Did the BOJ Save or Kill DB Pensions?
The Bank of Japan has launched a new kind of monetary easing as it set a cap on 10-year bond yields and vowed to overshoot its 2 per cent inflation target on purpose.
Its decision demonstrates that even eight years after the global financial crisis, central bankers are still willing to experiment with monetary policy tools as they struggle to escape from low inflation around the world.
The move marks another effort by Haruhiko Kuroda, BoJ governor, to surprise market expectations by expanding his monetary policy toolkit to signal his determination that Japan escape its decades of on-and-off deflation.
But the question for Mr Kuroda is whether three-and-a-half years of slow progress on prices have damaged the BoJ’s credibility too much for promises of higher inflation to be taken seriously by the public.
“The price stability target of 2 per cent has not been achieved … [and] this is largely due to developments in inflation expectations,” said the BoJ on Wednesday. “Inflation expectations need to be raised further in order to achieve the price stability target.”
Markets initially reacted positively, with the yen losing 1 per cent to ¥102.7 against the dollar, spurring a 1.9 per cent rally in the exporter-sensitive Nikkei 225 equity average, with banks and insurers leading the gains. But scepticism about the BoJ’s overhaul set in and the yen reversed its early losses, appreciating by 1 per cent by mid-afternoon in London.
The BoJ kept interest rates on hold at minus 0.1 per cent — describing further rate cuts as a “possible option for additional easing” — but announced a framework with two main elements.Tracy Alloway and Sid Verma of Bloomberg also report, The Way the World Thinks About Easy Monetary Policy Is Changing:
The first is a pledge to cap 10-year government bond yields at zero per cent. In essence, that means the BoJ is promising to buy any bonds offered for sale at that price.
It will maintain its government bond buying “more or less in line with the current pace” of ¥80tn a year. However, the BoJ will buy fewer very long-term bonds, which should make it easier for banks to earn profits by allowing the yield curve to steepen.
Second, the BoJ has pledged to continue buying assets until inflation “exceeds the price stability target of 2 per cent and stays above the target in a stable manner”.
Although that commitment is vague, it marks a departure for global monetary policy, following the logic of economists such as Paul Krugman by making a deliberate “commitment to be irresponsible”.
If the pledge is credible then it should raise public expectations of the price level in the future. That, in turn, should lower real interest rates and stimulate the economy because loans will be paid back in a devalued currency.
But the BoJ’s credibility is a big question given its struggle to raise inflation over the past three years, with headline inflation running at minus 0.4 per cent in July. Public expectations of future inflation have steadily declined over the past 18 months.
Some analysts were downbeat about the BoJ’s decision not to cut interest rates or expand asset purchases, seeing it as a signal that the central bank has little scope for further easing.
“We are quite sceptical that this change in the framework will loosen financial conditions in any meaningful manner,” said Kiichi Murashima at Citi in Tokyo. “Monetary policy has effectively reached its limit, in our view, and today’s decision appears to show that policymakers share this assessment.”
Masaaki Kanno, at JPMorgan in Tokyo, said the BoJ had “disappointed” by failing to cut rates. He said the pledge to overshoot the inflation target had come too late, at a time “when few people in the market believe that 2 per cent inflation will be achieved anytime soon”.
James Athey at Aberdeen Asset Management added: “The BoJ has reaffirmed its inflation target and will try to overshoot it. This in spite of the fact that it hasn’t hit its current inflation target, doesn’t seem likely to and hasn’t announced anything that might help it get there or beyond any time soon.
“The Bank has effectively told markets that it has a royal flush and the markets are questioning Kuroda’s poker face.”
It happened so quickly.So the BOJ surprised everyone by not cutting rates or expanding asset purchases further. Instead, it chose to anchor long-term rates higher in an attempt to stoke "animal spirits" and hopefully finally lift inflation expectations higher.
While analysts and economists had long debated the efficacy of quantitative easing — the central bank bond purchase programs aimed at lowering borrowing costs to stimulate the economy and stoke inflation — the narrative surrounding such efforts is rapidly shifting. In recent months, there's been a growing recognition of the limits and downsides to this particular form of monetary easing, underscored by the Bank of Japan's policy changes announced on Wednesday.
Some 15 years after first experimenting with QE, the BOJ announced that it intends to shift the focus of its policy framework to better finesse borrowing costs by, in effect, anchoring longer-term rates higher, and moving away from a rigid target for expanding the money supply. While market participants expect the central bank to further expand bond purchases and take the rate on a portion of bank balances deeper into negative territory in upcoming meetings, the BOJ's move is a recognition that its daring strategy to dramatically expand the money supply to fight deflation has delivered a blow to the financial sector's profitability.
"The biggest takeaway here is that the BOJ is now leading the world into a new era of central banking and is essentially making long-term interest rate, 10-year Japanese government bond yields a focal point in its central banking platform instead of negative interest rate policy," analysts at TD Securities Inc. led by Mazen Issa, wrote in a note today. "The yield curve control program is an interesting but untested concept. It is one attempt to provide relief for pension funds, [life insurance companies], and banks."
The program announced on Wednesday helped propel Japanese lenders' stocks higher, underscoring the evolution in easy monetary policy. The BOJ plans to buy enough 10-year government bonds to keep the yield close to zero percent, while potentially purchasing fewer longer-dated bonds, in a move expected to boost profits for the financial sector and encourage them to lend and invest.
The Bank of Japan had doubled-down on its QE program in February with the surprise introduction of a negative interest-rate policy on a portion of bank reserves, sharply lowering long-term rates — as well as bank stock prices — amid a squeeze on net interest margins for lenders.
Despite the shock-and-awe strategy early in the year, the yen appreciated in the aftermath of the move, while deflation risk remains unabated — with CPI at minus 0.5 percent year-on-year in July — and long-term inflation expectations remain stubbornly low.
Though the BOJ has maintained the minus 0.1 percent charge on some bank balances, its yield-curve commitment — similarly deployed by the Federal Reserve from 1942 to 1951 to lower the U.S. Treasury's post-war financing costs, but which remains unprecedented in modern times — represents a sea-change in the central bank's thinking.
The BOJ's newfound embrace of a yield-curve target is a belated recognition that NIRP can negatively impact financial intermediation and inflation expectations, say analysts.
"The good news is that BOJ has finally acknowledged that NIRP does have some negative impact on intermediation and potentially on inflation expectations – which the BoJ puts at the center of its policy goal," Morgan Stanley economists led by Takeshi Yamaguchi wrote in research published last week, for instance. "The fear is that this negative impact will wax and positive impact wane. Once the evidence is clear, the result may already have had serious adverse consequence for the real economy."
Hans Redeker, strategist at the U.S. bank, reckons a negative-yielding flat yield curve has reduced monetary velocity and pushed the yen higher, while a steeper yield curve — allowing financial intermediaries to borrow at low rates and invest at longer maturities — might unleash the animal spirits needed to increase risk-taking.
In a report last week, amid indications from officials that the BOJ would anchor long-end yields higher, Redeker wrote: "Financial sector balance sheets have been dismissed by central banks for too long," adding that the central bank's newfound focus on financial-sector profitability represents a belated recognition of banks in aiding the transmission of monetary policy to the real economy.
Tomoya Masanao, head of Japanese portfolio management at Pacific Investment Management Co LLC, in a research note last week, called on the BOJ to scale back JGB purchases at the long-end to steepen the yield curve and aid financial intermediation, arguing that negative long-end rates had facilitated the refinancing of existing debt rather than stimulating new productive investments.
Bankers argue low longer-dated yields and negative rates deliver a blow to their return on assets, offsetting the benefits of lower funding costs — and the BOJ's apparent capitulation might embolden critics of monetary policy in other advanced economies.
Questions over the effects of QE have already extended away from policymakers at the BOJ. In the U.K., Monetary Policy Committee Member Kristin Forbes suggested in the aftermath of the Brexit referendum that further easing could end up tightening financial conditions rather than loosening them.
"People will earn less on their hard-earned savings — potentially cutting back on spending to reach a target savings pot. Banks will make less money on lending," she wrote in an op-ed. "Pension and life insurance funds will have a harder time meeting their commitments. Companies may need to put more money into pension schemes — leaving less to spend on workers and investment."
Will it work? I'm highly skeptical and so is the market. As of this writing on Wednesday morning, the yen reversed course and is surging relative to the USD, up 1%, hovering around 100.68 (click on image; this can abruptly change this afternoon if the Fed raises rates):
Remember my warning to always keep an eye on a surging yen as it could trigger a crisis, including another Asian financial crisis because a stronger yen reinforces deflationary headwinds in Asia which can spread all over the world.
This is yet another reason why the Fed shouldn't raise rates now but we shall see what it decides to do later today. One currency trader I talk to thinks the fact the BOJ didn't cut rates or expand its asset purchases is a sign the Fed will surprise markets and raise rates on Wednesday.
And while the Bloomberg article above quotes someone as saying "it is one attempt to provide relief for pension funds, [life insurance companies], and banks," I'd put the emphasis on banks and lifecos, less on pensions (central bankers don't really care about pensions but they should if they want to stave off deflation).
In fact, if the BOJ fails to stoke inflation expectations higher, it will be forced to cut rates further into negative territory and this will negatively impact banks, life insurers and Japan's pensions, especially defined-benefit pensions which are already reeling.
Garath Allan and Shingo Kawamoto of Bloomberg recently reported, Negative Rates Not All Bad as Mizuho Sees Pension Business Boost:
Negative interest rates aren’t necessarily all bad news for Japanese banks, as companies flock to lenders for advice on how to manage their pension programs under the policy, according to Mizuho Financial Group Inc.As you can read, negative rates aren't all bad news for some Japanese banks as they have been collecting huge fees as companies opt out of defined-benefit pensions into defined-contribution pensions.
The Tokyo-based bank sees an opportunity to earn more fees from employers that are shifting toward 401(k)-style retirement plans as sub-zero rates make it more difficult for them to meet existing pension obligations. It’s seeking to expand the 1.7 trillion yen ($16.6 billion) of defined-contribution plans it manages for companies’ employees by 30 percent over the next three years, according to Koji Imuta, a senior manager in the asset-management business development department.
Pension Strain
The Bank of Japan’s negative-rate policy is driving momentum for companies to reconsider their employee pension arrangements, Imuta said in an interview in Tokyo. “Our customers are acutely aware of this as an issue and inquiries are growing,” he said.
Even before the BOJ announced negative rates in January, years of plunging bond yields squeezed returns from retirement funds in a nation where the aging population is also placing a strain on the pension system. Imuta’s goal to increase retirement assets reflects a push by Chief Executive Officer Yasuhiro Sato to boost non-interest income amid the risk that the central bank may take rates further below zero, crimping loan profits.
By arranging pension plans for employers and investing the funds on their behalf, Mizuho will earn fees that could help to reduce the impact of negative rates on profit, Sato said in May, without providing specific targets. The bank has forecast the BOJ’s policy will crimp its net income by 40 billion yen in the year ending March.
More firms are seeking to switch to defined-contribution plans from defined-benefit arrangements because swelling retirement liabilities are jeopardizing their financial health, Imuta said. “We see this as an opportunity,” he said.
The total pension shortfall for listed companies in Japan expanded about 43 percent over the past year to 25.6 trillion yen as of March 31, according to Nomura Holdings Inc. Japanese government bonds with maturities as long as 10 years are yielding less than zero even after a recent steepening of the curve.
Making Switch
Defined-contribution plans exist on top of Japan’s public pension system, allowing employees to select how their money is invested. The amount retirees receive fluctuates depending on returns, unlike traditional defined-benefit pensions where employers must pay out a set amount regardless of how much they earn from investing the pooled funds.
Employers are tailoring their pension programs, with some fully making the shift and closing defined-benefit plans and others maintaining aspects of their existing arrangements, Imuta said.
A total of 5.5 million company employees had defined-contribution plans as of March, up 8.5 percent from a year earlier, according to Ministry of Health, Labour and Welfare figures. More than 5,000 companies including Skylark Co. and Panasonic Corp. offered these to their employees as of July, the data show.
Mizuho plans to take advantage of its April 2016 conversion to an internal company structure to bolster cooperation between its bank and trust units on the pension business, Imuta said. About 250 employees work in Mizuho’s retirement operation across the two units, which previously conducted the business separately.
Unfortunately this shift out of DB into DC pensions will only exacerbate Japan's long-term deflation problem because it will shift retirement risk from employers to employees which will succumb to pension poverty once they outlive their savings. This is all part of the global pension crunch I recently discussed and it's a frightening trend which policymakers will be grappling with for decades.
Below, Chris Rupkey, MUFG Union Bank, explains how the Bank of Japan adjusted its monetary policy, and shares his thoughts on the likely outcome from today's FOMC meeting.
And CNBC's Rick Santelli speaks with Former Federal Reserve Governor Mark Olson about the upcoming FOMC decision and the Bank of Japan's policy meeting.
Lastly, Michael Contopoulos, Bank of America Merrill Lynch head of high yield, explains why he thinks the Bank of Japan decision is more important than the Fed meeting, and how its outcome could hurt markets. Interesting discussion, listen to his comments on flow of funds and high yield credit (HYG).
Now we can all wait for the Fed decision at 2:00 pm sharp. Even though the market isn't expecting a rate hike, the recent actions from other central banks suggest the Fed might hike now. Stay tuned.
Update: A divided Federal Reserve left its policy rate unchanged for a sixth straight meeting, saying it would wait for more evidence of progress toward its goals, while projecting that an increase is still likely by year-end.
“Near-term risks to the economic outlook appear roughly balanced,” the Federal Open Market Committee said in its statement Wednesday after a two-day meeting in Washington. “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”
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