The engines aren’t running yet, and the fuel is still on its way. But in last week’s announcements from the Bank of Japan there was the unmistakable sound of helicopters being wheeled out of their hangars.
Wednesday’s central bank double header saw the Federal Reserve deliver the usual mix of hawkish tones and no action that we’ve come to expect, having already been upstaged by Bank of Japan Governor Haruhiko Kuroda’s headline-grabbing innovations.
‘Yield Curve Control’: A Step towards Helicopter Money
Markets had expected a commitment to negative rates combined with a tweak to the bonds purchasing program to steepen Japan’s yield curve. Instead, Kuroda announced a more aggressive commitment to a 2%-plus inflation target and a target for the 10-year yield: Bonds will be purchased to keep the latter “around the current level” of zero per cent.
This is a commitment to negative deposit rates: Holding the 10-year yield at zero stops negative short rates from spreading out along the curve, and that upward slope should help banks and insurance companies survive as long as those negative rates are required.
It also doubles down on the QE “portfolio effect.” Should Japan one day succeed in generating growth and inflation, holding the 10-year at zero implies an increasingly negative real yield, and an ever-greater incentive to sell bonds and buy real assets.
But, most importantly, it is the clearest signal yet that the Bank of Japan wants the government of Japan to take on more debt and start spending aggressively. When you reach the outer bounds of what is possible with monetary policy alone, you need a fiscal policy that creates a genuine prospect of inflation, which in turn can provide the fuel for low rates to work through the portfolio rebalancing channel. Only then do the two arms of policy reinforce one another.
Back in July, we saw signs that the Japanese government was ready to contemplate new measures. By committing to buying 10-year bonds at a zero yield no matter what, the Bank of Japan has promised the “helicopter money” to finance those measures.
Some Market Players Will Fight This …
If this is an invitation to the government, it is also a challenge to financial markets. No good can come of such egregious market interventions and distortions, argue some very prominent investors; it’s unsustainable, and a lot of money can be made by those brave enough to try to break the policy. They point to failed interventions and policy targets of the past, from the Fed’s “Operation Twist” in the early 1960s, through various ill-fated currency pegs, to the unravelling of the European Exchange Rate Mechanism (ERM) after Black Wednesday in September 1992.
They may be right over the long term. Japan must hope it can rediscover modest growth and inflation with these policies before its enormous debt burden collapses the yen under its weight. That may prove impossible.
But would you bet on that failure now, when Japan has time and political commitment on its side? These are powerful forces. People have been shorting Japanese government bonds for 20 years already, and they keep getting carried off the field.
… But It Is Kuroda’s ‘Draghi Moment’
The world is very different than it was in 1992, when the ERM failed. The new era dates from 2012 and ECB President Mario Draghi’s defining pledge to do “whatever it takes” to preserve the integrity of the European single currency, the ERM’s successor. Before these words were uttered, the Greek debt crisis was dragging the euro to the edge of a very sheer cliff — and a lot of investors had been waiting years for the chance to push it over. Big, 100-year-old financial institutions had been shorted out of existence during the financial crisis, they reasoned. Surely it was a small step to do the same for the Eurozone?
They were denied their moment and we all learnt the dangers of trying to short political entities out of existence when they have strong leadership and resolve.
If the ECB can hold its own while trying to satisfy 19 disagreeing masters, imagine what the Bank of Japan can do with the full backing of its government. It is already well on the way to buying up the second-biggest bond market in the world. Now its helicopters are out, and markets probably won’t have the ammunition to shoot them down.
Brad Tank is a Managing Director, Chief Investment Officer, and Global Head of Fixed Income at Neuberger Berman.