NN IP: Japan - The costs and benefits of Yield Curve Control

It has now been more than year since the Bank of Japan (BoJ) switched from “pure” QE, i.e. having a target for the quantity of government bond (JGB) purchases, to Yield Curve Control (YCC) which is essentially a price target. As we argued before, this policy acts as an amplifier for positive growth shocks. This holds in particular for accelerating global growth which causes global safe Treasury yields to rise and for Japanese fiscal easing. The essence of the mechanism is that by keeping nominal yields fixed, these shocks reduce real yields which leads to a better growth momentum which, in turn, reduces real yields further. Yen deprecation is an important part of this story. The BoJ intends to continue using this instrument until it will have achieved a persistent inflation target overshoot. This is not to say that the 0-10yr yield curve will maintain its current slope of 10 bps until then, nor does it imply that the 10yr yield target will remain at 0%. Japan does not operate in a textbook environment but rather in the real world where there are also potential costs attached to the use of YCC. In fact, it was precisely the potential costs stemming from the previous main instrument of choice, “pure QE”, which triggered the switch to YCC in the first place. Maintaining QE at JPY 80 trillion per year could cause the BoJ to run into scarcity constraints at some point. What’s more, the low and flat yield curve could put financial sector business models under stress. This may at some point spill over into a contraction of credit supply or a drag on consumption as households start to doubt the viability of their savings products. The BoJ solved this by adopting a price target which enabled it to scale back purchases to around JPY 50tn currently (once again, the JPY 80tn promise is still there but it is an incredible promise now). What’s more, in doing so the BoJ also allowed the very long end of the yield curve to steepen which increased the profitability of life insurers and pension funds. 

However, it appears that YCC also has potential costs attached to it and in principle the BoJ should continuously weigh them against the benefits. If the costs become dominant in this comparison, it may be optimal to raise the 10yr yield target and/or steepen the 0-10yr curve even if the BoJ should remain on hold from the perspective of achieving the inflation target within a reasonable time horizon. In negative policy rate space there has been much talk about the “reversal rate” which is simply defined as the (negative) level of the policy rate where the marginal benefit of a further reduction is equal to the marginal cost. This reversal rate could well rise over time because the costs attached to negative rates in terms of corroding bank profitability can rise in a non-linear fashion over time. Of course one can extend this principle to YCC and apply it both to the slope as well as the position of the 0-10yr yield curve. Identifying or classifying costs and benefits is not always easy. A prime example here is yen depreciation. In principle, the ability of YCC to trigger yen depreciation is one of its prime benefits because it stimulates net exports and corporate profitability. However, beyond some threshold (determined by the speed and/or size of the depreciation) there could be substantial costs involved as well. One such cost is the reduction of real wages due to the fact that nominal wage growth is very sticky. Another cost could be a political one as too much yen deprecation could fuel trade tensions with the Trump administration.

A more unequivocal potential cost of YCC is its potentially detrimental effect on parts of the financial sector and as a result for overall financial stability. The most endangered species in Japanese financial space in this respect are its roughly 500 small financial institutions. None of them is systemically important individually, but they might be systemic as a group nonetheless. The key issue is that the 0-10yr bucket of the JGB curve is the main source of profit margin for these banks. Because this part of the curve is extremely flat, this margin has been very low for quite a long time, even though it used to be even lower between early 2016 and September 2016. In principle this can be offset to some extent by higher lending volume growth, which is a function of nominal GDP and the combination of YCC and fiscal easing is of course instrumental in putting the latter on a persistently steeper trajectory. 

What’s more, in the medium term a sustained better nominal growth performance is absolutely essential for the whole yield curve to move up and steepen. In addition to this, strong nominal growth will reduce the share of non-performing loans on the balance sheets of these institutions. Still, there is a chance that small banks will not survive that long. The issue was raised by BoJ Governor Kuroda in a speech in November where he paid quite some attention to it. Subsequently, it was discussed by Board Member Nakaso who said that the Japanese financial system is robust to  a Lehman kind of shock but that “chronic pressures on profitability” could over time still threaten the viability of financial sector business models. That having said, the capital basis of Japanese banks still looks pretty solid at this point in time. The issue is thus that for small banks it could potentially be steadily eroded as long as the short end of the curve remains in its current position.

Could financial stability concerns lead to an early hike?

As a result of all this, some pundits have started to toy with the idea of an early 10yr yield target hike or steepening of the yield curve in 2018. By early we mean before underlying inflation has convincingly increased to around 1% so that real yields can be kept at -1%. A complicating factor here is that the issue is partly structural, i.e. in view of the decline in population growth and the number of firms Japan in a sense has too many small banks. In that sector fierce competition has caused the spread between lending and deposit rates to become increasingly squeezed. In response to this, many of those banks have adopted the short-term bucket of the JGB curve as their main source of income. In the long run, the small bank sector clearly needs to shrink which would also be good for overall Japanese productivity as labour and capital can be released from this sector and deployed in more productive sectors. Still, a massive wipe out of small banks in a short period of time could clearly send shockwaves throughout the entire financial system. Structural and governance reform in the banking sector is therefore clearly called for. 

This structural problem in the small bank sector thus cannot be solved by monetary policy but the latter still has the potential to trigger widespread bankruptcy. As a result, the BoJ does face a potential trade-off between price stability and financial stability. The question is of course how the BoJ will handle this issue. First of all, the explicit attention given by Kuroda to this issue may also have a political component. After all, Kuroda is up for re-appointment and his main rival, Honda, is even more dovish than him. Honda belongs to the “monetarist camp” which effectively wants to increase the pace of money printing until sufficient traction on nominal GDP is obtained. Needless to say that such a dovish shift would be bad news for Japanese small banks. In short, Kuroda probably wants to position himself as the man who carefully weighs all costs and benefits and is firmly focused on the BoJ’s twin mandate of price and financial stability. Assuming that Kuroda remains BoJ Governor (very much our base case) we believe the game plan is to stick to the current slope and position of the yield curve until 1% inflation is reached sustainably. 

In this respect, we emphasize again that sustained reflation is ultimately absolutely necessary for bank profitability via a move up in the yield curve and support for lending activity and the quality of the loan book. Maybe, the BoJ will get lucky in 2018 and inflation may finally surprise on the upside. The labour market is pretty hot and even though businesses are dealing with that primarily by investing in labour saving technology, at some point they cannot escape wage increases. Also, the government is applying moral suasion and tax incentives to induce companies to spend some of their excess cash on higher wages. If (wage) inflation surprises on the upside, we could see a change in YCC in the second half of 2018 which will bring relief to small banks. On the other hand, if inflation does not pick up strongly, we believe the BoJ will remain on hold as long as there are no signs of additional and substantial pressure on the small bank sector. H1’18 will also be crucial here because at the end of Q1 we get new information about the balance sheet quality and profitability of the small banks. If the BoJ is forced to adjust YCC in response to a substantial deterioration in this respect it will be in the direction of steepening the yield curve. What’s more, the BoJ will then be at pains to communicate it is a one-off adjustment aimed at financial stability to prevent excessive yen appreciation. Still, given what we know now about the health of small banks, an early change to YCC aimed at financial stability is not our base case.

The absence of forward guidance can be confusing

The fact that the cost-benefit trade-off of YCC is clearly on the mind of investors was illustrated this week by the market reaction to what was essentially a technical monetary policy adjustment. The BoJ reduced its purchases in the long end of the curve (beyond 10 years) perhaps because it wants that part of the curve to steepen somewhat. As we argued before, this will help the profitability of life insurers and pension funds while the macro cost is limited because the majority of private sector borrowing takes place against relatively short-term lending rates. This caused the kind of sell-off in 10yr JGB yields and degree of yen appreciation one normally sees around monetary policy meetings where new information about the future monetary policy stance is signalled. 

The most important conclusion from this is that the market has difficulty in distinguishing between true policy signals and noise created by operational adjustments. Other central banks attempt to mitigate this problem by providing some form of forward guidance, which helps to anchor expectations about the future policy stance. However, the BoJ does not provide any forward guidance about its YCC policy in general or how it would strike the afore-mentioned cost-benefit trade-off in particular. We believe it would be helpful if the BoJ explained under which kind of circumstances in terms of the trend in underlying inflation and the outlook for financial sector stability it would consider raising the 10yr yield target and/or steepening the 0-10yr curve. In the absence of such guidance, “mini taper tantrum” events such as the one seen on Tuesday 9 January could well occur again in the future.