The Bank of Japan continues to play solo in these times of global inflationary pressures by keeping an ultra-dovish monetary policy while the rest of the world is tightening. As a consequence, the yen is weakening while Japanese food and energy import costs are soaring.
For the first time in decades, Japan is facing strong inflationary pressures. While this should have led to higher bond yields, Japan can not afford high debt servicing costs due to the country’s huge debt load (>250% of GDP). As such, the BoJ is using a mechanism known as yield curve control (YCC) where they keep buying JGBs (Japanese government bonds) to make sure yields do not rise above an upper limit at 0.25% for the 10 year JGB.
However, macro hedge funds and other investors are now betting that YCC is unsustainable and are thus shorting the JGB market – in the same way hedge fund manager George Soros attacked the pound in the 199os. The BoJ is being forced to buy even more JGBs to defend the 0.25% hard limit.
Japanese monetary policy is way beyond normal
“The pace of BoJ buying has accelerated to a monthly run-rate which is now double the pace of buying at ‘peak Abenomics’ at around 20 trillion yen of government bonds,” explained Charles-Henry Monchau, Chief Investment Officer at Syz Group. “It is the GDP-equivalent of the Fed doing $750bn of monthly QE in the US.”
The only way the world can start reversing emergency level monetary policy, while simultaneously running record level debt and deficits, is if the Bank of Japan is running wide-open-throttle, unlimited QE. In doing so, the BoJ has become the shock absorber for the global economy. In return, they get to devalue the yen, and devalue the world’s worst debt burden.
With this policy divergence, and implicit license to devalue the JPY, the yen has crashed more than 17% since the Fed made its first rate hike in March. By April it had already experienced a record losing streak. It is plumbing new 24-year lows against the dollar.
“One of the reasons that the Bank of Japan is maintaining a starkly different path to other central banks is the belief held by policy officials that current inflationary pressures in Japan will be temporary,” said Richard Aston, manager of the CC Japan Income & Growth investment trust. “We remain cautious but note announcements from Asahi Group Holdings that domestic product prices (beer and non-alcoholic beverages) will be increased between 6% and 10% (the first increase for 14 years) and by convenience store operator Lawson that it will raise the price of its popular fried chicken (“kara-age”) for the first time in 36 years. Backing up these moves are data which shows that input costs (as measured by PPI) are rising at the fastest rate since 1980 while consumer inflation expectations are at 14-year highs.”
Is this just a giant Ponzi scheme?
Some other commentators are calling the BoJ’s policy a “giant Ponzi scheme.” As a consequence of the above, the BoJ is forced to lend the equivalent amount. This then sparks off what usually happens when investors get ultra-low financing in a currency which keeps weakening: plenty of carry trades. But should the yen strengthen and/or yield rise (due to the BoJ finally abandoning YCC), we will get a massive unwinding of carry trades, aka a market sell-off.
“The Bank of Japan having reiterated its policy of keeping 10-year bond yields below 0.25% has helped drive the yen’s decline to a 20-year low against the dollar at a time of rising US Fed rates,” observed Taeko Setaishi, manager of the Atlantis Japan Growth investment trust. “This has a negative knock-on impact for Japan in terms of commodity imports, particularly with the jump in energy costs globally. At a time when real wages have risen only marginally the impact on Japanese households will be felt hard. Even though the headline rate of inflation is likely to remain lower than other developed economies, it will be a shock to an economy that has witnessed stubbornly low inflation for over 20 years.”
The BoJ is thus playing with fire and the risks go well beyond Japan’s islands. The weakening yen creates currency devaluation risk across Asia (which will trigger higher inflation and higher dollar-debt costs and thus default risk) while the existing carry trades could create a global shock the day they get unwound. This is a time bomb in the making which FX traders will need to keep a close eye on, even if trading outside JPY.
“This is the type of financial accident (led by monetary policy tightening in the US vs. loosening in Japan) which could indeed lead to more market downside and a global recession,” said Monchau. “Something to watch carefully.”