big election win. Rumours hint at a government fiscal injection of around 5% of GDP, to be announced next Tuesday. This will be financed by the issuance of long-dated bonds (up to 50 year maturity), most of which will be gobbled up by the Bank of Japan under its existing or an extended bond-buying program.
While the media is likely to play up the boldness of this Abe/Kuroda double act, markets won’t be reacting markedly unless one of them has pulled a rabbit out of the hat. Kuroda has done so previously; he’ll have another opportunity Friday.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.
Jim Earls Jim Earls
So how does the BoJ do shock and awe, if their balance sheet is fully extended and lowering the deposit rates only causes more pain on their financial services industry?
Max McKegg Max McKegg
Well Jim, one way would be to for the BOJ to deliver “helicopter” money i.e direct payments to the population. Those funds would not increase the money base per se nor the size of the BOJ’s balance sheet. The money would be spent on goods and services; it would not end up back on the BOJ’s books in the form of deposits – as happens when they buy bonds from private banks. Of course, that may only provide a once-off boost to prices, whereas the Bank is targeting the *rate* of inflation year on year.
KaranKK KaranKK
Based on the previous experience, when BOJ introduced negative interest rates, markets took it as a negative sign, USD/JPY fell and Nikkei fell. What happens if BOJ gets into more negative interest rates ? Will the Nikkei rally and USD/JPY rally, as expected or does the market again take this as negative news ?
Max McKegg Max McKegg
I think the BOJ acting on its own and cutting the deposit rate will be a waste of time – as you suggest (unless of course, they did something dramatic like helicopter money, but that’s improbable). What’s needed, and likely, is a co-ordinated approach with the government. So I think the response to the BOJ on Friday will be muted: markets will want to see what the government’s fiscal package on Tuesday brings to the party.


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