While many impartial observers have been lamenting the death of Abenomics now that the Nikkei – essentially the only favorable indicator resulting from the coordinated and unprecedented action by the Japanese government and its less than independent central bank – has peaked and dropped 20% from the highs, Wall Street was largely mum on its Abenomics scorecard. This changed overnight following a scathing report by Goldman which slams Abenomics, it sorry current condition, and where it is headed, warning that unless the BOJ promptly implements a set of changes to how it manipulates markets as per Goldman’s recommendations, the situation will get out of control fast. To wit: “Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for (Read more…) duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased. It will not be an easy task to completely rebuild confidence in the BOJ among overseas investors after it has been undermined, and the BOJ will not be able to easily pull out of its 2% price target after committing to it.”
Bad, bad Kuroda.
Not surprisingly, the primary driver of skepticism – both Goldman’s, and that of its clients who recently got crushed based on Goldman’s long Nikkei trade recommendations – is the epic surge in JGB vol, which Zero Hedge first cautioned about when the BOJ unleashed its monetary bazooka and since then with periodic updates. And sure enough, Goldman which disappointed with its expectation that the BOJ would unveil a 2 year LTRO equivalent operation, is once again back to tutoring its failing student, Kuroda, about what he should do in order to put Abenomics back on the tracks, or else risk the complete loss of confidence in this latest (and possibly last reflationary chance) program from both the most important bank, as well as those whose money is critical in preserving the smooth glidepath of Abenomics – overseas investors (i.e., Goldman’s clients).
Will the BOJ implement Goldman’s ultimatum, and if not, will the great Japanese reflationary experiment crash and burn? Find out soon enough.
From Goldman’s Naohiko Baba
Impact from new BOJ easing disappears, eroded confidence is one significant factor
One of the main focuses for overseas equity investors since late May has been the JGB market. They have invested in Japanese equities with one eye on the tail risk from Japan’s fiscal problems, which could explode at any time. They are therefore more nervous than most Japanese about the rise and instability in long-term JGB yields since unprecedented easing was introduced in April. We believe there is a particularly large gap in recognition between overseas investors and the BOJ on this issue.
BOJ Governor Kuroda’s comments at a press conference on May 22 after the monetary policy meeting were taken by the market as an acceptance of rising JGB yields. Overseas investor confidence in the BOJ was further undermined after the June 11 policy meeting when the committee decided not to extend the duration of fixed interest rate operations, an action that was already reported in the press and priced in by the markets.
As a result, instability in long-term JGB yields has been having a significant knock-on impact on the equity and forex markets since late May. A look at forex, equities, and the JGBi expected inflation rate shows that most of the initial positive impact from unprecedented easing was reversed in mid-June, with only high yields and volatility remaining. The BOJ urgently needs to reestablish forward guidance for its policy duration and a communication strategy that does not involve contradictory messages.
Or else… Goldman continues:
Overseas investors focused on JGB market instability
The author has recently returned from meetings with more than 100 overseas investors in Europe and Asia in early-June and have also talked to investors who visited Tokyo from around the world. Discussions with them focused on Abenomics, and we were surprised that the JGB market was not only the main focus of investors who concentrate on rates and forex, but also for equity investors.
The specific themes that came up in our meetings with these investors included: (1) reasons why long-term JGB yields rose and have become unstable after the introduction of unprecedented easing aimed at doubling the monetary base over two years through large-volume JGB purchases (announced by the BOJ on April 4); (2) how to interpret BOJ’s stance toward the JGB yields and their stability based on conflicting statements made by Governor Haruhiko Kuroda on long-term yields; (3) whether or not the government, and the Finance Ministry in particular, plans to allow the JGB market to remain unstable; and (4) the possibility that huge JGB purchases by the BOJ may cause the government to lose incentives for fiscal restructuring, given calls to postpone consumption tax hikes among some officials close to Prime Minister Shinzo Abe.
Of course, this strong interest in the JGB market among overseas investors is due to concerns over Japan’s fiscal conditions. Given government debt is currently at 240% GDP and still rising, they probably see Japan’s fiscal state as fragile, which could potentially give way under further pressure (see Exhibit 1). These overseas investors are very conscious of this huge tail risk when they invest in Japanese equities, and compared to the Japanese, they have been much more uncomfortable with the increased yield volatility under the current unprecedented easing (see Exhibit 2). In the beginning, the easing helped the yen to depreciate and pushed up the Japanese equity market, and the BOJ may be thinking that volatility on the JGB market is a small price to pay for these positive market reactions.
Up to now, the driver of Abenomics has been overseas investors, but we see a significant gap between these investors and the BOJ in terms of the degree of concern over the instability of the JGB market. As a result, Kuroda’s remarks at a press conference post the May 22 monetary policy meeting were interpreted as an acceptance of further rises in long-term rates. Overseas investor confidence in the BOJ was further undermined at the June 11 monetary policy meeting when the BOJ decided to forego an extension to fixed rate operations after it was widely reported in the media and already factored into the market.
Of course, other negative factors were present, including disappointing market reaction to the “third arrow” growth strategy in Abenomics and an increase in global volatility on expectations that the Fed could wind back its quantitative easing measures soon. However, any positive market reaction to unprecedented easing has largely been undone, leaving only high JGB yields and high volatility, and we are not in any doubt that overseas investors have started to lose their confidence in the BOJ (see Exhibit 3).
Instability exacerbated by a lack of credible forward guidance for policy duration and conflicting statements from Kuroda
The 2-year commitment for the 2% price target is the backbone of Kuroda’s unprecedented monetary easing. Under the previous BOJ governor, Masaaki Shirakawa, the duration of JGBs bought under the Asset Purchase Program was limited to three years, which acted as a sort of forward guidance for policy duration and kept short-/medium-term rates low and stable. Kuroda’s designation of a two-year time frame for the 2% price target was meant to be another such forward guidance, by which the BOJ intends to lower the short- and medium-term zones in a stable manner. Meanwhile, massive JGB purchases are meant to suppress yields for longer-term zones.
The economic outlook report issued by the BOJ on April 26 stated that it saw a high probability of achieving 2% consumer price inflation in the next two years or so. We have already pointed out that we were not convinced by the BOJ’s argument for the economic impact of monetary easing, and we do not think the BOJ is able to earn market confidence about such a commitment. Under these conditions, the two-year time frame was unlikely to take root as credible forward guidance.
We are currently hearing two main prospective scenarios from market participants. In one, the BOJ undertakes massive JGB purchases, but inflation does not go up significantly, and the BOJ is obliged to unwind its current easing policy within two years due to concerns over the possible side effects. The second scenario involves the BOJ maintaining the easing on a semi-permanent basis until it achieves its 2% price target. Either case appears to suggest rising JGB yields in the future – due to supply-demand deterioration in the first scenario and concerns about debt monetization in the second. Furthermore, JGB market volatility tends to increase when visibility of the market outlook is quite low, as suggested by the current situation. We believe this has led to the comparatively large rise in 5-year JGB yields.
At the same time, inconsistencies in statements from Kuroda have caused confusion not only on the JGB market but also in the equity and forex markets. One specific example of this relates to his claim that the BOJ would aim to bring down the yield curve as a whole through large-volume JGB purchases. Kuroda made this claim when he introduced the unprecedented easing measures on April 4, and it was intended to be an important policy transmission channel. When long-term JGB yields started rising against his intentions, Kuroda said it wasn’t a problem as it was a result of inflation/growth expectations. Somewhat sardonically, the expected inflation rate (an indicator frequently referred to by both Kuroda and Deputy Governor Iwata; represented by CPI index-linked JGB movements) began to decline sharply after May 22, when Kuroda made the statement about rising bond yields (see Exhibit 3).
The BOJ also used the buzz word “portfolio rebalancing” to describe the effects its increased presence on the JGB market would have in encouraging institutional investors (banks, life insurance companies, etc.) to move away from the JGB market and into other markets, such as lending and foreign assets. Some institutional investors actually sold off JGBs as the BOJ expected, but market liquidity dried up with the resulting exit of these liquidity providers. This in turn increased market volatility, and some other market participants came under pressure to sell their JGB holdings in order to manage their risk, which fuelled a malignant cycle of further instability. The BOJ was left as one of the few buyers on the JGB market, and it is also being criticized for reducing market liquidity because of the lack of clarity around its large-lot JGB buying operations. Also, equity prices of some regional banks declined as a result of their substantial JGB yield risk exposure and the current instability of yields as well of concerns about future yield rises. We also need to be aware of the risk that they might attempt to sell even more JGBs than they need to if the JGB market continues to be volatile in the future.
JGB market instability spilled over to the equity and forex market, further exacerbating volatility
The rumblings in the JGB market have transferred to the equity and forex markets as well. We believe this reflects concerns among overseas investors about a lack of BOJ determination to stabilize the JGB market, as mentioned at the beginning of this report. The remarks made by BOJ Governor Kuroda at the press conference after the May 22 policy meeting were particularly interpreted as an acceptance of rises in JGB yields, and this has strengthened the link between volatility in long-term yields, equities, and the forex
market (see Exhibit 5).
In order to investigate this phenomenon more rigorously, we analyzed the reaction in volatility of equity prices and forex rates when long-term JGB yield volatility changes by 1% (see Exhibit 6). We can see a big change in trend from May 22, when Kuroda held his post policy meeting press conference. Equity and forex volatility began reacting strongly to changes in JGB yield volatility with a particularly noticeable reaction in equity volatility. Of course, we do not attribute all of the market volatility to the BOJ. Other factors have impacted the markets, including disappointing market reaction to the “third arrow” growth strategy of Abenomics and an increase in global volatility on expectations that the Fed could unwind its quantitative easing measures soon. Still, our conversations with overseas investors suggest to us that instability in the JGB market is a significant factor behind the diffusion of that instability to the equity and forex markets as the BOJ gave the impression that it sees JGB market volatility as acceptable or lacks measures to stabilize it.
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In conclusion, here is Goldman’s ultimatum to Japan on what it should do now – and yes, life would be so much easier if Goldman had one of its alumni running the central bank in Japan, as it does in the US, Europe and now, England.
Urgent need to rebuild the forward guidance and communication strategy
Exhibit 7 summarizes the market reaction from the start of the unprecedented easing on April 4 all the way to the present. We extracted a common factor from three variables in the BOJ’s focus for policy transmission (equity prices, forex rates, and the JGB expected inflation rate) using principal component analysis. Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for policy duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased.
It will not be an easy task to completely rebuild confidence in the BOJ among overseas investors after it has been undermined, and the BOJ will not be able to easily pull out of its 2% price target after committing to it. We therefore see a need for the BOJ to offset this with an improvement in its communication strategy. We especially see a need for the BOJ to clearly outline its basic intentions and provide, in a consistent manner, a time frame for how long-term yields will be formed under the unprecedented easing. It also needs to establish specific measures to stabilize the JGB market in case of an emergency. Unprecedented easing relies overwhelmingly on financial market transmission channels, and it is important for the central bank to urgently rebuild stability thereby enhancing thevisibility for the main players on these markets – overseas investors.
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To summarize: Goldman is angry (that year end bonuses may not be at new all time highs, which after all was the whole point behind Abenomics). And you don’t want to see Goldman angry.