USDJPY basis will have more impact on trade than Trump blustering
- Bank of Japan policy announcement on Tuesday amid negative inflation
- Deputy governor warns of hidden vulnerabilities in global financial system
- USDJPY basis a key indicator for global trade movements
By Max McKegg
The Bank of Japan will issue updated economic forecasts tomorrow at the conclusion of a two-day monetary policy review meeting. The forecasts will determine whether the current yield curve control strategy remains appropriate.
Over the past few months the focus has been on holding the 10-year government bond yield at “around zero percent”, even as the rate on the US Treasury equivalent climbs.
USDJPY has fluctuated in line with the day-to-day movement in the yield differential. The news last week that inflation is still in negative territory will provide a sober backdrop to the discussions between bank governor Haruhiko Kuroda and his colleagues.
The following chart shows the BoJ’s inflation benchmark (CPI ex fresh food) declined by 0.2% over 2016, a slight improvement on the -0.5% reached earlier in year, almost entirely due to a turnaround in energy prices.
The core-core rate (CPI ex fresh food and energy) remains stuck at zero. Regardless of the measuring point, Japan’s inflation is miles away from the 2% target.
The BoJ will be pinning its hopes on the upcoming “spring offensive”, when labour and business agree on wage policy for the year ahead.
Higher employee incomes would flow through to consumer spending and, in turn, business investment. This is the so-called “virtuous cycle”, long promised by proponents of Abenomics but yet to materialise.
Meanwhile the BoJ is on the look out for “hidden vulnerabilities” in the global financial system stemming from the monetary policies of Japan and the US. In a recent speech, Monetary Policy Divergence and Global Financial Stability, deputy governor Hiroshi Nakaso addressed the issue, pointing out that there was a “close connection between fluctuations in bank’s cross border claims and global economic activity”.
Cross border claims are loans made by non-US banks to clients who are looking to expand business internationally.
Usually the loans are in US dollars and, as the chart below shows, Japanese banks are now leading the way, while UK and European banks continue to de-leverage.
Nakaso’s point is that if the supply of US dollars starts to dry up and the cost of borrowing rises, it will have a more dramatic impact on global trade than any blustering by US President Donald Trump.
Global bank lending
Source: Bank of Japan
Japanese banks have no natural sources of US dollars, so in recent years they have been active users of the FX swap markets, lending JPY in exchange for USD.
At the same time Japanese institutions have been increasing their investments in US government bonds, often fully hedged for currency risk.
With the banks and institutions coming from the same side, the extra cost over Libor of borrowing USD in the swap market, known as the basis, has blown out to 80 basis points, a record.
Source: Bank of Japan
The attraction of offshore bonds to Japanese investors is obvious, given that the domestic market has been offering miniscule yields for years; in fact, currently negative out to ten years.
But the rate differential was significant in the mid-2000s as well, yet, as the chart shows, the basis held close to zero, as per the law of covered interest rate parity that the textbooks said must apply always and everywhere.
Banks would simply borrow US dollars at Libor and lend them out in the swap market whenever a gap between the two opened up. Bankers running arbitrage books earned large bonuses by simply expanding their employer’s balance sheet.
After the GFC and the regulatory reforms that followed, things have changed: Banks have less balance sheet space available to take the other side of the FX swap trades.
In addition, recent changes to US money market fund rules mean the funds are no longer buying USD commercial paper issued by the Japanese banks, forcing the banks to find alternative sources, such as widening their deposit base or, more expensively, using the swap market.
Japanese institutions such as life insurance companies and pension funds have no alternative to the swap market to hedge their offshore investments; they just have to pay the basis. Enter sovereign wealth funds, emerging market central banks with USD FX reserves, and private investment companies.
The yawning arbitrage gap left as banks withdrew became hard to resist and these players stepped in.
In exchange for lending dollars in the swap market, they were able to borrow JPY at negative rates, invest in short term Japanese bonds on a fully hedged basis and end up with a net return well above that available in any other large government bond market.
What could go wrong? Plenty. When the Chinese share market crashed in mid-2015, emerging market reserve managers, aware of the potential need to defend their currencies, refrained from offering dollars in the FX swap market, switching instead to US Treasury bills.
A similar thing happened when Donald Trump won the US election in November. As for sovereign wealth funds, the amount of dollars they have to lend is a function of the oil price.
Furthermore, interest rate rises in the US could bring about a rapid and large-scale capital outflow from emerging market economies. If the supply of dollars dries up and the cross currency basis expands, Japanese banks will cut back on cross-border lending and the close connection between fluctuations in bank’s cross-border claims and global economic activity will be exposed.
This is the “hidden vulnerability” in the global financial system spoken of by BoJ deputy Nakaso. So keep an eye on the USDJPY basis: It has the potential to create more trouble than blustering by the US President.
-- Edited by Adam Courtenay
Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade, then click here to follow him.