Policy Quagmire threatens to boost JPY
Exempting MRFs from negative rates narrows the BoJ’s NIRP more clearly to large institutions and allows retail investors to park their cash in safe zero-yielding funds. NIRP was before and even more so now is aimed at weakening the JPY. However, by standing by and letting the JPY strengthen in the face of this policy, the BoJ has generated confusion and dismay and damaged its credibility. There would have been no better time than in the last month to draw the foreign exchange intervention card. By leaving it in the deck, Japan officials have only reinforced the reluctance to use this tool and weakened the effectiveness of the NIRP. Still there are few other options than to further cut the NIRP rate in the hope of bludgeoning the JPY lower. The BoJ sorely needs the cooperation of the government to enact more fiscal stimulus and push ahead with structural reforms and use these as cover to put a line in the sand under the USD/JPY.
With less global financial market uncertainty, still strong USA labor market and higher than expected inflation in recent months, the Fed may reinstate its assessment that risks are balanced. If so at least two hikes are likely to be projected for the rest of this year. With only one hike currently priced into the market, the FOMC may provide moderate support for the USD.
BoJ narrows focus of NIRP to big institutions
The initial reaction to the BoJ policy statement on Tuesday was mild disappointment, weakening the transmission of the overall monetary policy easing measures.
The BoJ failed to make significant changes to either its asset purchases or its interest rates. This was the widely expected outcome, but there was some chance that it would further ease policy in light of ongoing evidence of a weaker economy since the beginning of the year, a lower inflation outcome, weaker inflation expectations, a stronger JPY and weaker Japanese stock market since the 29 January meeting.
The BoJ tweaked its NIRP to allow Money Reserve Funds (MRFs) to avoid paying negative interest rates. These are used by retail investors to hold cash balances. The BoJ said it was exempting these funds to help facilitate securities investment. The investment management industry had pressured the BoJ to make MRFs exempt, arguing that funds were being withdrawn from MRFs and this might in turn weaken investment in equities.
If this is the reason why the BoJ has exempted MRF then it might be regarded as simple fine-tuning of their January policy decision and of little consequence.
But it has led some to conclude that the commitment to NIRP is weak and thus the preparedness of the BoJ to push this policy further with deeper cuts into negative territory is less than it may have been in January.
If it genuinely does help facilitate domestic equity and other security investment, then this is a positive measure that might help support the overall policy easing measures. On the other hand, if it just gives domestic investors another safe place to park their cash without incurring an interest rate penalty (negative rate), then it hinders the overall policy easing.
Essentially the decision to exempt MRF reinforces the message that the NIRP is not intended for domestic retail investors. They can find ways to park cash without a penalty, and thus they have to genuinely fear inflation to force them to put that money to work in a way that might increase domestic demand and help boost inflation.
The NIRP is therefore mostly directed at large corporations and wholesale investors. To avoid negative rates, these institutions have to pull their money out of JPY deposits and either buy risker assets in Japan or deposits or other assets in other currencies. These institutions are likely to be more globally focused than retail investors. In this sense, Japan’s NIRP, is most clearly aimed at weakening the JPY.
Mis-firing NIRP highlights a reluctance to use FX intervention
A key problem with NIRP is that the BoJ/MoF have stood by and watched the JPY do exactly the opposite of what they implicitly intended the NIRP policy to do. The result is government and public dismay over the policy, global investor confusion and a sense of policy failure.
Japan appears to have signed up with its G20 counterparts not to engage in competitive devaluation, and as such is seen as very reluctant to intervene in the foreign exchange market. The BoJ probably hoped that NIRP would weaken the JPY and it would not have to call the MoF to request they help out and intervene.
Arguably there would have been no better time than in recent months for Japan to pull out the intervention card to reinforce the message from the NIRP move on 29 January. But they left that card in the deck, and as such have sent a message that it will probably not be played at all, at least not until it is the absolute last resort, by which time the JPY will be much stronger.
As a result the BoJ is left with taking rates even more negative in subsequent meetings to attempt to bludgeon the market into selling JPY. But it didn’t work the first time. In fact it mis-fired and JPY has been stronger since. Doubts that NIRP can work would surely intensify if it mis-fires a second time. Fearing criticism, the BoJ stood still on Tuesday like a deer stuck in the headlights of an oncoming truck.
Few other options than to cut NIRP rate further
There appears to be few other options at this stage than cutting NIRP further. It is already buying more than sufficient government bonds, it is hard to see what buying still more will do.
It could resort to buying other domestic assets in greater volume. It is buying small amounts of ETFs and REITs, but the size of these markets is small, and if it really wants to make a splash in this area it might have to get dirty and pour money into fund managers that directly buy equities, property, anything in significant volumes.
I would not put it past the realms of possibility that the BoJ, under Kuroda, could adopt such extreme measures, but the most likely course of action is that the BoJ cut their NIRP rate further.
I can understand why Kuroda kept the next NIRP cut in the bag this time. Politically, FX intervention does not appear to be a viable option. Therefore the risk of another backfire was high, and he could ill-afford that happening, his credibility could become irreparably damaged.
A problem Kuroda and the government face is that sanctioning intervention will aim foreign criticism squarely at the government for not doing more to introduce policies aimed at boosting domestic productivity and demand; putting some oomph into the third arrow.
By resorting to the NIRP policy, a policy that implicitly aims for a weaker exchange rate, it highlights the failure in Japan to reinvigorate domestic demand through BoJ asset purchases and government policy reform. It is falling back on a weaker exchange rate to boost export demand. But even that policy is faltering because the government is reluctant to sanction intervention.
Policy Quagmire threatens to boost JPY
Kuroda appears to be in a bit of a policy quagmire at the moment, the current trend is towards a stronger JPY, a signal that his recent switch to NIRP is not working.
The size, scope and timing of his next move is uncertain. He sorely needs more government support via both potentially more fiscal stimulus and structural reform and probably some willingness to play the intervention card. FX intervention itself will seem more viable and presentable to the G20 if the government is moving on fiscal and/or structural reform.
Fundamentally, I still see JPY as weak and expect serious further action by Kuroda and the realization to sink in that intervention may be required, along with more pronounced efforts to boost domestic demand from the government.
But I also see a wide degree of market confusion, creeping doubts over the capacity of Kuroda and the government, and USD/JPY that is in a downtrend. As such there is a significant risk that JPY strengthens further while we wait for pressure to build on Japan’s policy makers to get their act together.
FOMC may support the USD
As we approach the FOMC meeting this week, the USD is more buoyant, perhaps a sign that the market senses that the Fed may continue to project an upward trajectory for rates, especially now that much of the global financial markets uncertainty has eased.
The USD is broadly weaker this year, relieving some of the concern that a strong USD will hold back the US economy and dampen inflation.
Economic activity indicators have weakened this year compared to six months ago, but importantly unemployment has fallen further to already meet the Fed’s forecast long term neutral rate, and core inflation has risen more than expected.
In light of these data, the Fed is likely to retain at least two and maybe three of its projected rate hikes this year. In December, the Fed were projecting 4 hikes this year. They have effectively missed one already (presuming no change tomorrow).
The Fed may also reinstate its assessment in its policy statement that it sees “the risks to the outlook for both economic activity and the labor market as balanced.” This would be consistent with the Fed projecting at least two further hikes this year.
It is the normal state for the market to price in significantly less tightening than the FOMC projections. This has indeed been justified, since the Fed delayed its hikes throughout last year. And before that it began to unwind its QE policies later than originally projected.
Nevertheless, the market has backed off Fed rate hikes enough so that it appears some risk towards a firmer USD on the FOMC meeting tomorrow.