Monetary policy since the Credit Crunch has spawned an extensive list of obscure acronyms and the Bank of Japan (BoJ) has delivered a new one; start getting used to ‘YCC’ – yield curve control. The aim behind YCC is simple – to shore up the banking system.
Generally (and prior to the GFC) the yield curve steepens ahead of an increase in economic growth (first chart) and vice versa. [It should be noted that post GFC changes to the yield curve and the economy have been much more coincident.] In these days of heightened focus on policy communication, an upward sloping yield curve can also usefully convey a confidence-inducing sense of ‘jam tomorrow’; a flat curve delivers a much more downbeat message. In operating near- zero or negative policy interest rates together with QE, the world’s major central banks have sought to stimulate demand by cheapening the cost of and improving access to credit. The result has been flatter yield curves than might otherwise have been the case. These flat curves have cast doubt upon the economic outlook – doubt that generally been validated in the subsequent data.
Banks rely on borrowing short and lending long – so the more upward sloping the yield curve, the fatter the margin that banks can earn. In a QE/ zero-interest rate world yield curves flatten – eating into bank profits; not least because central banks are actively buying bonds along the curve. The yield curve in Japan is now negatively sloped – challenging the ability of banks to operate normally and offering a stark economy prognosis. The BoJ has reached the point where these extra-ordinary monetary policies are creating more problems than they solve – no point in lowering the cost of credit if, in doing so, you enfeeble the credit transmission mechanism, the banking system.
Going forward, the BoJ will deliberately adjust their ongoing monetary expansion (QE) to target a steeper yield curve – how steep is unclear; they are however aiming to ensure that the yield on the 10-year government bond is no less than zero – the recent low (at the end of July) was minus 0.3%. In order to achieve this it is possible that the BoJ will have to sell 10-year bonds and presumably buy more shorter-dated bonds (this would be the reverse of Operation Twist used by the US Fed in 1961 and 2011). This would seem to mark the end of the line for the multi-decade decline in Japanese 10-year bond yields.
Abenomics, begun in 2013, aimed to promote economic activity and to deliver Japan from deflation by generating a sustainable 2 per cent inflation rate. A key driver was intended to be a lower exchange rate. The sharp slide in the currency induced by Abenomics saw inflation surge to 3.7 per cent in May 2014 but the latest reading, for July, shows that Japan is once again deflation (at 0.5 per cent p.a.) and the Yen is appreciating afresh.
Classically a steep yield curve should be bad for the associated currency; longer dated yields are reflecting an inflation risk for which there isn’t compensation in short-term interest rates; the currency should fall to reflect the prospective loss of purchasing power. YCC should be currency negative however many (most?) classic relationships haven’t survived well in the post-GFC era.
The challenge for policymakers (wanting a weaker currency) is that Japan, after being in external balance in 2014, is once again operating a substantial external surplus which could easily push the Yen higher by another 20 per cent. The goal of boosting activity by competitive devaluation would have then been lost (if it hasn’t already). The launch of YCC highlights, potentially for the first time, the cost of running QE and zero interest rates for an extended period. In doing so it suggests that extra-ordinary monetary policies – in Japan at least – are nearing the end of the line.
There is also good reason to suppose that YCC will ultimately fail (arguably as every other Japanese policy initiative has before). Japan faces many challenges, not least the demographic pressure of an aging population as captured in the headlines this week – 27 per cent of the population are over 65. Economic outlook per worker in Japan is very healthy (and better than its major competitors); unfortunately the number of workers is shrinking (down 9 per cent over the last decade). Imposing a zero bound on 10-year bond yields falls far short of the remedial measures required. The Yen has offered investors sanctuary during times of stress; YCC won’t change that.
Scott Jamieson is head of multi asset at Kames Capital.