Richard Koo

EQUITY RESEARCH

May 21, 2013

Surge in long-term rates/talk of exit strategy highlight problems with quantitative easing
The surge in Japanese long-term interest rates between Friday, 10 May and Wednesday, 15 May probably caused some lost sleep among bond market participants and policymakers as the 10-year JGB yield climbed 34bp from 0.58% to 0.92% over the course of four days. Had this trend continued, it could well have marked the beginning of the end for the Japanese economy. Fortunately, interest rates settled down that Wednesday and fell back below 0.8% at one point. But as of 20 May the 10-year yield is still trading at 0.84%, which is higher than it was the preceding Thursday. I suspect the rise in yields has left market participants and observers alike much more cautious for the first time in years. Although the stock market has welcomed the yens continued slide against the dollar, this trend needs to be carefully monitored, as simultaneous declines in JGBs and the yen can be interpreted as a loss of faith in the Japanese government and the Bank of Japan. It is also worth noting that small-cap equities and REITs both fell in tandem with government bond prices during this period. Overseas, meanwhile, a major debate on an exit from quantitative easing by the Fed and the Bank of England seems to be starting in the US and the UK. The IMF has also released a paper discussing the costs of this exit, and I expect the discussion to become more active going forward. Sharp rise in JGB yields despite BOJ easing is cause for concern The rise in Japanese government bond yields that began a week ago last Friday has been attributed to a number of factors. Of primary concern is the fact that it happened at a time when the BOJ was buying large quantities of government bonds. Until the recent events there was an expectation in the JGB market that bond prices would not fall substantially even if the Banks aggressive easing program depressed the yen and lifted inflation expectations as long as the BOJ remained a major buyer. The BOJ also argued that, like its counterparts in the US and the UK, it was trying to prop up the economy by lowering long-term interest rates with the purchase of longer-term JGBs. But when the Bank actually started buying these bonds in quantity, interest rates did not fall. In fact, they rose, with the initial rise in rates in the 5-year portion of the curve pushing even mortgage rates higher. This was initially attributed to poor management of operations by the BOJ where it failed to inform its intentions at the short end of the market. But the events beginning a week ago last Friday occurred in the long-term sector and showed that even large-scale BOJ purchases of JGBs cannot stop yields from rising.
Richard Koo is chief economist at Nomura Research Institute. This is his personal view.

Richard Koo r-koo@nri.co.jp

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Japanese version published on May 20, 2013

See Appendix A-1 for important disclosures and the status of non-US analysts.

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May 21, 2013

Bond vigilantes One possible cause of the rise in JGB yields is the bond markets role as economic policeman. As soon as signs of inflation emerge in the economy, bond prices drop and long-term interest rates rise, cooling off the economy and putting a damper on inflationary pressures. The same is true of deflation. When prices start to fall, bond prices rise, lowering longterm interest rates and providing support for the economy. That is an accurate description of conditions in the JGB market over the last 20 years. From this perspective, nearly all past inflationary episodes prior to the 1980s happened when the government bond market and interest rates were still under government control (e.g., Regulation Q in the US) and the bond market was unable to act as policeman. This role emerged as interest rates were liberalized around the world in the 1980s and beyond, and as a result both the incidence and severity of inflationary episodes declined sharply. Higher inflation expectations inhibit banks from lending at low rates The Kuroda BOJ started off by declaring it would generate inflation with aggressive monetary accommodation. But financial institutions that believe that pledge will find it difficult to lend money at todays low interest rates. At a time when the BOJ is declaring it will use all tools at its disposal to lift the inflation rate to 2%, holding 10-year bonds that yield only 0.6% will lead to massive losses. Hence banks sell bonds, which pushes yields higher, slowing the economy and restraining inflation. That is why the bond market is called an economic policeman. Financial markets quicker to react than real economy The financial markets are far quicker to react than the real economy. If a businessman on Main Street sees inflation on the horizon and thinks it might be a good idea to purchase real estate or equipment, it takes time to decide which property or machine to buy and then obtain the necessary funding. In the world of finance, in contrast, it takes only a few minutes for an investor who senses inflation on the horizon to sell her JGB holdings. The implication is that the JGB market could plunge and send interest rates sharply higher in a short period of time if people actually start to believe that Mr. Kuroda will use any and all means available to create inflation. Inflation does not ordinarily precede recovery Long-term interest rates typically rise during an economic recovery. But in Japans case we are not seeing inflation concerns arise as a rebounding economy approaches full employment. Instead, the government and BOJ have decided to set an inflation target, generate inflation first, and hope that recovery follows. This means the usual order of things has been reversed, with inflation coming first and recovery second. In this case the increase in long-term rates in response to inflation concerns is likely to occur much sooner than it ordinarily would and may even take place before the recovery takes hold. If the rise in long-term rates precedes the economic recovery, people who had planned to borrow money and invest it in anticipation of inflation could start to have second thoughts, throwing a damper on the nascent recovery. Rising JGB yields could also hamper banks ability to supply funds In Japans case, moreover, the arrival of higher long-term interest rates prior to recovery could lead to large losses for the financial institutions holding large JGB portfolios, with the resulting shortage of capital crimping their ability to lend. Losses on banks bond portfolios could prevent them from lending by causing an impairment of capital ratios. Funds supplied by the BOJ under the new easing regime would then remain in the banking system, further clouding the prospects for recovery. In the traditional pattern, whereby long-term rates rise only after the recovery takes hold, private-sector demand for funds is lifted along with the economy and provides a boost to

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bank earnings, so there are earnings to defray losses in banks bond portfolios caused by rising rates. But that is not the case when the order is reversed. Rising long-term rates will also affect share prices On this point, the higher share prices that have resulted from the weaker yen will provide a significant cushion to offset potential losses coming from banks bond portfolios. But a material rise in long-term interest rates could also weigh on share prices. The portion of the recent stock market gains that is attributable to improved corporate earnings via the weak yen is justified over the long term with the argument that a strong currency is not likely soon for a nation already running large trade deficits. The problem is that some of the recent gains cannot be justified by the weak yen alone, and these could evaporate if long-term interest rates rise. Advance rise in interest rates could bolster calls for austerity The potential ramifications of an early increase in long-term interest rates go beyond financial institutions to include the government. In an ordinary recovery, inflation concernsand the corresponding rise in long-term ratesemerge only after the real economy is in recovery. The rise in tax revenues from the recovery is then capable of offsetting the governments increased debt service costs. In the present case, however, the Japanese authorities are trying to generate inflation first and then hope for recovery, which means debt service costs will increase before tax revenues do. Such a state of affairs could easily lead to calls for early fiscal consolidation given the size of the nations public debt. Austerity + shortage of borrowers would break the recoverys back Such calls are already being heard in the media. But the reason the BOJ is engaged in quantitative easing in the first place is that the private sector refuses to borrow money and continues to save in spite of zero interest rates. The government has prevented the economy from entering a deflationary spiral by running fiscal deficits and serving as borrower of last resort. If rising rates prevented it from playing that role any longer, there would be significant ramifications for the economy. In other words, an increase in long-term rates would prevent the deployment of fiscal stimulusthe second component of Abenomics. Stopping the government from borrowing the 8% of GDP that households and businesses are saving at a time of zero interest rates could easily lead the economy back into recession. Kuroda succeeded in fostering inflationary expectations Businesses and households have until now refused to borrow money in spite of zero interest rates. The lack of borrowers means the money multiplier is negative at the margin. This means, no matter how much liquidity the central bank supplies, the liquidity remains within the confines of financial markets and is unable to contribute to either economic recovery or inflation. But by unveiling what could be called a reckless program of monetary accommodation, Mr. Kuroda has succeeded in persuading the media and the general publicwho are unaware that the money multiplier has turned negative at the marginthat inflation might just be on the horizon. Pundits in the media, and especially on television, have devoted a great deal of attention to the subject of inflation, and the more people hear about it the more they are inclined to believe it, even if it is not true. As a result, even those who were reluctant to borrow money are starting to take a more positive attitude. Of course some of this change is also attributable to the rising stock market, something made possible indirectly by Japans trade deficits, which have prompted the G7 and G20 to tolerate a weaker yen in spite of their past opposition. Long-term rates may rise before real economy recovers Repairs to Japans private-sector balance sheets have already been completed. That businesses and households still refused to go into debt can be attributed to the trauma of struggling to pay down debt for 15 years. This was not a problem of being unable to

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take out new loans because of excessive indebtedness, but was instead a psychological issue. Mr. Kurodas psychological tactic of repeating a lie often enough that it becomes the truth has succeeded brilliantly. The problem is that it works on lenders as well as on borrowers. Moreover, borrowers are agents in the real economy and need time to react, whereas lenders are financial sector entities that can respond instantaneously, creating the possibility that lenders will react sooner than borrowers. The fact that the BOJ has also reversed the traditional order of things and is trying to spark an economic recovery by generating inflation has increased the possibility that higher long-term rates driven by inflation concerns will emerge sooner than higher longterm rates rooted in a recovery in the real economy. Time inconsistency problem hangs over BOJ If we refer to higher interest rates driven by an economic recovery as a good increase and higher rates sparked by inflation concerns as a bad increase, I think there is a significant possibility that the latter will emerge first in this case. That would not only weigh heavily on the first shoots of private loan demand to arise in a long time but could also focus attention on the banks and the governments financial health, damping the positive momentum in the economy and markets seen over the last four months. This kind of contradiction in timing is called the time inconsistency problem, and it will continue to hang over the policies of the Kuroda BOJ. Implications of lack of synchronicity with private investors The recent rise in rates appears unlikely to have any lasting effects, but the fact that it happened at a time when the BOJ was buying JGBs in such large amounts is cause for concern. It showed that once inflation concerns start to emerge the BOJ will be unable to restrain a rise in yields no matter how many bonds it buys. Investors seeking to profit by shorting Japanese government bonds may see this as an opportunity. It is well known that past efforts by US and UK hedge funds to short JGBs have failed spectacularly. The reason was that falling government bond yields during a balance sheet recession do not signal a bubble but are a natural result of the absence of private sector borrowers, which causes funds to be channeled into the government bond market. In other words, hedge funds did not realize that this was a good decline in rates. BOJ could be providing opening for short-sellers This time, however, the financial authorities themselves have said they will use any and all means to generate inflation. The risk is that this has altered the market structure of the past two decades, in which unborrowed private-sector savings flowed into the government bond market, and contributed to the rise in JGB yields since 4 April. For the last decade, the BOJ had no need to fear inflation because the money multiplier was negative at the margin. As such, it could respond to hedge fund short selling of JGBs by orchestrating short squeezes with almost unlimited buying. But the recent rise in interest rates in spite of heavy BOJ buying suggests the BOJ may no longer have that capability. That may prompt some investors, flush with profits from the yen and Japanese stocks, to set their next sights on the JGB market. Question of how to contain bad rise in rates is critical Prior BOJ governors and staffers were all concerned about these issues. Now that the Kuroda BOJ has put the new easing regime into practice, the issue is how to control the risks.

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Mr. Kuroda himself says that the accommodative policies have just been launched and that this is no time to be worrying about side effects or exit strategies. However, interest rates have already begun to rise, and in a nation where a bad increase could emerge before a good increase, the authorities should start preparing for such an eventuality now. BOJ needs to declare it will not tolerate overshooting of inflation What can the BOJ do? To begin with, the Bank and the government could make it clear that they are targeting a 2% rate of inflation but at the same time, they will not under any condition tolerate a significant overshooting of that rate. The Bank of Japan has built up an enviable record as an inflation fighter over the past 30 years and in the process won the publics trust. Accordingly, I think such a declaration would still carry a lot of weight. By stating that they will not accept an overshooting of the target, the Bank of Japan and the government could reassure the markets that there will be no plunge in the yen and no bouts of uncontrollable inflation. I think the risk of a sharp rise in long-term rates will also be significantly reduced if the BOJ can successfully communicate these points to the market. The yens rapid declinewhich contributes directly to inflationand stocks sharp rise in recent months has raised the possibility of such an overshooting. I think it would be appropriate for the BOJ to consider adjusting the pace of easing going forward in response to these unexpectedly quick improvements. I think it is also important for the Abe administration to dispel the perception that its scenario for economic recovery is heavily dependent on BOJ policy by placing greater emphasis on the second and third components of Abenomics. If the government is seen as relying excessively on monetary policy at a time when everyone recognizes that the second and third components are essential for a longer-term recovery, the whole enterprise could be stopped in its tracks once monetary policy is perceived as having run up against the wall because of a rise in long-term rates, etc. And if the Abe government is seen as taking the position that there is no need to pursue the politically difficult second and third components since monetary policy has been so effective thus far, the investors who have led the stock market higher could quickly and collectively become sellers. Once the second and third components are in place, the positive developments in the broader economy will continue even if a rise in long-term interest rates hinders the effectiveness of monetary policy. Growth strategy must also be bold and inventive From this standpoint, the growth strategy that was partially unveiled by Mr. Abe in a speech on May 17 was a step in the right direction but lacks the punch needed to drive the broader Japanese economy. It is not possible to perform a proper assessment given that the overall vision and the detailed components of the plan have yet to be announced. But what we need now are the kind of bold measures that would make observers stand back in awe, much like Mr. Kurodas initial announcement. It is my hope that the strategy will contain such measures by the time it is officially announced in June. Active discussion of costs and benefits of quantitative easing in US and UK Shifting our attention away from Japan, we are seeing active discussion of an exit from quantitative easing policies in the US and the UK in spite of their much higher unemployment rates. Discussion has been driven by the fact that both economies have stabilized to some extent along with concerns that continued use of quantitative easing will lead to unfavorable side effects that outweigh the policys benefits. The IMF recently released a report titled Unconventional Monetary PoliciesRecent Experiences and Prospects and dated 18 April (the online version was published on 16 May). The report argues that quantitative easing was the right way to respond to the financial crisis but that it had only a limited impact on the macroeconomy and, moreover, that this impact has diminished over time.

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This is consistent with the argument we have been making for a long timethat quantitative easing is an effective and essential response to lender-side problems, such as a financial crisis, but can do relatively little to address the borrower-side problems seen in a balance sheet recession. Conclusion: difficult to determine impact of quantitative easing The report claims that quantitative easing has had some macroeconomic impact, but says it is difficult to determine precisely how large an impact since a lack of data makes it impossible to estimate the base-line scenario (with no quantitative easing) using the Funds econometric models. I think the IMFs acknowledgment that it cannot provide a base-line scenario and therefore cannot estimate the impact of quantitative easing represents progress, but the report does not attempt to analyze why the economy did not improve when central banks took rates down to zero or why central banks were forced to engage in quantitative easing in the first place. In that sense, I do not think the IMF fully understands the importance of the fact that these countries are in balance sheet recessions, with private-sector borrowers paying down debt in spite of zero interest rates. This lack of understanding is also underlined by the following passage: A key concern is that monetary policy is called on to do too much, and that the breathing space it offers is not used to engage in needed fiscal, structural, and financial sector reforms. Conventional monetary policy has lost its effectiveness because private-sector borrowers are no longer borrowing in spite of zero interest rates. If the government renounces its role as borrower of last resort under fiscal reform at a time when the private sector is also not borrowing money, GDP and the money supply can spiral downward in a repeat of the Great Depression of the 1930s. Unfortunately, the IMF researchers who demanded fiscal reform in this report seem unaware of this risk. Exit from quantitative easing likely to be a bumpy ride Be that as it may, the reports central argument is that the exit from quantitative easing is likely to be a bumpy ride. The IMF economists even estimated the extent of central bank losses on government bond holdings in the event of a normalization of economic conditions. For example, they estimate that an event similar to 199394, when the Fed began normalizing monetary policy by raising the policy rate from a starting level of 3%, would generate central bank losses equal to 2.04.3% of GDP in Japan, the US, and the UK. These represent capital losses on the government bond portfolios of the central banks that are likely to result when interest rates normalize, sending bond prices sharply lower. These losses also represent a one-time fiscal burden on the governments involved, since they reduce the central banks payments to the government and hence the governments revenues for that year. BOJ losses could climb to 7.5% GDP in worst-case scenario In 1994 the Greenspan Fed raised the federal funds rate from 3%, then a postwar low, to 4.5%, which pushed the 10-year Treasury yield 200bp higher in what was described as a bloodbath in the bond market. Today, the central banks must not only raise short-term interest rates but also mop up excess reserves amounting to 16.3x and 9.9x statutory reserves in the US and UK, respectively. Moreover, the only assets central banks can sell to absorb those reserves are long-term government bonds. This process will almost certainly be a difficult one for long-term bond markets in all of these countries. Although the excess-to-statutory reserve ratio currently stands at about 5x in Japan, it will rise to 18.7x if the BOJs new easing program is carried through to completion. The IMF report also contains estimates of what would happen in the event that central banks exit strategies failed, triggering a loss of confidence in the central banks and their currencies. In Japan, where the central bank is attempting the most aggressive quantitative easing program of any of the three countries, the IMF estimates that losses would rise to 7.5% of GDP.

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This amount would be added to the Japanese governments already severe fiscal deficits and could potentially create a serious fiscal problem for the country. Emphasis needs to shift quickly from monetary policy to fiscal policy and growth strategy The IMF defines a failed exit strategy as a delay in the removal of the policy that leaves the authorities behind the curve. This kind of situation can be avoided by bringing quantitative easing to an early conclusion. In Japans case, doing so could also reduce the possibility of a bad rise in interest rates emerging first. With even the IMF declaring that countries with quantitative easing programs have a bumpy ride ahead as they seek to navigate an exit, the Japanese government needs to shift the focus of its economic strategy as quickly as possible from monetary policy to the second and third elements of Abenomics. The US and the UK also face similar challenges. Quantitative easing: easy to start, scary to end The scale of the potential losses suggests that quantitative easing, while easy to initiate, can be scary to bring to an end. It is therefore important that the authorities move quickly and decisively to ensure they do not fall behind the curve. The first round of quantitative easing at the Fed (QE1) was similar to the Bank of Japans quantitative easing program from 2001 to 2006 in that all operations were conducted in the short-term money market, making them easy to wind down. The dismantling of Japans quantitative easing program in 2006 therefore went surprisingly smoothly. However, the Feds subsequent QE2 and QE3 and Japans recently announced new dimension of easing are conducted with long-term government bonds. This has the potential to create a great deal of turmoil in the market, as the IMF notes, when the programs are discontinued. I think it is important that Japan quickly prepare the second and third elements of the economic program, reduce the dependence of its economy and markets on monetary accommodation, and create an environment conducive to the dismantling of quantitative easing so as not to fall behind the curve. The same can be said of the US and the UK.

Richard Koos next article is scheduled for release on 4 June 2013.

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