Yield Curve Control Blues

The Bank of Japan surprised people with a change to its yield curve control (YCC) policy. This has caused a mild sell-off in Japanese bonds, with the 10-year Japanese Government Bond (JGB) yield up 15 basis points on the month when I last checked.

Although I think some of the usual suspects have tried to get excited about this — a harbinger of doom to Japan and/or the global fixed income complex! — this is still in nothingburger territory. (Note: people who discuss bond yield changes as a percentage of previous yields — e.g., “bond yields rose by 100%!” when the yields go to 0.2% from 0.1% — are innumerate clowns and are safe to ignore.) Nevertheless, if the yield cap was raised by a lot more, there would be a lot of wailing and gnashing of teeth.

One standard dodge of a forecaster is to say that this might be important for global bonds. This makes one sound like a very serious forecaster with an eye on those darned black swans. However, any number of things can cause global bond yields to rise. If you want to be a yield forecaster (I don’t!), at some point you have to put your money where your mouth is and either recommend long/short positions and/or option strategies (if you want to position for tail risks). Although I am not a forecaster, I see no reason why I would change any non-Japanese market views as a result of these recent events.

Achilles Heel Of YCC

Yield curve control is a popular discussion point, particularly for Modern Monetary Theory types. My view is straightforward: yes, the government can make yield curve control stick. The problem with the policy is when the yield target is revised.

With short rate targeting, the central bank is not directly causing capital gains and losses for bond holders. Sure, they cause carnage, but they have plausible deniability: bond yields are set in the market, we are just setting the overnight rate! Sure, it’s stupid, but plausible deniability is still plausible deniability. On the other hand, with yield curve control, the central bank is directly handing out mark-to-market losses to widows, orphans, and pension fund bond managers. That’s a pretty potent political coalition burning you in effigy on the steps of the central bank’s main office.

It is also a financially unstable policy. A short-rate pegging regime works because forwards represent a market-clearing level in the private sector. Only an academic or central banker would be delusional enough to believe that central bankers can plant “expectations” where they want by announcing shifts to their views. In reality, the forwards represent the average guess as to how wrong the central bank’s forecast it. Once the central bank starts planting forwards by decree, market participants only have it a “take it or leave it” decision. If the forwards are too low, they dump bonds en masse — also known as an attack on the yield peg.

Needs Institutional Support

Anyone who has been paying attention to central banks has noticed several allegedly “permanent” self-imposed policy regimes by central banks over the past few decades (being a more detailed regime than the looser statutory inflation-targeting regime), each being abandoned whenever it became inconvenient. The lesson is that the only credible monetary policy regime is one that is backed by statute.

That is, the only way yield curve control is going to be a stable long-term policy is that it has to be set by law — and the rest of economic policy needs to be coherent with the policy. My view is that we are nowhere near a situation where policy is coherent with YCC, which is why I am not enthusiastic about the policy.

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(c) Brian Romanchuk 2022

Five Years Later, Not Much Doom (Yet!)...

Remember five years ago, when Olivier Blanchard was saying that Japan would face a solvency crisis and be forced to inflate away its debt within the next five years? Good times. https://t.co/2tbAbyVu0H

— JW Mason (@JWMason1) June 25, 2021

J.W. Mason put out this snarky tweet that had a follow up that linked to one of my articles (that I have long forgotten about!): Olivier Blanchard Joins The “Japan Is Doomed!” Crowd. To be slightly fair to Blanchard, what I referred to was an interview with a journalist, and not long form content of his own.

Japan And The Costs Of Bond Yield Control

The dangers of distorting free market interest rates is one of the bits of market folklore that keeps getting passed around. There is actually not a whole lot of data to defend this view; it is best viewed as faith-based reasoning. This topic is particularly interesting in the case of Japan. I am somewhat agnostic on this issue; I do not see particular risks from manipulating the yield curve in the current environment, yet I can see some plausible dangers.

BoJ NIRP Makes Fed Rate Hike Look Even More Foolish

The JGB collapse has been delayed yet again. The Bank of Japan (BoJ) has introduced a Negative Interest Rate Policy (NIRP), via a complicated 3-tier policy rate, with one of those rates at -0.10%. Once again, year-end forecasts of higher bond yields have been met with an early bond bull market.

Higher Debt-To-GDP Ratio And Lower Bond Yields: Japanese Experience

I recently referred to an older article in which I showed how higher debt-to-GDP ratios for the U.S. Federal Government was correlated with lower bond yields. The post-war U.S. experience was not an isolated case; similar relationships hold for the countries with free-floating currencies. The Japanese Government Bond (JGB) market is the poster child for this correlation.

JGBs Are Doomed Because Of ... Demographics? Good Grief.

After losing money for almost two decades on the thesis that "the IMF-calculated gross debt-to-GDP ratio for Japan is too high", JGB bears are rotating into another structural thesis why the JGB market must collapse - demographics. (Why German bunds and Swiss bonds are spared from this single-minded hatred of low nominal yields is beyond me.) This complements the pivot towards talking about "yen collapse" instead of a JGB calamity. The problem with this theory is that being worried about demographics is akin to worrying that a steamroller two miles down the road is heading in your direction.

For The Japanese MoF, "Debt Service" Does Not Mean "Interest Costs"

There has been a widespread inability to comprehend how the Ministry of Finance ("MoF") uses the term "debt service" in the English translations of its documents. For some unfathomable reason, the MoF includes the rollover of debt issues as part of its "debt service" figure. [Update: This seems to based on the usage of "debt service" as defined for external debt.] As a result, foreign analysts that complain about a high "debt service to revenue" ratio are missing the point. (I would note that I had not seen this error in broker research amongst Japan specialists.)

The 'Widowmaker' And Yen Crash Theories

There has been a recent shift amongst those predicting the collapse of the Japanese economy to switch away from the so-called "widowmaker trade" - short Japanese Government Bonds (JGBs) - towards forecasts of a collapse in the Japanese yen (pictured above). Although this may result from learning a lesson from roughly two decades of failed "JGB collapse" predictions, I suspect that this is the result of learning the wrong things. Being structurally short the yen is hardly the safest trade in the world either.

Why The JGB Market Ignored Moody’s Downgrade

Moody’s rating agency downgraded Japan to A1 from Aa3 on December 1st. The non-reaction by the JGB market was a cause for some amusement; once again stern warnings by ratings agency analysts are essentially being laughed at. This is not complacency on the part of bond market participants, rather it reflects the fact that the rating agencies have no sensible methodology to deal with currency sovereigns.

Abenomics - Mission Accomplished?

The news that Japan has entered technical recession was viewed as a "surprise" in the financial press, when it really should not have been. (Although to be fair to those who produce quarterly GDP forecasts, the timing of a recession would not be obvious.) This has prompted a few articles discussing the failures of Japanese policy. My feeling is that the Japanese may have accomplished their true objectives (which were not the ones publicly announced).

Japanese Policy Affecting Financial Markets, Not So Much The Real Economy

The yen has rapidly weakened in response to the latest instalment of Quantitative Easing by the Bank of Japan. We have seen this sort of thing before, and it will probably only matter for the financial markets. The alleged end to deflation in the real economy will be just a blip. The only hope for improved growth in Japan is the result of increasing export market share, which is only going to matter if importing nations are in a position to keep doing so.

Japanese Business Cycle Not Yet Dead

The Japanese business cycle is still alive. But a prudent analyst might consider checking its pulse fairly frequently. The economy lacks upward momentum, and it now has to absorb the sales tax increase.

More Dismal Japanese Data

Japanese data released yesterday were dismal, with fourth quarter GDP below expectations, and the current account deficit hitting a record.

Abenomics: Looking Like A Faceplant

In a previous post I asked: "Abenomics: Lift-Off or Faceplant?". Well, Mr. Market is hinting that "Faceplant" is the answer we were looking for...

Japanese Income Data - No Signs Of Inflation

This is a big week for labour market data. In today's entry, I will mainly comment on the recently released Japanese household income data...

OECD Delusional About Japan (Again)

Yet another "stronger growth in the second half of our forecast horizon"outlook, this time by the OECD. The headlines for the latest OECD Economic Outlook highlighted the danger of slowing developing economies, and so they have notched down their 2013-2014 global growth forecasts by 0.4%. But, as one has come to expect, stronger growth awaits at the back end of their forecast horizon:  2013, 2014, 2015 annual global growth rates are forecast to be 2.7%, 2.6%, 3.9% respectively.

I do not follow the developing economies enough to comment on the global forecast, but I am not too optimistic about accelerating growth in the developed economies. The euro area is a horror show of misguided policies. In other regions, the action of increased tax payments in response to nominal growth should help keep growth stabilised near its present pace. And I  may be missing something, but the capital expenditures cycle already looks mature.

However, the OECD analysis for Japan is particularly weak.

Abenomics: Lift-off Or Faceplant?

One of the more interesting initiatives undertaken by Japanese Prime Minister Shinzo Abe in his "Abenomics" programme is a push to get companies to raise wages. If Japan wishes to have a steady positive inflation rate of 2%, it will need to get a mild wage-price spiral going. This wage-price spiral will probably have to get underway before the hike in the Value-Added Tax (VAT) hits the economy. The government is planning on using infrastructure spending to dampen the blow of the VAT hike, but there are a lot of historical precedents that indicate that this policy mix may still end up being a drag on growth. The risk is that the Japanese domestic economy will do a faceplant once again when hit by a tax hike.

Why Will The JGB Market Collapse?

In this article I examine reasons why I believe the Japanese Government Bond (JGB) market will eventually collapse. My explanation is simple: the JGB market will collapse when it is in the national interest of Japan for the collapse to occur.

I define a “collapse” as a rise in the 10-year JGB yield to at least 5%, although not necessarily in one fell swoop. This is a move well outside the experience of the JGB market for the 15 years or so. Headline writers may not agree with this, being desperate for snazzy article titles. For example, if the 10-year JGB yield doubled to 1.20% in the next three weeks, the airwaves will be filled with JGB bears announcing “I told you so”. (My favourite potential headline "Japanese bond yields rise by 100%!") But a 60 basis point move that just returns the 10-year yield to the middle of its multi-decade trading range – who cares? I am talking about a serious bear market here.

I am giving a framework for thinking about why the JGB market will collapse, but I am not worried yet about timing. For reasons that shall be seen, I expect that the JGB market will manage to hold on below 5% for a while longer. Pinpointing the timing will require a deeper dive into Japanese data. However, Japanese data are very difficult to follow; for example fiscal data seems to be invariably presented in a manner to maximise the apparent size of Japanese debt levels. I used to cover Japan as a rates strategist before 2006, and I have seen a lot of basic errors made by analysts who have used Japanese economic statistics without understanding their context. In order to avoid making similar errors myself, I will remain very general herein and do a deeper analysis of the data in later articles.

Theoretical Background

Why do I argue that the collapse in the JGB market will occur when it is in the national interest of Japan for this to happen? This is based on my preferred way of analysing the bond market. In summary (see linked articles for a longer explanations of these points):

1. As per Modern Monetary Theory, government bonds act as a reserve drain; government spending creates reserves, and then bonds are issued to mop up reserves to keep interest rates from falling. This means that increased supply of bonds does not raise yields; in fact, we see the opposite pattern in practice.
2. Government bonds are an asset of the non-government bond holders. This is an important insight of Stock-Flow Consistent modelling (and of Hyman Minsky, who can be viewed as a forerunner of Stock-Flow Consistent modelling). In order to disrupt the bond market, you need to disrupt the portfolio preferences of the private sector, which have considerable inertia.
3. With supply and demand effects neutralised, bond yields instead track the expected path of the short-term rate. This rate is set by policymakers, and therefore rising bond yields have to reflect policymakers’ preferences.
4. Quantitative easing does not work; all the Bank of Japan gymnastics with the monetary base have had no impact on the economy. Thus the inflation predicted by the Quantity Theory of Money has not happened.

These factors explain why previous predictions of the demise of the JGB market have not panned out.

Why would policymakers want the JGB market to collapse? There are two very good potential reasons.

1. The Japanese domestic economy is growing rapidly, and inflation has become a serious concern. Rates will be hiked to moderate inflation*.
2. The Japanese yen is falling in value, creating inflationary pressures. Policymakers will want a higher policy rate to increase the demand for the currency.

I will discuss these two possibilities in more detail below. (Note that the two scenarios could occur at the same time, as both can be viewed as variants of the same idea - the yen is losing purchasing power.) I believe the first possibility is the more likely of the two, but I imagine that many analysts will prefer the second.

This mode of thinking is probably alien to many people. I believe this is based on thinking about government finances in terms of household finances, or the Gold Standard experience (introductory economics textbooks often make assumptions that are equivalent to having a Gold Standard in place). If a bank offers you a mortgage for 4%, you do not respond by saying that the rate should be 5% in order to better regulate the operation of the economy. However, this is exactly how you have to think if you are the central government borrowing in a currency you control.

Rapid Growth Forcing Rate Hikes

Policymakers historically have tended to follow the rule proposed by the neoclassical growth model: nominal interest rates ought to be close to nominal GDP growth rates. I think that rule is probably a bit of economic superstition, but it can be seen as an approximation to typical central bank reaction functions. As the chart above shows, Japanese nominal GDP growth has been well below the 5-6% level that would appear consistent with the collapse I discuss here. But it is seems too pessimistic to assume that this will be the case forever. Here are a list of possible reasons for faster real growth and/or inflation.

1. Some serious fiscal policy moves to tighten the labour market (targeted job creation), or a properly targeted tax cut. (Previous fiscal policy moves were enough to stabilise the economy, but not cause an inflationary boom. My reading is that is exactly what was desired.)
2. The labour market could be tightened up by reducing potential work hours. For example, increased maternity and paternity leaves in order to push up the birth rate.
3. A new labour-intensive consumer good or service becomes a new large source of demand. This could be related to population aging, for example. Note that if it is a manufactured product, it may be that the production is automated and employs few people, but the installation is labour intensive.
4. A booming export sector.

I do not see this growth boom happening in the near-term, but I may be missing something. It seems pessimistic (or complacent, if you are a JGB investor) to assume that this will not happen on a multi-year horizon.

One key issue is that it may be very hard to dislodge Japanese inflation expectations. Japan has achieved price-level stability, and it may be hard to convince locals that this will change. (This is in contrast to many foreign commentators, who obsess either about Japanese deflation or hyperinflation, or both at the same time.)

Rate Hikes As A Currency Defence

A collapsing yen is a popular story among JGB bears, but I feel it is less of a risk than a domestically-led expansion.

The key vulnerability of the yen is Japan's need for energy  and other commodity imports; an upward spiral in energy prices could put the yen under immense pressure versus the currencies of energy producers. However, an upward spike in energy prices will simultaneously wipe out the purchasing power of other developed world consumers (particularly in the U.S.). As we saw in 2008, the global economy does not handle surging energy prices well. This limits the capacity of energy prices to remain at extremely elevated levels. It will take time to create the structural conditions we had in the 1970s that will allow the world economy to absorb energy price rises via a generalised inflation.

Otherwise, I find it hard to worry about the yen. The Japanese government has been intervening massively to hold down the value of the yen, and has an immense store of reserves to preserve its value versus other currencies without needing to raise rates.

And we cannot ignore the private sector holdings of non-yen assets. Given the configuration of the Japanese economy, with an aging population and slow domestic growth, we should expect that Japan would run persistent current account deficits. The earnings on foreign assets should be mobilised to finance the purchase of imports. The fact that Japan has been running current count surpluses makes it unsurprising that the yen has been uncomfortably strong.

For the foreseeable future, Japan will not need to attract foreign investors to finance a current account deficit; the economy only has to draw back a stream of proceeds from domestically-owned foreign currency assets. Given that domestic investors are typically managing their portfolios versus yen-denominated liabilities (financial debts or actuarial liabilities), they are more comfortable with Japan's optically low interest rates than foreign investors would be. 

 

A Final Note

If and when the JGB market collapses, there will be plenty of quotations by Japanese policymakers complaining about “too high” interest rates. This does not disprove my argument; it only shows that many individuals do not think very carefully about governmental finance. The policy rate will be hiked voluntarily by a committee of policymakers.

Bond yields will rise before the rate hikes; that is the nature of trading expectations. But unless policymakers ratify those rate hike expectations, bond yields will come back down again. For example, this has been the case for the past few years in the U.S.; the market has repeatedly priced in relatively aggressive rate hike paths, and the market was forced to back down each time. The fact that bond yields rise before rate hikes does not mean that bond investors force the rate hikes; bond investors were just doing their job within the current institutional framework of government finance. In other words, I am not worried about the so-called “Bond Vigilantes”.

* Many non-mainstream economists (in particular, MMT economists) have doubts about using rate hikes to control inflation. I have some sympathy to this viewpoint, but I will have to examine this some other time given the complexity of the subject. From the point of view of central bank watching, I expect the Bank of Japan would stick to the mainstream consensus that rate hikes are the best method to control inflation.

(c) Brian Romanchuk 2013

Fujimaki: Japanese Hyperinflation By 2015!

One of the public services now provided here at bondeconomics.com is the tracking of outlandish forecasts about Japan and/or the JGB market. The first entry is provided by Takeshi Fujimaki, an ex-advisor of George Soros and now a member of the Japanese upper house of parliament.

I have enjoyed reading crackpot theories about the collapse of the JGB market since I started covering it around 2001, and this entry by Fujimaki looks like it represents the state of the art in this highly competitive field.

In this article on Bloomberg, we see the following:

• “Because the BOJ is buying huge amounts of JGBs, market principles in this country do not work.” The balance sheet of central banks throughout the developed world consist mainly of government bonds, and it has been this way for decades. The most successful means of determining bond yields consists of guessing what policy rate government bureaucrats will set. In other words, even slight familiarity with how government bond markets work will tell you that government bond yields are not really set by “market principles”. However, this statement will make him popular with all the gold bugs.

• He has an outlandish bond yield forecast:               

Yields on 10-year Japanese government bonds may jump to 70 percent based on what happened in Russia when it defaulted in 1998, Fujimaki said. 

Sure, what happened to Russia is a great benchmark for a country with $1,135 billion in U.S. Treasury holdings (TIC data; July 2013) and no foreign currency debt.

• He throws in an outlandish inflation prediction:

“If the yen goes up to 120 per dollar, Mr. Abe doesn’t need a third arrow,” according to Fujimaki, who expects the currency to drop to as low as 1,000 when Japan faces hyper-inflation in the next two years.  

Hyperinflation by 2015! Looks like liftoff is starting right now! Really going for the gold bug crowd.

• He ends of with a sensible-sounding bond-bearish call:

“The Olympics [in 2020 – BR]  will come at the time of a booming economy,” he said. During that period of economic growth “maybe 5 or 6 percent are reasonable levels for the 10-year yield.”

This is actually a very impressive stratagem. Even though his 70% yield forecast has a 0% chance of occurring, there is a chance there could be a “renormalisation” of rates within 7 years; why not? And if the 10-year does rise to something like 4% by 2020, he will be able to say “I told you so”.

What sets this apart, in my mind, is what he did not say.

• He does not rely on debt-to-GDP ratios (but the reporter does mention them in the piece). Ten years ago, it was enough to state that the debt-to-GDP ratio was “unsustainable” and hence the JGB market was going down “soon”. But such a strategy is now suicidal, as the blogosphere is stocked with tons of charts on research on the (non-)impact of high debt-to-GDP ratios. (This is the result of a previous ill-advised academic paper on the dangerous impact of the 90% debt-to-GDP “threshold”.) 
• He avoids setting a near-term target for JGB market collapse (like “a few months”). Only people with too much spare time on their hands will remember a blown forecast on a two-year horizon.

Of course, his worries (debt default and hyperinflation) are incompatible. In a hyperinflation, the monthly inflation rate is 50% or higher; so even an inflation-linked bond with a standard monthly computation period of one month will lose at least 50% of its purchasing power due to the indexation lag. If the yen collapses, the Japanese government need only sell a tiny sliver of its Treasury debt to buy back most of its debt. But why quibble, since there’s no chance of it happening anyway?

To be honest, the real story embedded in the Bloomberg article is that he wants to cut corporate taxes. The real logic behind his bizarre forecast:

1. Lawmaker wants to raise corporate profit share of GDP at the expense of households.
2. This is to be done by hiking the consumption tax rate, and cutting the corporate tax rate.
3. Funnily enough, polls say such a policy is unpopular with the voters.
4. So he makes up risks to the government bond market. 
5. He then states that the rise in the consumption tax miraculously cures those risks. 

Simon Wren-Lewis wrote an article on how austerity is being used as cover for political objectives about a week ago, explaining why this rhetorical strategy should not come as a surprise.

But to end off on a more serious note: this is part of a push to raise the Japanese consumption tax, which appears likely to occur. The theory is that the planned fiscal policy shifts are supposed to be neutral for growth, as there will be offsetting stimulus undertaken. I do not have a fancy model of the impact of their proposed fiscal changes, but it seems that they are effectively replacing “high multiplier” spending by “low multiplier” spending. In order for the impact to be neutral on growth, the fiscal deficit would have to be larger. Additionally, I am skeptical that businesses will take up investment incentives in the current sluggish growth environment – especially if domestic consumption falls due to the tax hike. And so, it appears highly possible that Japanese policymakers will drive their economy into recession yet again due to a foolish focus on fiscal ratios.

(c) Brian Romanchuk 2013