The BoJ delivered, and then some. TMM has been fairly positive on the reflation story for Yen-denominated assets all along, but even TMM is pleasantly surprised. With a unanimous vote behind an ambitious act of policy, Kuroda has at the very least pushed back any scepticism that BoJ policy will be timid.
TMM feel that there are two questions here and it may be helpful to clarify that ahead of time:
A) How will the BoJ policies affect the actual economy?
B) How will the BoJ policies affect investor perceptions, and through that, asset prices?
For
A) TMM think the question could be framed as the battle between expectations and declining real demand with the expectations channel being the main channel by which the BoJ hopes to succeed. Creating base money, even lots of it, hasn't worked, as we know and a 50bp decline in 10y rates is arguably not SUCH a big deal. And now it can't fall much further.
As it's the weekend of the UK "Grand National", the most gruelling of horse races noted for its number of fatalities, perhaps we should consider the policy as the course, the Japanese economy as the horse and growth as the finish. The BoJ has chosen a course to growth that goes via "Inflation" so let's have a look at the course and fences -
1) Force inflation to rise through a decrease cost of money relative to goods which compounded by (2) an FX driven rise in imported goods costs should create within the populace (3) an expectation of inflation to continue rising and therefore (4) a propensity to spend now rather than later. Combined with a (5) negative real interest rate this will push a move from (6) saving to spending and should drive local demand and (7) increase investment domestically and so lift growth.
As per our
Non-prediction number 1 at the start of the year we see this policy ultimately working and the expectations of it working yielding profits for long inflation trades this year. However the true measures of success are going to be a long way down the line and probably only visible once 5 minute macro has moved on to fight other wars.
The processes laid out in our yearly non-predictions are clear, however and here we invoke that classic Japanese "however" clause. TMM know that Japan occupies a part of the financial universe that is far enough away from the normal universe not to share the same rules of economics. Before you cry out in horror perhaps we should apply a caveat. Japan does share the same rules of economics but the cultural and demographic overlay applied to those same rules means that the paths to predicted outcomes are not as straightforward and definitely not as efficient as others we know. So where as we may expect some obvious results to occur when an inordinate amount of freshly printed money is thrown at an economy, things are different in the land of ZIRP where the culture is to save, particularly offshore, and not to spend (c.f. Western culture and media programming of today's young). If normal economics are Newtonian physics, then Japanese economics is what happens at the event horizon of a black hole.
So let's have a look at the fences.
1) The cash injections are indeed huge and as a proportion of GDP, dwarf the US actions. On this basis alone decrease in the cost of money through the huge cash injection will dilute the money/goods ratio. But global connectivity spreads the flood increasing liquidity everywhere just as the US actions did. The melting of the Greenland ice sheets means sea levels in New Zealand rise a bit. Japanese banks may be queuing outside the study of the BoJ ready to have their orders to lend spelled out to them, but TMM wonder how much of it will ultimately remain domestic as the real demand for credit is in the West "Roll up, get your cheap funding here", rather than within a domestic culture that saves rather than borrows. The flow out of yen to achieve this moves the affect to FX (2). We are already seeing the liquidity tsunami with Japanese lifers hoovering European bonds at the expense of JGBs. Check France / Japan 10 year spreads today. (Note - remind Eurogroup to write thank you letter)
2) FX driven inflation tends to be a one off shock, unless you can get your currency to crawl lower but then the incremental moves are just smaller. It's all good, but do it too much and things start getting bad quickly, either due to a lack of investor confidence or trade partners setting up tariffs. FX driven inflation can be seen as the wrong type of inflation if it doesn't drive wage demands higher but locally stifles purchasing power.
3) Expectations of inflation rising will most probably first be seen through the FX function, which as we said could be transitory (unless this goes Weimar). So once the FX starter motor of inflation expectation is done a continued domestically driven inflation has to take over. As with the west this will have to be associated with wage inflation which we know can be extremely stubborn and culturally even more difficult to kick off in Japan.
4) Propensity to spend now rather than later. If, as we gather, the BoJ is hoping to increase inflation in the service sector we wonder how increases in inflation expectations will increase demand, as most services are not hoardable. A consumer who anticipates the cost of haircuts going up cannot go and get his hair cut 20 times now in order not to have any later. The same applies for most of the service industries that we can think of. Entertainment, accountants, lawyers, medical services, transport, maintenance - it's all time spaced. So what do you do if you are a consumer who thinks inflation is going to go up. You don't buy tech as that depreciates faster than jpy can. Once you have bought a car a year early, and the furniture you were putting off, maybe had a holiday, there is little else apart from putting on financial hedges. Property? Japan considers property as a depreciating asset and "
An unusual feature of Japanese housing is that houses are presumed to have a limited lifespan, and are generally torn down and rebuilt after a few decades, generally twenty years for wooden buildings and thirty years for concrete buildings" and
is taxed as such. However this could imply that the price of the land that they are built on rises.
5) Real rates are very important to the investor as a measure against returns, but TMM would suggest that to the man on the street the cost of a loan on something he isn't going to sell again (so won't consider for asset growth - see furniture, household stuff) is the cost of loan against how much more he thinks he will earn in the future. Wage inflation rather than CPI. So if wage inflation stays flat (as it has in the UK) then his real interest rate will not be negative. This is where the investor, who is always looking at resale value is very different to the consumer, who as a "consumer" by definition won't have anything left to sell on.
6) And where do they save? Overseas where the yields are and you are hedged against the expected FX driven inflation. BoJ policy change does not remove the incentive for Mrs Watanabe to borrow locally and buy Aussie bonds. It may even increase it.
7) Domestic investment will react to FX moves as wage costs become more competitive. We see no problems with this last fence. In fact once this occurs the finish line of growth is clearly insight. We just have to hope that all the other fences have already been cleared.
We will not know the result of this race for a few years but market punters are piling in to the bookies backing their horses .
So where is the money is going? Or our question
B)Looking ahead, TMM reckons that the BoJ is probably done for a few months, as it watches to see the results of its announcement today. The next step for the markets is likely to be dependent on the evolution of retail inflation expectations. This will all take time to properly assess, but in the meantime, there is little (at least domestically) that stands in the way of a continuation of recent trends.
With respect to the Nikkei, it's a bit like 1999 internet stocks, to the point that we could say that stock prices are showing stronger inflation expectations that anything else. But this is from the investment community, not the man on the street. TMM also have their money on Nikkei but not at these prices. We would like to see the 5 minute macro crowd get bored, get washed out and then join for wave two. We are acutely aware that were it not for the BoJ action equity markets would be on an even clearer downward move.
FX - We are also of the opinion that jpy has to depreciate. Either through first round liquidity transfers (as seen above) or second round inflation rallies (if they get them) moving faster than growth pushing real yields even lower.
JGBs - "The Battle of Kyle Bass". The huge JGB purchase program from the BoJ will see leakage as domestic JGB holders diversify for yield and currency fears. But this probably leaves a curve trade in play, short the short end for rate differentials (European spreads) against long the longer end for continued government QE purchases and as it becomes more apparent that this is a long race and that policy will not have the swift response that some are trading on.
In summary, the BoJ may have muddled causality and correlation and mistakenly picked inflation as the waypoint on its GPS route to growth. Its problems are demographic and a shorter route to growth, rather than the monetary response, may be the UK "Gordon Brown" response. Encourage immigration to rebalance both the demographic imbalances and maybe even some cultural ones.
However the monetary race has begun and it is a tough course.
