"The person attempting to travel two roads at once will get nowhere." - Xun Zi, Chinese Philosopher
"I think, yes, we have enough ammunition," Kuroda said, when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the target. "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." - Haruhiko Kuroda, Bank of Japan's governorWe had Japan in mind when we selected our title analogy for this week's musing "Road to Nowhere", the 1985 rock song written by David Byrne from the Talking Heads album "Little Creatures". What is of "humoristic" interest is that David Byrne indicated the following about his song:
"I wanted to write a song that presented a resigned, even joyful look at doom," - David Byrne
"I think, yes, we have enough ammunition," (when asked whether the BOJ had sufficient monetary policy options, or "ammunition," left to achieve the 2% inflation target). "If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates." Haruhiko Kuroda, Bank of Japan's governor
- Macro and Credit - Looking back a the "Three arrows"
- Macro and Credit - Is the Fed on a "Road to Nowhere"?
- Final chart: Now is the right time to "hedge"
- Macro and Credit - Looking back at "The Three arrows"
In our April conversation "Shrugging Atlas" we already touched on the impact of three years of QQE and the impact of the deflationary mindset that has taken hold in Japan. We argued at the time:
"It seems more and more evident that, the experiment overtaken by the BOJ in the last three years has failed to move upwards inflation thanks to any significant wage increases. The Japanese government cannot afford to allow rates to rise, and yet by keeping rates so low it increases distortions in the economy through the "mispricing" of risk. This is clearly evident by the inversion in correlation between bond prices and the Nikkei index!We also argued that the headwinds facing Japan and as well Europe in our April conversation stem from "demography", rendering the problems more "structurally" acute. When it comes to Japan and its central bank and credit transmission we have a case of "broken arrow". Europe seems to be as well facing very similar difficulties we think.
Furthermore, the size of the BOJ's buying spree in the Japanese market has led to the market becoming not only unstable but as well as totally broken and volatile. Basically what was supposed to be riskless in the Japanese Government Bond (JGB) has become the most risky and volatile investment of all thanks to the BOJ" - source Macronomics, April 2016
When it comes to assessing the effectiveness of the "Three arrows", we read with interest Nomura's take on the subject in their Japan Economic Weekly note from the 20th of May entitled "Taking a fresh look at the three arrows":
"Summary: 1) Reconstructing the "three arrows"
When the second Abe administration was formed in December 2012, it announced what it called "the three arrows." Since last year, the government has been talking about "three new arrows," policies aimed at achieving its goal of the "dynamic engagement of all citizens." While the label may have changed, the government is presumably still committed to what it has called "growth strategies," structural reforms aimed at supporting economic growth.
Summary: 2) Shortcomings of existing economic policies
While the government has in the past claimed that deflation would soon be overcome, it cannot be said to have achieved this or to have boosted economic growth. We see two shortcomings in its policies. First, it has failed to sufficiently counter dwindling expectations of economic growth, with the result that the first and second arrows of traditional monetary and fiscal policy have not had the expected impact. Such policies seek to bring forward demand at the expense of the future. With demographics depressing growth expectations, policies that seek to bring forward future demand can make households and companies even more reluctant to spend. Second, in terms of the third arrow of growth strategies, the government may not have properly considered whether to bias its policies in favor of either labor or capital or, how in what order to do so.
Summary: 3) Some distinctive features of the Japanese economy now
The government's focus, which during the early stages of its strategies for growth was on capital (specifically on increasing corporate earnings power by means of structural reforms such as corporate governance), has since gradually shifted to trying to boost the labor participation rate (eg, by means of the government's Plan to Realize the Dynamic Engagement of All Citizens) and improving the share of labor. As a result of implementing policies biased towards capital and, especially, improving shareholders' rights, Japanese companies have probably become more focused on efficiency, productivity, and profitability than ever. The result is a state of affairs where wage growth and the labor share have failed to increase and a virtuous cycle of rising employment, incomes, and consumption has failed to develop.
Summary: 4) Challenges
It would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. What the government needs to do next is to increase the number of companies that succeed in improving their earnings power, thereby increasing both employment and the labor share, rather than encourage such companies to use those earnings to increase the labor share." - source NomuraWhen it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited. This is clearly explained in Nomura's interesting note:
"To put it rather bluntly, traditional fiscal and monetary policies seek to boost the real economy and stir inflation by bringing forward demand at the expense of the future. Monetary policy basically works by artificially reducing the future value of a currency, whether by means of positive or negative policy interest rates or by means of interest rates or the quantity of money, in order to encourage companies and households to spend more. Fiscal policy, on the other hand, does not exactly bring forward future demand but achieves a similar effect by using (increased) future government revenue as collateral to fund current spending.
The Nikkei and other news media reported on 14 May that Mr Abe is probably going to announce that the planned increase in the consumption tax is going to be postponed for a second time. Bolstering current demand by postponing a tax increase is also a kind of fiscal policy as it tries to encourage current spending by using future government revenue as collateral.
However, policies that try by one means or another to bring forward future spending in order to boost current economic growth assume that people will expect the economy to grow. However, if people are convinced that the economy is going to shrink, traditional economic policies may have the unintended consequence of making people even more reluctant to spend. We cannot rule out the possibility that the demographic headwinds facing the Japanese economy in the form of a declining and aging population may have led many Japanese households and companies to assume that the Japanese economy will inevitably shrink. This may explain why traditional fiscal and monetary policies have not had the expected impact." - source Nomura
While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) as displayed in Nomura's note:
"ROIC, far from declining, has been rising despite a substantial decline in interest rates in general suggests to us that companies have increasingly been focusing their capex on projects with better returns than in the past. In other words, that companies have been increasing their capex and stepping up depreciation of their existing plant and equipment without raising more capital suggests to us that they have managed to both increase their capex and improve their margins without expanding their balance sheets.If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere". The challenges facing Japan in revisiting its "three arrows" are clearly underlined in Nomura's note:
At the same time, we note a marked tendency for the profits generated by this efficient capex to accumulate as retained earnings and to be paid out as shareholder returns in the form of dividends, etc without impairing ROE." - source Nomura
Assuming the above analysis is correct, it would seem fairly clear what kinds of policies are needed in order to increase Japan's economic growth. The main challenge is how to raise growth expectations, and the solution probably lies in the existing policy mix.We could not agree more, unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable".
Two of the existing growth strategies that have proved relatively successful are probably (1) the corporate governance reforms aimed at increasing corporate earnings power and (2) the resulting increase in capex. If that is indeed the case, the next step that needs to be taken is presumably to implement a strategy for increasing the number of companies that succeed in increasing their earnings power.
The labor and employment policies the government has begun to push strongly should focus on those aimed at further improving corporate earnings power as well as on increasing employment and the labor share by increasing the number of Japanese and foreign companies that develop their earnings power, rather than focus on policies aimed at increasing labor participation or the labor share that target existing Japanese companies.
With a widening income gap becoming a social problem on a global scale and politics heading in a direction that reflects that trend, coming up with such policies will be no easy matter. However, in view of Japan's position as the most disadvantaged country in terms of the impact of its demographics on growth expectations, the need for such policies is all the greater." - source Nomura
Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street".
When it comes to the effect NIRP has had on Japanese Life insurers, we have discussed on numerous conversations the impact it has had on their foreign allocations and in particular bonds. This was as well clearly displayed in Nomura FX Insights note from the 26th of May entitled "JPY: Lifers' hedge ratio inched up":
"As monthly flow data have been showing, the nine major lifers accumulated foreign exposures aggressively during H2 FY2015 (Figure 2).
Total foreign exposures held by the nine lifers increased to JPY42.9trn ($391bn) from JPY40.2trn six months ago. After considering the FX valuation impact, we estimate they have increased foreign exposures by JPY4.9trn ($44bn) during H2 FY2015, the highest pace at least since FY2002, which is consistent with the historically biggest foreign bond investment by lifers in February and March, after the introduction of negative rates by the BOJ (see “Temporary pause in portfolio outflows”, 12 May 2016).
Unhedged foreign exposures stood at JPY18.8trn ($171bn), largely unchanged from JPY18.7trn in September 2015. As we expected, most of the recent foreign bond investment by lifers has been on an FX-hedged basis. At the same time, they kept unhedged exposures almost constant despite JPY appreciation in Q1, which suggests lifers were likely small dip buyers of USD/JPY, to keep FX exposures.
US assets remained preferred
A large part of the foreign investment during H2 FY2015 was in USD-denominated assets as expected. The nine major lifers’ exposures in USD assets increased to JPY26.9trn ($245bn) from JPY24.6trn. The USD share in total foreign assets increased to 62.7% in March from 61.3% in September 2015, recording the highest share since September 2002. The FX hedge ratio for USD assets increased to 55.7% from 51.6% during the same period (Figure 3).
As a result, unhedged exposures in USD assets stayed at JPY11.9trn ($108bn), largely unchanged from September last year (Figure 4).
Lifers’ preference for US assets remained strong, but they still prefer FX hedged investment for now.
Fed policy and political risk to be important for lifers’ hedging stance
Major lifers’ FY2015 financial results confirmed their strong appetite for foreign bond investment, without increasing FX risks for now. The results also showed stronger preference for US assets over other foreign assets. As JGB yields remain low, UST investment could give lifers slightly higher yields than JGB investment even after FX hedging (see “Lifers’ shift into foreign bonds continues”, 20 May 2016). The major lifers’ investment plans for FY2016 showed a strong appetite for foreign bond investment this fiscal year, but their investment should be largely FX hedged for the time being (see “JPY: The shift into foreign assets by lifers should continue”, 27 April 2016).Of course the latest "sucker punch" delivered to the US dollar versus the Japanese yen thanks to the clearly weak Nonfarm payroll data could somewhat tamper the hedging appetite of the Lifers and trigger some additional volatility on the currency pair.
At the same time, the likelihood of a Fed rate hike by July is clearly rising now, which will increase hedging costs further. Lifers’ risk appetite could also improve after the UK referendum on Brexit. Thus, lifers may consider taking more FX risks in H2 this year." - source Nomura
Whereas Japan has stronger demographic headwinds, the latest miss in the United States coming from the labor market pushes us to ask ourselves on our second point if indeed the Fed is not as well on a "Road to Nowhere" when it comes to its willingness in hiking further during this summer.
- Macro and Credit - Is the Fed on a "Road to Nowhere"?
"The Fed is not stimulating anything. The Fed is only massively monetizing the US fiscal deficit. Therefore, a lower unemployment rate is actually worse, because a lower unemployment rate implies higher wages, sooner rather than later. And if wages rise, people will have more purchasing power to afford the increasingly higher commodity prices. The higher wages will validate the higher prices of food and oil. In the process, the supply of money, ceteris paribus, will decrease. If the US fiscal deficit continues unabated (our key assumption here), the Fed will be forced to engage again in quantitative easing. For this reason, we think that the unemployment rate announced on Friday was actually bullish of gold."
What is of interest today is that with this kind of employment report, the job of Janet Yellen at the Fed has become even more complicated. On that note we read with interest Bank of America Merrill Lynch's take from their US Economic Watch note from the 3rd of June entitled "Payroll pain for the Fed":
"As expected, average hourly earnings grew 0.2% mom and 2.5% yoy, the latter pace holding steady from April. The modest acceleration in wage growth from last year reflects the tightening in the labor market, although there is still a debate as to whether we have reached full employment. Indeed, the broader measure of the unemployment rate, the U6 figure, held at 9.7%.
What does this mean for the Fed?
There was no saving grace in this disappointing report, and the recent sluggishness in the labor market warrants increased Fed cautiousness. We think a June hike is off the table (and the markets agree, pricing in less than a 5% chance of hike after the number this morning). While a hike in July is still a possibility, we are increasingly comfortable with our September call. There is simply not enough time leading up to those summer FOMC meetings to see the growth and labor data rebound convincingly, and inflation continue to accelerate—all necessary conditions for another increase in rates. After today’s report, Fed Chair Yellen’s speech on Monday will be even more important." - source Bank of America Merrill LynchAs a reminder if a lower unemployment rate implies higher wages, sooner rather than later, then indeed Janet Yellen's hiking job is difficult. So far wage acceleration doesn't seem to be that material from the latest readings. A real tightening scare from the Fed would only happen if there is concrete evidence of an acceleration in wage pressure. On the other hand, deteriorating market conditions, meaning falling share prices and rising credit spreads à la Q1, would most likely lead the Fed to some renewed easing we think.
What is more and more apparently clear is that too much conflicting communication snippets from Fed members are leaving market pundits puzzled and are indeed eroding more and more the Fed's credibility. This was bound to happen and was clearly illustrated by Nomura's economist Richard Koo, quoted in our November 2014 conversation "Chekhov's gun":
"Since the Greenspan era, however, transparency has gradually come to be viewed as a desirable characteristic in the conduct of monetary policy. This trend gathered momentum under the leadership of Mr. Bernanke, who had been making a case for greater transparency in monetary policy since his days in academia. During his tenure at the Fed, this view was reflected in the shortening of the time required for FOMC minutes to be released, the holding of press conferences by the Fed chair, and the release of interest rate forecasts by FOMC members."- source Richard Koo, Nomura Research InstituteThis outcome of "eroding credibility" has been highlighted in our musings and has also been put forward by Bank of America Merrill Lynch in their Ethanomics note from the 3rd of June 2016 entitled "The Fed's risk management":
"Dazed and confused
It is fair to say that many clients are a bit confused and frustrated with Fed communication. The Fed seems to be constantly changing its focus from one meeting to the next. They seem to regularly promise hikes, only to back off at the last second. Fed statements often seem stale, reflecting where the economy and markets were a couple months ago, rather than current conditions. They say their 2% inflation target is not a ceiling, and yet they only plan to bring inflation back to 2%. They argue that the risks to the outlook are very asymmetric—with rates near zero they have limited anti-recession ammunition—and yet their inflation target is symmetric. This is policy transparency?
Here we pierce the cacophony and offer a simple guidebook to understanding the Fed. The core lesson here is simple: until the Fed is able to achieve significant separation from the zero lower bound for interest rates they will remain highly risk averse. This means they will:
• focus on the latest risk factor rather than their baseline,
• pause at relatively small signs of trouble,
• be very slow to “turn off” risk warnings,
• take a very high risk of overshooting their inflation target,
• and take very little risk of an economically meaningful hawkish “policy mistake.”
Attention deficit disorder
A common complaint from clients is that the Fed seems to be constantly shifting its focus. One day it is the labor market, and then it is GDP, then inflation, then global developments and then financial conditions. No wonder markets are confused about just what “data” the Fed are “dependent” on.
Contrary to popular belief, the Fed is not constantly changing its mind. Instead, their shifting focus is a sign of very high risk aversion. With the Fed and many other central banks facing chronically low inflation, a weak recovery and near-zero rates they are much more sensitive to downside risks to growth than to upside risks to inflation. As a result, their focus tends to shift to whatever is causing downside risks at the moment.
The labor market has been out of the Fed spotlight for a long time because it is the healthiest part of the economy. By contrast, there have been a number of troubling dead spots for GDP growth and there have been repeated periods of elevated global economic and financial risks.
We expect the Fed to remain highly risk aversion until they have created significant separation from the zero lower bound. Get used to it: as risks rotate, so will the Fed’s focus.
Markets are fast, the Fed is slow
Despite a rebound in the markets in late February and March, Fed officials remained super dovish until after the April 26-27 FOMC meeting. Some investors wondered “what more are they looking for to become more optimistic” and “if this improvement is not enough, will they ever hike?” Recall that even in normal times, there is a good deal of inertia in Fed decision making as they have a very strong aversion to flip flopping. This is one reason why the lagged funds rate is often included in econometric models of the Fed reaction function. Moreover, in our view, each shock is making the Fed a bit more risk averse, making them a bit slower to give the “all clear sign.”. Yellen’s next major speech is on June 6th and we expect her to offer a much less stale view, given months of better markets and no sign that the risk-off trade damaged the economy. There are two lessons here: (1) what the Fed is looking for is more time to decide, and (2) their caution means slow hikes, not no hikes.
The inflation target: do the right thing
Another confusing part of the Fed’s message is the way they describe their inflation target. On the one hand, they swear 2% is “not a ceiling” and they want to average 2% over time. On the other hand, they only want to raise inflation to 2% in the next few nyears, taking an equal risk of overshooting and undershooting. As we noted here, inflation tends to be low early in business cycles and then rise late in the cycle. Hence achieving average inflation of 2% requires overshooting in the second half of economic recoveries. As we also note, this has nothing to do with making up for past low inflation, but is a requirement if the Fed is going to avoid repeatedly undershooting its target in the future.
They also have an inconsistent message on the risks around policy. On the one hand, they underscore that their targets are “symmetric”; on the other hand, they argue that with interest rates near zero the risks to the economy are asymmetric to the downside.
If the risks are asymmetric, why would they have a symmetric target? Moreover, the zero lower bound constraint is one of many things arguing for asymmetry:
• Inflation expectations have clearly slipped below their 2% target, restoring
expectations requires proving that they can achieve average inflation of 2%.
• The increased volatility of the business cycle means the Fed needs to have a higher
nominal funds rate at the end of an expansion to have sufficient ammunition to
fight the next recession.
• The drop in the equilibrium real funds rate lowers the equilibrium nominal funds
rate, giving the Fed less anti-recession ammunition, not more.
• The risks of deflation have risen relative to when the Fed first set its target.
• With other central banks stuck at zero, the Fed may be alone to fight the next
We see only two offsetting arguments. First, overshooting could trigger political backlash. The Fed can deal with this by quietly overshooting and assuring that the overshoot will be limited. Second, a slow exit adds to bubble risks. However, even with its slow exit the Fed has already taken some of the froth out of high yield bonds and commercial real estate lending.1 Ultimately, we expect the Fed to do the right thing and acquiesce to a moderate overshooting of their inflation target. Hence we expect them to act like they have a de facto target of 2.5% over the next several years.
It is hard to fall down when you are crawling
For much of the economic recovery, the bond market consistently priced in rate hikes that never materialized, but the last two years the roles have reversed with the market pricing in less hikes than the Fed is forecasting. Thus a common refrain is that the Fed is “making a policy mistake.” They are going to hike too quickly, damaging the recovery and may be forced to reverse course.
We are skeptical. A corollary of this high risk aversion is that the Fed is unlikely to make a “hawkish” policy mistake. The Fed is moving at a snail’s pace and pauses at every sign of downside risks. Indeed, they have delayed every planned tightening. Moreover, the economy has done fine despite the “taper tantrum,” the “surging dollar” and repeated stock market corrections. The Fed may be making small tactical mistakes, but their goslow-and-hesitate strategy makes an economically meaningful tightening error very unlikely.
Damned if you do; damned if you don’t
The bond market sees a relatively low probability of a rate hike in the second half of the year (Chart 2).
Presumably this is partly because of the looming Presidential election. Clearly the Fed is under political pressure: some candidates have been quite critical of the Fed, there are several bills in Congress designed to reduce Fed independence and a move near the election is likely to attract a good deal of criticism. In our view, political pressure on the Fed is the highest since Paul Volcker broke the back of inflation in the early 1980s. A risk-averse central bank may decide to go into hibernation around the election." - source Bank of America Merrill LynchIn relation to Bank of America Merrill Lynch's point about inflation tending to be low early in business cycles and then rising late in the cycle, we reminded ourselves that equity bear market tend to coincide with high global core inflation as we wrote about in June 2014:
"Interestingly, back in 2008 in the US the Core inflation rate peaked in August 2008 at 2.54% before we had the "bear market" of 2008:
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively." - source Macronomics, July 2014And if historically, a true peak in the equity market always happens between 2 and 14 months before recessions, a sudden burst of inflation on conjunction with heightened velocity in the rise in oil prices could indeed have severe consequences on equities we think. Given the on-going complacency and significant rally seen since the bottom of the first quarter, and the low level attained by the Vix, it seems to us that the time is right to start thinking about "hedging" your US equity risk as per our final chart.
- Final chart: Now is the right time to "hedge"
"We’ve been here before
We also looked at buying options opportunistically, using various tactical indicators. We find that it is relatively easy to identify economic crises of a more cyclical nature by monitoring such indicators as the valuation of the stock market, high-yield spreads and the cost of hedging. Forecasting financial and geopolitical crises is a much more daunting task.
Using risk indicators can help reduce the cost of hedging in good times, and possibly buy more options in times of stress. But in the long run, such tactical choices matter less than such seemingly mundane issues as selecting the right expiry, leverage, and strike.
It is interesting to note that most of the indicators we have selected show that now is the right time to hedge equity risk. Volatility is cheap, especially for the S&P and Eurostoxx. As Andrew Lapthorne argues in ‘High aggregate PE valuations and weak profits and not wholly down to Energy’ [GS5], price/earnings valuations are high and profits weak. US high-yield spreads are wide, as they were in the late 1990’s and before the subprime crisis.
Nobody can predict exactly what will happen next, but we think it is a good time to take a serious look at hedging strategies." - source Société GénéraleWhile nobody can predict exactly what will happen next, from our point of view, we know from the early signs of the growing stress in some segments of the credit markets, that it will happen, how it will happen, namely what will be the trigger remains a big unknown. Revisiting hedging strategies, we agree with Société Générale is essential particularly if one believes the US economy is indeed, like Japan on a "Road to Nowhere".
"Fun without sell gets nowhere but sell without fun tends to become obnoxious." - Leo Burnett, American businessmanStay tuned!