October 20, 2016    4 minute read

Yielding Control: The BOJ’s “Whacky” Policies

License To Spend    October 20, 2016    4 minute read

Yielding Control: The BOJ’s “Whacky” Policies

Trust grows at the rate of a coconut tree but falls at the rate of a coconut.

The Bank of Japan (BOJ) has thrown the kitchen sink at the economy to seemingly no avail. The latest policy design to complement negative rates and their extraordinary QE program has been to adopt yield control – a target rate for the Japanese ten-year government bond.

The question is: how is this different to the other experimental policies?

The BOJ’s Weapons

The BOJ policy rate is the rate at which Japanese banks are charged to keep their reserves (rainy day fund) in the central bank vault. Currently, this rate sits at -0.1%, meaning that the BOJ wants to encourage commercial banks to spend their excess cash, rather than sit on it. Just to give some perspective, back in the early 90’s, this rate was circa 5-6%.

The next “whacky” policy is QE, which most developed central banks have adopted over the past few years, due to the financial crisis. QE’s aim is to lower yields across all durations, by buying bonds from banks, which in turn allows cash to be freed up and lent out to the consumer.

Yield control is slightly different but is more like QE than simply lowering the base rate. It aims to keep control of longer-term rates to maintain the BOJ’s loose policy stance. They do this by setting a target rate for the 10-year government bond, which is a key reference rate for credit ratings and government average borrowing maturities.

And they do this because economics teaches that the central bank can control short-term rates by changing the base rate as mentioned above, but the balance of investment and savings and other international factors determines longer-term rates.

But ultimately, as an investor, why should one care?

Spend, Spend, Spend

The BOJ has given a license for the government to spend like there is no tomorrow. By keeping sovereign borrowing costs low, seemingly indefinitely (0% target for the ten-year bond), the government can crank up fiscal spending while paying no interest in the process. Talk about a free lunch. Short rates are controlled in-house, and it seems now longer term rates are also controlled in house. From an investor perspective, what can one take from this?

First, the BOJ is clearly worried about the economic situation and realises that monetary policy is heading to the point where it is counterproductive. They have given the green light to Tokyo but will they press the accelerator? If only the government had the same invention as the BOJ. If they did, growth rates would be up near 5% with inflation significantly passing their target.

The Outlook

Second, for an equity investor, domestic firms that are sensitive to the business cycle will likely do well, irrespective of currency swings. You might say well you could have had that idea in late 2012 when Abe came to power and presented the three arrows. This is true, but back then monetary policy by the BOJ was just in its infancy, and the situation is a lot more critical now. One would expect to see a rally in domestic infrastructure companies.

Looking ahead, if one were to forecast the BOJ’s next move, it would be to target the 30-year and in time every other major maturity. The yield curve would then by fixed. Supply and demand dynamics would disappear meaning investors would not know the fair value of Japanese debt. Rating agencies would not know what to do either, but then again what else is new. This would have repercussions for the currency and the ability to attract foreign direct investment. Of course, this is an extreme case, but this is the road the BOJ is rapidly heading down.

They may be able to control a bond yield or two but would relinquish control of the wider economy.

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