Dovish Hold by BOJ Thursday Should Weaken the Yen

The Bank of Japan meets this Thursday. No change in policy is expected, but it will likely present new forecasts that extend its forward guidance. Such a dovish hold should help weaken the yen. The BOJ meeting comes ahead of the six-day “Super Golden Week” holiday that stretches out over two weeks from April 29-May 6.      

POLITICAL OUTLOOK

Prime Minister Shinzo Abe first took power when his Liberal Democratic Party (LDP) won the December 2012 elections in a landslide. “With the strength of my entire cabinet, I will implement bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment, and with these three policy pillars, achieve results.” And so, the Three Arrows of Abenomics were born.

Prime Minister Shinzo Abe has presided over a solid period for the economy. From 2013-2018, GDP growth has averaged 1.2% per annum. Compare this to the previous six-year period, when growth averaged 0.1%. The labor market remains tight, with unemployment at a multi-decade low of 2.3%. No wonder Abe remains very popular, and the LDP easily won snap elections in December 2014 and again October 2017.

Abe’s ruling coalition just suffered two rare losses in by-elections this past weekend. This serves as a warning shot ahead of upper house elections this July. Every three years, half the upper house is elected. The ruling coalition currently holds 151 of the 242 seats in the upper house. The next lower house elections are due by 2021.

Abe will visit the US for a two-day summit with President Trump that begins Friday. The obvious topics for discussion are US-Japan trade, North Korea, and China. Press reports suggest FX will not be discussed, as previously agreed.

Emperor Akihito will become the first one in over two centuries to abdicate when he steps down on April 30. He has been Emperor since the death of his father Emperor Hirohito in 1989. Emperor Akihito will be replaced by his son, Crown Prince Naruhito, on May 1, Coronation Day. This is a ceremonial post and will have no impact on policy.  The first official guest that Akihito hosts will be President Trump in late May, which shows how important it is for Japan to maintain good relations with the US.

Due to the ascension of the new Emperor, this year’s Golden Week holiday has been extended and dubbed “Super Golden Week.” What is normally a three-day holiday will be stretched to six this year. Markets will be closed from April 29 to May 6, and many market participants are already fretting about the thin market conditions and the possibility of another dollar/yen flash crash. The one seen earlier this year took place on January 3, a bank holiday that followed a three-day holiday period from December 31-January 2.

 

A BRIEF HISTORY LESSON

After the bubble burst in Japan in the early 1990s, Japanese policymakers struggled to fight deflation. The Bank of Japan (BOJ) cut rates aggressively during that decade but reached the lower bound in 1999 still facing deflationary conditions. Officially, the so-called Zero Interest Rate Policy (ZIRP) came into effect in April 1999, which consisted not only of zero rates but also a pledge to keep them at zero until deflation risks ended.

The first stab at ZIRP ended in August 2000, when the BOJ hiked the overnight call rate to 0.25%. This turned out to be premature, as the economy deteriorated at the end of 2000. This led the BOJ to cut the policy rate again. This was deemed insufficient and so the BOJ was searching for unorthodox methods to stimulate the economy.

The Bank of Japan introduced Quantitative Easing (QE) in March 2001. The nominal policy rate had already fallen to zero. Under QE, the BOJ increased its target for so-called current account balances of the commercial banks well above their required reserves at the BOJ. It did so by directly purchasing JGBs and other securities. This target was increased nine more times between March 2001 and December 2004. QE ended five years later in March 2006 and the policy rate rose above zero.

As the Great Financial Crisis developed, the BOJ already had the tools to respond. It cut its target for the key overnight call rate several times in late 2008. The BOJ also tried to facilitate corporate financing by expanding its commercial paper (CP) repo operations and then its outright purchases.

Haruhiko Kuroda was appointed Bank of Japan Governor by incoming Prime Minister Abe back in March 2013. As Abe tried to end the battle against deflation once and for all, Kuroda became responsible for the so-called First Arrow of Abenomics, which was monetary policy. Kuroda was known to favor extremely loose monetary policy and he did not disappoint.

At Kuroda’s very first BOJ policy meeting in April 2013, he announced Quantitative and Qualitative Monetary Easing (QQE). This policy aimed to double its holdings of JGBs and ETFs over two years to achieve the 2% inflation target at “the earliest possible time.” The BOJ pledged to conduct money market operations that would increase the monetary base by JPY60-70 trln per annum.

The economy fell into recession after the consumption tax was hiked from 5% to 8% in April 2014. When that happened, Kuroda surprised the markets in October 2014 with another round of monetary stimulus via expanded asset purchases. It increased the annual rise in the monetary base from JPY60-70 trln to JPY80 trln. The BOJ also tripled its purchases of ETFs and REITs then.

Negative interest rates were introduced in January 2016. The key short-term rate was set then at -0.1% and that is where it remains today. Thus, BOJ policy became known as QQE with a Negative Interest Rate. It’s worth noting that the ECB was the first major central bank to introduce negative rates, and that was back in June 2014.

The Bank of Japan shifted to Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC) in September 2016. This committed the BOJ to control the yield curve with a negative interest rate (-0.1%) at the short end and to keep the 10-year JGB yield near zero with bond purchases. The BOJ also committed then to allowing inflation to overshoot its 2% target.

YCC is now the primary policy goal. The amount of bond-buying needed to control the long end of the curve will vary. As such, the BOJ is likely to continue tweaking its bond purchases as needed across the curve to keep rates within the targeted ranges. The BOJ just tapered its bond purchases in the 10- to 25-year tenor last Friday. This was unexpected, coming ahead of this week’s BOJ meeting. However, we do not believe it has any policy implications.

Governor Haruhiko Kuroda’s was reappointed to a second 5-year term before his first term ended this month. He has presided over the entirety of Prime Minister Shinzo Abe’s “Abenomics” experiment. His reappointment suggests that experiment will continue. Indeed, the BOJ is expected to maintain current stimulus policies until at least FY2021, the earliest that inflation is expected to reach the 2% target.

 

ECONOMIC OUTLOOK

The economy remains sluggish. The IMF recently cut its 2019 growth forecast for Japan by a tick to 1.0% but kept its 2020 forecast steady at 0.5%. GDP was flat y/y in Q4 after rising 0.1% y/y in Q3, the slowest rates since Q1 2015. As such, we see some downside risks to these growth forecasts. Press reports suggest the BOJ will shave its growth forecasts at the upcoming meeting.

Price pressures are still low. Headline national inflation picked up to 0.5% y/y from 0.2% in February, as expected. Ex-fresh food was a tick higher than expected at 0.8% y/y. Overall, however, inflation remains frustratingly low and far from the 2% target.

The BOJ next meets April 25, and no change is expected then. Press reports suggest that the BOJ will forecast inflation of 1.5-2.0% in FY2021 in its quarterly outlook report for that meeting. If so, this would imply that stimulus will likely remain in place well into FY2021 that ends March 2022.

BOJ Governor Kuroda is clearly concerned and has leaned more dovish in recent weeks. He recently noted that the BOJ will consider four options for further easing if movement towards its inflation target wasn’t sustained. These included lowering the already negative short-term policy rate, lowering the long-term yield target below zero, buying more assets such as government bonds, and increasing the monetary base.

Because of Abenomics’ so-called Second Arrow, the fiscal accounts remain weak. This is the major reason behind the government’s plan to hike the consumption tax this October from 8% to 10%. This hike was originally scheduled for October 2015 but has been delayed twice already. The budget deficit was -3.2% of GDP in 2018 and the OECD expects it to come in around -3% in 2019 and -2.6% in 2020. Much will depend on how the economy responds to the consumption tax hike.

There are clearly some concerns about the impact of the tax hike. Acting LDP Secretary General Hagiuda reportedly suggested the October hike could be delayed if the economic outlook worsened. This was quickly denied by Finance Minister Aso, who said that only a global economic crisis on the scale of 2007-2008 would derail the hike. We agree that the bar to a third delay is very high.

The external accounts are likely to improve modestly. The IMF sees the current account surplus remaining steady at 3.5% of GDP this year before rising a tick to 3.6% in 2020. However, we see risks ahead as exports have been contracting y/y the last five months. On the other hand, imports are likely to surge due to higher oil prices. These trends bear watching. Lastly, Japan’s Net International Investment Position has risen to 62% of GDP, the highest since 2015. As such, Japan’s external vulnerability remains quite low.

 

INVESTMENT OUTLOOK

The yen is performing so-so after outperforming last year. In 2018, JPY rose 3% and was the best performer in the majors. So far in 2019, JPY is -2% and is in the middle of the pack. USD/JPY is trading just below 112 at nearly the highest level since December 20. The pair is on track to test the December 13 high near 113.70 initially on its way to test the October 4 high near 114.55.

Japan equities are still underperforming. In 2018, MSCI Japan fell -16.5% compared to -11.5% for MSCI DM. So far in 2019, MSCI Japan is up 8.5% vs. 16.5% for MSCI DM. With growth likely to remain sluggish, we expect Japan equities to continue underperforming, as suggested by the VERY UNDERWEIGHT on Japan given by our DM Equity Allocation model.

Japan bonds are underperforming. Perhaps it is unfair to rank Japan against other DM bond performances given the YCC policy that is in place. The yield on 10-year local currency government bonds is -3 bp YTD and is ahead of only the worst DM performers Singapore (+15 bp bp), Norway (+4 bp), and Switzerland (-2 bp). If global rates rise more, then we think Japan bonds will start to outperform more due to YCC, which would tend to limit the rise in Japan yields.

Our own sovereign ratings model shows Japan’s implied rating worsened a notch to AA-/Aa3/AA-, continuing last quarter’s deterioration. Still, there remains some modest upgrade potential to actual ratings of A+/A1/A.