"The governor of the Bank of Japan (BoJ), Haruhiko Kuroda, was given a clear mandate by the Prime Minister in 2013, to end the deflationary pressure which had been weighing on the country since 1998. In order to do so, the governor implemented an ultra-aggressive monetary strategy, based on massively increasing securities purchases by the central bank and by including more risky securities in the asset purchase program, particularly listed real-estate investment companies and equity ETFs. Three years after the launch of this quantitative and qualitative easing program (QQE), it is clear that the results have fallen short of initial expectations. Although underlying inflation has managed to move into positive territory, it has struggled to break through the 0.8% threshold, compared to the official target level of 2% (chart 1). Even worse, anticipated inflation reflected in a variety of sources (fixed-income markets, corporate and household surveys), have fallen back perilously close to zero. This failure has dented the credibility of the BoJ.
Furthermore, the cross-currency basis swaps market has become saturated in Japanese counterparty-risk, which limits the ability of domestic institutional investors to diversify their portfolios into foreign bonds. Heavy portfolio rotation towards foreign assets (initiated by the giant public pension fund GPIF) has effectively created strong demand for currency-risk hedging among Japanese investors. These hedges, set up through the cross-currency basis swaps market, triggered a “Japan premium” on the yen leg of swap contracts (chart 3). This premium has wiped out part of the additional anticipated remuneration from foreign bonds. Investing in foreign bonds has therefore become less attractive for domestic investors, which increases their dependence on the JGB market.
An alternative option would be to abandon the quantitative objective of increasing money supply and instead target long-term interest rates directly. The BoJ would undertake to maintain long-term rates below a given ceiling limit as long as anticipated inflation remains low. The most credible strategy would nonetheless be for the BoJ to acknowledge that QQE implicitly monetizes public debt (chart 4) and therefore only makes sense if it is coordinated with an ambitious budgetary stimulus program and structural reforms. This amounts to reminding the government of the meaning behind the legend of the three samurai arrows: each one breaks easily on its own, but they are more resilient when held together.
Unfortunately, Prime Minister Abe no longer appears to enjoy the political capital to implement such a Big Bang. His reelection hinges on his promise to drastically adjust the budget, by increasing value added tax (VAT). If the next VAT hike expected in April 2017 is delayed, the government could have to re-establish its legitimacy by dissolving parliament again.
Japanese equities and long-term rates are likely to remain highly volatile given the imbalance in the JGB market and fears of QQE ending as early as mid-2017.
We remain underweight on Japanese equities in our global multi-asset portfolio."
Strategist – Investment and client solutions
Natixis Global Asset Management