“At the Monetary Policy Meeting held today, the Policy Board of the Bank of Japan assessed the virtuous cycle between wages and prices, and judged it came in sight that the price stability target of 2 percent would be achieved in a sustainable and stable manner toward the end of the projection period of the January 2024 Outlook Report (Outlook for Economic Activity and Prices). The Bank considers that the policy framework of Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control and the negative interest rate policy to date have fulfilled their roles. With the price stability target of 2 percent, it will conduct monetary policy as appropriate, guiding the short-term interest rate as a primary policy tool, in response to developments in economic activity and prices as well as financial conditions from the perspective of sustainable and stable achievement of the target. Given the current outlook for economic activity and prices, the Bank anticipates that accommodative financial conditions will be maintained for the time being.” Bank of Japan, “Changes in the Monetary Policy Framework”, March 19, 2024.
https://www.boj.or.jp/en/mopo/mpmdeci/mpr_2024/k240319a.pdf
And with that the era of NIRP and YCC, at least for now, came to an end in Japan. Bank of Japan (BOJ) moved their policy rate from -0.10% to a range of 0.00% – 0.10%, ended Yield Curve Control (YCC), ceased the purchases of ETFs and J-REITs, and announced the phasing out of purchases of CP and corporate bonds. In reality, as historic as it may seem, it was little more than just a token move by the BOJ. Interest rates barely moved, financial conditions stayed unprecedentedly loose, equity markets kept rising, and the Yen continued to weaken.
Figure 1: GS Financial Conditions: Japan. 1994 – March 2024
Source: Bloomberg
Figure 2: Nikkei 225 Index. 1994 – March 2024
Source: Bloomberg
Figure 3: Spot USD/JPY FX Rate. 1994 – March 2024
Source: Bloomberg
Inverting the scale on the FX Rate makes it pretty easy to see the close link between the currency value and financial conditions.
Figure 3: GS Financial Conditions: Japan (white) USD/JPY (green inverted). 1994 – March 2024
Source: Bloomberg
If Japan wants to tighten its financial conditions, they likely need to reverse the weakening trend of their currency. For some additional perspective on Japan’s financial conditions, we can throw them into the same chart with the US and the Eurozone.
Figure 4: GS Financial Conditions: Japan (white), US (yellow), Eurozone (purple). 1994 – March 2024
Source: Bloomberg
And a version with financial conditions for Japan and China.
Figure 5: GS Financial Conditions: Japan (white), China (blue). 2009 – March 2024
Source: Bloomberg
Certainly, by this measure, you could call Japan loose.
Our views on the relevance, to date, of the BOJ’s policy evolution were fantastically well represented by former BOJ Governor Shirakawa in an Opinion note published by Nikkei.
https://asia.nikkei.com/Opinion/BOJ-policy-shift-not-yet-a-turning-point-for-Japan-s-economy
Like us, Mr. Shirakawa gives little relevance to the policy shift thus far in Japan. He states it ever so eloquently:
“One reason for this is that because the monetary policy strategy that the BOJ has been following has not proved effective, its discontinuation is unlikely to have a material impact on the economy.”
“A second reason for caution is that even after the recent decision, Japan’s policy rate remains just 0% to 0.1%…This does not represent a substantive change in the interest rate environment that has seen short-term interest rates stuck at practically zero for the past 30 year. Whether or not this baby-step change in monetary policy marks a historic turning point or not will depend on whether the actual course of monetary policy is significantly altered going forward.”
For some perspective on the point about not really representing a substantive change, here is 1yr government yields for Japan and the US versus respective measures of price stability.
Figure 6: JGB 1yr Yield (white). US 1yr T-bill Yield (Yellow). Japan CPI exFresh Food & Energy YoY% (magenta). US Core PCE YoY% (green)
Source: Bloomberg
Much like ourselves, Shirakawa-san questions BOJ’s belief in the efficacy of their own policy tools. As we have so often noted in our own conversations with the advocates of extreme monetary policy measures, they continue to strongly affirm their own confidence that such policies “WILL NOT WORK!” We’ve written extensively on this topic, even titling our July 2023 Update – “IT WILL NOT WORK!” https://convex-strategies.com/2023/08/15/risk-update-july-2023-it-will-not-work/.
Shirakawa-san frames it this way:
“It is indeed curious why the BOJ adopted such dovish forward guidance about future monetary policy because its inflation projections do not appear consistent with interest rates remaining at an ultralow level.”
Shirakawa-san, noting the low efficacy in achieving the stated goals and that structural issues, eg. demographics, may be contributive to the low inflation environment, along with a range of negative side-effects, raises the obvious but never asked question:
“In any case, whatever the cause of Japan’s low inflation is, an important question is whether the central bank should maintain low interest rates simply on the grounds that inflation is low.”
Finally, exGov Shirakawa says exactly what we too hope for:
“One positive effect of the BOJ’s bold monetary policy experiment over the past 11 years is that many people have belatedly come to realize that monetary easing is not a solution for the problems facing Japan. If Japanese society really starts to tackle the country’s structural problems, 2024 might indeed come to be remembered as an historic turning point.”
Amen!
What they have achieved, as we indicated above, is loose financial conditions aligned with a weak currency. Again, comparing it against China, we can go all the way back to the circa 50% CNY devaluation of 1994. We can also show that another way by using measures of Real Effective Exchange Rates (REER). Below we compare JPY REER with CNY REER along with the CNY/JPY cross FX Rate.
Figure 7: FX Rate: USD/CNY (blue), USD/JPY (white), CNY/JPY (papaya). March 1990 – March 2024
Source: Bloomberg
Figure 8: FX Rate: CNY/JPY. JPM CPI-Real Effective Exchange Rate: CNY (blue), JPY (white), Normalized. Jan 1994 -March 2024
Source: Bloomberg
Obviously, the CNY/JPY cross rate shows the extreme of relative strength between the two currency pairs, at the moment, but the divergence of the two REERs since the CNY devaluation in 1994 and the JPY peak strength in May 1995, gives a good idea of just how far this divergence in relative value has accumulated. As we have discussed in the past, the PBOC has held the CNY remarkably steady in the face of an historically large growth of money and credit.
Figure 9: M2 Money Supply: China (blue), US (papaya), Japan (white). May 2003 – March 2024. Log scale. Normalized
Source: Bloomberg
Despite that long run of Renminbi creation, the currency, relatively speaking, has been an out performer in the fiat race to debasement. You can get some perspective of that comparing the three currencies to the recently surging price of gold.
Figure 10: Gold vs JPY (white) USD (papaya) CNY (blue) Log-scale Normalized May 2003- March 2024
Source: Bloomberg
Many will be familiar with our representation of the declining relevance of China’s FX Reserves as a moat around the behemoth of domestically created money.
Figure 11: China FX Reserves divided by M2 Money Supply. Feb 1996 – Feb 2024. Log-scaled.
Source: Bloomberg
We suspect that all of the above has something to do with what we might term the neglecting of their own currency management methodology by the PBOC (they would call it an extended period of applying their Counter Cyclical Factor – CCF). The dark bars in figure 12 show the divergence from model of the PBOC’s daily fixing of USD/CNY (above the 0.00 line indicates a stronger than model fix for the CNY). We have now been through a good nine months of consistently stronger than model fixes. We have also placed the CNH/JPY cross FX Rate in the chart which indicates some sort of possible relationship. Hard not to notice.
Figure 12: PBOC daily fixing USD/CNY divergence, CNH/JPY cross FX rate
Source: Bloomberg
It is not for us to say what is or isn’t ‘fair value’. However, if you want to get people pondering the question, we suspect circumventing your own methodology day after day, for nine months, will get that job done. Does PBOC need to ignore the mechanism around which they have explicitly defined the allowed adjustments of their currency’s value? Does BOJ need to continue to set policy rates at essentially 0% and continue relentless QE? What we would posit is that it seems unbearably imbalanced and likely in the process of getting more imbalanced.
For an exceptional discussion on these two global monoliths, and the role they play in the big global imbalances, we cannot recommend strongly enough listening to Russell Napier’s recent podcast with Jack Farley.
Russell builds a clear case for an inevitable eventual change in the existing global monetary regime, focusing on the roles of China and Japan, and what we might term their desynchronous stages relative to the rest of the USD reserve-based fiat-world of today.
As we have mentioned several times before, Russell shares very similar Asian Crisis scars to our own. This, not surprisingly, leads us to very similar conclusions about unsustainable paths and likely end-game attempts at solutions. The conclusions that Russell continues to arrive at parallel in many ways our own, what we have previously analogized as “The Hunger Games”. https://convex-strategies.com/2023/11/17/risk-update-october-2023-the-hunger-games/
Towards the end of the discussion, Russell lays out his simple version of where things likely end up.
“It has to be a monetary policy that inflates away that debt.”
Again, much like us, he lays out these three, maybe inevitable, steps as countries vie to sustain these high levels of debt.
- Higher rate of inflation.
- Forced purchases of government bonds.
- Capital controls.
Russell wraps up with this clear prescription for governments around the globe.
“The government is getting back into the business of allocating private sector savings.” Russell Napier, 2024.
Who is going to buy the bonds?
We’ve written (too often) about the relentless narrative around the need for an early ceasing of Quantitative Tightening (QT). We conceded the point in last month’s Update – https://convex-strategies.com/2024/03/15/risk-update-february2024-wheres-the-risk/.
“Ok, enough already, you don’t have to beat us over the head. We believe that balance sheets will not return to past levels of normal size. Not all the troops are going to be withdrawn. That gives us at least one clear answer to ‘who’s going to own the 40?’ The central banks, again. Financial repression.”
We won’t go into further detail but, for those so inclined, we link below a March note from the BIS folks on the same topic. Just in case anybody was doubting the ubiquitousness of this narrative.
The macroprudential role of central bank balance sheets (bis.org)
The issue of ever more funding needs seems to be a particularly active topic in Europe. Former Governor of the Bank of Italy, former Chair of the Financial Stability Board, former President of the ECB, and former Prime Minister of Italy, Mario Draghi, has been appointed to head up an EU competitiveness task force, presumably because he was overseeing much of the past decline in competitiveness. The below link from Politico updates on a recent meeting on competitiveness related issues.
EU must find ‘enormous amount’ of money to face global challenges, Draghi says – POLITICO
The article notes that:
“All participants appeared to agree on what needs to change to boost EU competitiveness, from lowering energy prices to reducing regulatory burdens, but divisions emerged when talking about public money.”
The article notes nothing about paths forward for lowering energy prices or reducing regulation but does expand on the need to fund more spending and the necessity to channel European private savings because, as Mr. Draghi puts it, “public money will never be enough”. The inevitable solution, though not something that everyone is prepared to get behind, is a push for more EU “common debt”.
The implications of just these sorts of issues was touched upon in a speech by current ECB dignitary, Isabel Schnabel. Ms. Schnabel gave a speech neatly titled “R(ising) star?”.
One of her key explanations for a growing belief that r*, the so-called natural rate of interest, has increased, is that under the ‘savings-investment hypothesis’ the need for massive investment “towards a climate- and nature-preserving economy may in itself necessitate investments comparable to what was required to rebuild the European economy after the Second World War.”
“Such investments will be particularly large in the EU, which has been lagging the United States and China markedly over the past years.”
“Considering that part of these massive overall investment needs will be government-financed, and that, in the new geopolitical situation, defence spending may have to be significantly stepped up, public debt burdens are likely to rise.”
“Higher net issuance, in turn, may face a shrinking supply of global savings, as a gradual retreat in globalisation may reduce current account surpluses.”
This is precisely the battle to fund government finances that we call The Hunger Games.
To Russell’s point from above, who is going to provide those funds? US savers? Japan savers? China savers? Probably not. More likely, trapped European savers. They should scroll back up and read Russell’s three points.
In line with those thoughts, the ECB announced their “changes to the operational framework for implementing monetary policy”.
https://www.ecb.europa.eu/press/pr/date/2024/html/ecb.pr240313~807e240020.en.html
There isn’t anything really new or earth-shattering in this. It follows along to the preparatory groundwork laid out by ECB Chief Economist, Philip Lane, that we discussed in our November 2023 Update – “Recession. Yay!” https://convex-strategies.com/2023/12/14/risk-update-november-2023-recession-yay/.
We would direct you to pay particular attention to what they have dubbed “Secondary objective”, which smoothly slides in with our above comments from Mr. Draghi and Ms. Schabel.
“Secondary objective: To the extent that different configurations of the operational framework are equally conducive to ensuring the effective implementation of the monetary policy stance, the operational framework shall facilitate the ECB’s pursuit of its secondary objective of supporting the general economic policies of the European Union – in particular the transition to a green economy – without prejudice to the ECB’s primary objective of price stability. In this context, the design of the operational framework will aim to incorporate climate change-related considerations into the structural monetary policy operations.” ECB Statement by the Governing Council, March 2024.
I think we can take it, yet again, as the ECB is going to buy the bonds. The good old days of a central bank with a very clear central focus on maintaining price stability continues to erode with many many more tasks falling onto their plate. Oddly, having significantly failed at maintaining price stability in line with their stated target, their revised framework seems to emphasize everything but their previous core tenet.
As we have so often discussed, the universe of Sharpe World institutions is choking on bonds. Bonds that were sold to them, courtesy of generous Sharpe World accounting and risk methodologies, on a spectrum between riskless and risk mitigating. Those heydays of low volatility and stable, slightly negative, correlation don’t seem to be quite the sure thing that they once were.
Those days, increasingly, seem like they could be behind us.
Recent updates, of what we like to call our “Headwinds for Bonds” pictures, indicate that the volatility of the key central bank measures of inflation might be moving back into a (more normal?) regime of higher volatility, and the temporary period of negative correlation may, likewise, have been the anomaly.
Figure 13: UK 20-year Average Inflation vs Inflation Volatility 1217-2024
Source: https://personal.lse.ac.uk/reisr/papers/22-whypi.pdf /, Millenium dataset of the Bank of England, Bloomberg, Convex Strategies
Figure 14: 5-year Equity-Bond Correlation vs 5-year Annual Inflation 1947 – 2024
Source: Meketa, Bloomberg, Convex Strategies
Bonds have not been good diversifiers, much less good risk mitigators. They have been a means by which Sharpe World advocates have implemented the premise of driving slowly as their fundamental form of risk management. Falling into the trap of the compounding destroyer known as the Sharpe Ratio. The more worried you are, the slower you drive, cautiously targeting the average lap-speed, not the separation and safety allowed by focusing on acceleration and deceleration – aka convexity.
The bane of Sharpe World based investment strategies is forever under-participating in positive markets, and under-protecting in bad ones. Consistently having too little risk to achieve the return opportunities when they are presented, while running too much unmitigated risk to survive unscathed through times of market dislocations. Put good brakes on your racing car and, safely, drive faster.
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