The New Negative Normal?
Japan’s central bank has made a shock decision to adopt negative interest rates, in an attempt to protect the flagging economy from market volatility and fears over the global economy.The big surprise out of Japan sent a jolt down global bond markets as bond yields are collapsing all over the world. The U.S. 10- year Treasury yield now stands at 1.93%, making it tougher for U.S. pensions to meet their future liabilities. Meanwhile, negative bond yields in Germany will place even more pressure on European pensions teetering on collapse.
In a 5-4 vote, the bank’s board imposed a 0.1% fee on deposits left with the Bank of Japan (BoJ) – in effect a negative interest rate.
The move, which follows the similarly aggressive precedent set by the European Central Bank in June 2014, is designed to encourage commercial banks to use excess reserves they keep with the central bank to lend to businesses.
The surprise decision came just days after the bank’s governor, Haruhiko Kuroda, suggested he had dismissed any drastic easing measures to boost business confidence.
On Friday, the bank said it had not ruled out a further cut. “The BoJ will cut the interest rate further into negative territory if judged as necessary,” it said in a statement.
It said the move was intended to lessen the risk to Japanese business confidence from turbulence in the global economy, a week after data showed the Chinese economy had grown at its slowest pace for a quarter of a century in 2015.
Some BoJ board members are reported to have voiced concern that slumping Tokyo stocks could threaten attempts to get firms to boost capital expenditure.
The shift to negative interest rates – which in effect “taxes” financial institutions for parking excess reserves with the BoJ – is seen as an attempt to drag Japan out of its deflationary mindset.
Policymakers have been trying to achieve that through qualitative and quantitative easing, under which the BoJ expands its monetary base through the aggressive purchase of Japanese government bonds and risky assets.
But with so few assets left to buy, that policy appears to have run its course, according to some analysts. “I think this is a regime change and the BoJ’s main policy tool is now negative interest rates,” said Daiju Aoki, an economist at UBS Securities in Tokyo. “This shows that the ability to buy more Japanese government bonds is limited.”
The decision took some analysts by surprise. “Kuroda had been saying that he didn’t think something like this would help so it is a bit surprising and it’s clear the market has been surprised by it,” said Nicholas Smith, a strategist at CLSA based in Tokyo.
“The banking sector is getting smoked right now, though everything else seems to be doing just fine. This has obviously had a big effect on inflation and on inflation expectations.”
Markets had been divided on whether the central bank would opt for more stimulus as slumping oil costs and soft consumer spending have ground inflation to a halt in the world’s third biggest economy.
Earlier on Friday, official data showed Japan’s inflation rate came in at 0.5% in 2015, way below the BoJ’s 2.0% target, as the government struggles to convince cautious firms to usher in big wage hikes to stir spending and drive up prices.
“The 2% target is now totally out of reach,” said Taro Saito, economist at NLI Research Institute.
The bank extended the deadline for achieving its 2% inflation target to the first half of fiscal 2017 from its previous estimate of the second half of fiscal 2016.
Other data published on Friday pointed to a weak economy with spending by households in December falling 4.4% from a year ago and monthly industrial production contracting 1.4%.
The BoJ cut its core consumer inflation forecast for the coming fiscal year beginning in April to 0.8% from 1.4% projected three months ago.
The authorities will be hoping negative interest rates encourage commercial banks to lend more to promote investment and growth.
The rate cut had an immediate knock-on effect, sending shares on the Nikkei average up by more than 500 points early on Friday afternoon. However, shares soon plunged back down again as traders digested the broader implications of the move, which forced down the value of the yen and which could spark a currency war.
“The fact markets pared back this bounce soon after the announcement may in some respects reflect growing market concern that central banks are delving into a tit-for-tat currency devaluation war,” said Angus Nicholson at the online trading firm IG in Melbourne.
“And the grand macro-economic elephant in the room is what happens if China is forced into a major one-off devaluation in retaliation. Markets are unlikely to react well to a big yuan devaluation, and the further the ECB and the BoJ force their currencies down the more they push China to act.”
The decision came a day after the prime minister, Shinzo Abe, lost one of the key architects of his inflation-oriented economic policy, known as “Abenomics”. Akira Amari was forced to resign as economy minister on Thursday following allegations that he and his aides received bribes from a construction company. Amari has denied any wrongdoing.
Jesper Koll, chief executive officer at WisdomTree Japan, applauded the BoJ’s decision. “I’m very happy with governor Kuroda’s leadership today – adopting negative rates is exactly what was needed to re-assert the relentless, pro-active and pro-growth determination that underlies Abenomics,” he said.
“The fact that Kuroda has gone out on a limb – with a 5-4 vote – reasserts that this is his BoJ, not the technocratic non-risk taking BoJ of the past. As we keep insisting, this is not a business-as-usual leadership team.
What are my thoughts on "Japan's big bang"? It smacks of desperation and this is where things get tricky and potentially dangerous. Why? Because we saw what happened last year following China's Big Bang, and as I explained in my Outlook 2016 on the deflation tsunami, the risks of a full-blown emerging markets crisis are rising and this will have ripple effects throughout the world:
[...] if China decides to once again devalue its currency, it will have ripple effects throughout Asia, including Japan where the prime minister and central bank governor have applied fresh pressure on companies to do their part in putting a sustained end to deflation by boosting wages and investment, with little success.Now, some commentators, like Yves Lamoureux who is predicting QE4 and Dow 25,000, think deflation in China and Japan is a good thing. Cheaper goods will flood North America and along with that "declining oil price dividend", it will help consumption on this side of the Atlantic.
All this to say keep monitoring emerging market currencies in 2016. This is where you will see the global battle against deflation take place. Unfortunately, it's a losing battle and one that will export disinflation and deflation throughout the world at the worst possible time.
In my opinion, the problems in emerging markets are only going to get worse in 2016 so I have a hard time buying the global recovery theme which some elite funds are betting on. Even Canada's large and powerful pensions are betting on energy but those investments might not pan out for years or worse still, decades if global deflation sets in.
It has been my contention all along that the sharp decline in oil and commodity prices is not "unambiguously good" as it's a symptom that's clearly warning us the deflation supercycle is not nearing an end.
Worse still, deflationary pressures are picking up steam all over the world, especially Asia, and that means the risks of deflation coming to America are rising too. How is this possible? Through lower import prices. Look at the mighty greenback, it's gaining on all currencies again following the Bank of Japan's surprise move.
The greenback's strength will only reinforce commodity and asset deflation, lower import prices and inflation expectations, and in my opinion, it will force the Fed to reverse course fast.
In fact, the U.S. central bank has now put the world on notice that the slide in oil prices and sharp slowdown in global growth may rank as one of those very shocks, capable of changing the Fed's bias from implying a steady set of future rate hikes to one pointing to an extended pause or even a rate cut driven by stubbornly low inflation.
Below, I highlight the key passages in this week's FOMC statement:
Information received since the Federal Open Market Committee met in December suggests that labor market conditions improved further even as economic growth slowed late last year. Household spending and business fixed investment have been increasing at moderate rates in recent months, and the housing sector has improved further; however, net exports have been soft and inventory investment slowed. A range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources. Inflation has continued to run below the Committee's 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation declined further; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.There's a sea change going on at the Fed and even though it decided to stand pat on rates, be prepared for a shift in policy given its renewed focus on global economic and financial developments. Brian Romanchuk is right, the BoJ's NIRP makes a Fed rate hike look even more foolish.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen. Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further. The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.
Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.
As far as the Fed's 2% inflation target, it's dreaming when it says the decline in energy and import prices are "transitory." I think the Fed needs to wisen up and listen carefully to Larry Summers, low energy prices are here to stay and the risks of deflation are rising fast.
As I write this comment keeping my eye on stocks, I notice there's a little party going on in most high beta stocks that got pummeled early in 2016, especially Metal & Mining shares (XME) which are up almost 7% on Friday mostly because of the 18% surge in the shares of Consol Energy (CNX).
Be very careful here. The big bet is that as central banks pump more liquidity into the system using all sorts of unconventional monetary policy tools, those funds playing the global recovery theme will come out ahead, but for me this is nothing more than another short-covering countertrend rally that will fizzle as global deflation becomes more entrenched. That's what the bond market is telling us.
And if global deflation becomes more entrenched, you can bet the Bank of Canada will regret its recent decision to stay put and that negative interest rates are coming to Canada too (short the loonie on any pop in oil prices).
What else? Right now, central banks are the only game in town and they're desperately trying to save the world from a global deflationary slump that will likely last for decades. Unlike what some market gurus claim, the Martingale casinos aren't about to go bust, but clearly central banks cannot fight the global deflation tsunami and the world desperately needs a new macroeconomic paradigm to fight the secular stagnation Larry Summers has warned of.
But my fear is that the fiscal response to world's economic woes is lacking, either because of politics or high debt levels constraining public finances, and this means central banks will go it alone and negative interest rates will be the new normal.
And if you think negative interest rates can never be used in the United States, think again. In an interview with MarketWatch, former chairman Ben Bernanke said the Federal Reserve should consider using negative rates to counter the next serious downturn.
“I think negative rates are something the Fed will and probably should consider if the situation arises,” Bernanke said in the interview last month. You can read the entire interview here.
Now, I ask all you global asset allocators, especially those of you working at large global pension funds: Are you prepared for the new negative normal?
On that note, please take the time to once again listen to Larry Summers discussing oil prices, global bonds and the risks of deflation below. He is bang on, with the risks of deflation rising and central banks already stretched in terms of what they can do, we're going to have to start thinking of fiscal policy in the years to come. The thing that worries me is do we need another crisis to get the ball rolling on this front?
Second, Bill Gross discusses why the Fed is on the wrong track and why the risks of a U.S. recession are rising in 2016. Take the time to listen to his comments.
And Gordon Long of the Financial Repression Authority interviewed Dr. Lacy Hunt of Hoisington Investment Management who explains why inflation and bond yields are heading lower. Great interview, listen to his comments and read Hoisington's latest quarterly review and outlook.
Last but not least, I'd like to remind all of you to please take the time to donate or subscribe to this blog and support my efforts in bringing you thought provoking and insightful comments on pensions and investments. You simply won't find a better free lunch on the internet, so please show your support and contribute to my blog via PayPal on the right side. Thank you and have a great weekend!
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