The Japanese Grand National.

The BoJ delivered, and then some. TMM has been fairly positive on the reflation story for Yen-denominated assets all along, but even TMM is pleasantly surprised. With a unanimous vote behind an ambitious act of policy, Kuroda has at the very least pushed back any scepticism that BoJ policy will be timid.

TMM feel that there are two questions here and it may be helpful to clarify that ahead of time:

A) How will the BoJ policies affect the actual economy?
B) How will the BoJ policies affect investor perceptions, and through that, asset prices?

For A) TMM think the question could be framed as the battle between expectations and declining real demand with the expectations channel being the main channel by which the BoJ hopes to succeed. Creating base money, even lots of it, hasn't worked, as we know and a 50bp decline in 10y rates is arguably not SUCH a big deal. And now it can't fall much further.

As it's the weekend of the UK "Grand National", the most gruelling of horse races noted for its number of fatalities, perhaps we should consider the policy as the course, the Japanese economy as the horse and growth as the finish. The BoJ has chosen a course to growth that goes via "Inflation" so let's have a look at the course and fences -

1) Force inflation to rise through a decrease cost of money relative to goods which compounded by (2) an FX driven rise in imported goods costs should create within the populace (3) an expectation of inflation to continue rising and therefore (4) a propensity to spend now rather than later. Combined with a (5) negative real interest rate this will push a move from (6) saving to spending and should drive local demand and (7) increase investment domestically and so lift growth.

As per our Non-prediction number 1 at the start of the year we see this policy ultimately working and the expectations of it working yielding profits for long inflation trades this year. However the true measures of success are going to be a long way down the line and probably only visible once 5 minute macro has moved on to fight other wars.

The processes laid out in our yearly non-predictions are clear, however and here we invoke that classic Japanese "however" clause. TMM know that Japan occupies a part of the financial universe that is far enough away from the normal universe not to share the same rules of economics. Before you cry out in horror perhaps we should apply a caveat. Japan does share the same rules of economics but the cultural and demographic overlay applied to those same rules means that the paths to predicted outcomes are not as straightforward and definitely not as efficient as others we know. So where as we may expect some obvious results to occur when an inordinate amount of freshly printed money is thrown at an economy, things are different in the land of ZIRP where the culture is to save, particularly offshore, and not to spend (c.f. Western culture and media programming of today's young). If normal economics are Newtonian physics, then Japanese economics is what happens at the event horizon of a black hole.

So let's have a look at the fences.

1) The cash injections are indeed huge and as a proportion of GDP, dwarf the US actions. On this basis alone decrease in the cost of money through the huge cash injection will dilute the money/goods ratio. But global connectivity spreads the flood increasing liquidity everywhere just as the US actions did. The melting of the Greenland ice sheets means sea levels in New Zealand rise a bit. Japanese banks may be queuing outside the study of the BoJ ready to have their orders to lend spelled out to them, but TMM wonder how much of it will ultimately remain domestic as the real demand for credit is in the West "Roll up, get your cheap funding here", rather than within a domestic culture that saves rather than borrows. The flow out of yen to achieve this moves the affect to FX (2). We are already seeing the liquidity tsunami with Japanese lifers hoovering European bonds at the expense of JGBs. Check France / Japan 10 year spreads today. (Note - remind Eurogroup to write thank you letter)

2) FX driven inflation tends to be a one off shock, unless you can get your currency to crawl lower but then the incremental moves are just smaller. It's all good, but do it too much and things start getting bad quickly, either due to a lack of investor confidence or trade partners setting up tariffs. FX driven inflation can be seen as the wrong type of inflation if it doesn't drive wage demands higher but locally stifles purchasing power.

3) Expectations of inflation rising will most probably first be seen through the FX function, which as we said could be transitory (unless this goes Weimar). So once the FX starter motor of inflation expectation is done a continued domestically driven inflation has to take over. As with the west this will have to be associated with wage inflation which we know can be extremely stubborn and culturally even more difficult to kick off in Japan.

4) Propensity to spend now rather than later. If, as we gather, the BoJ is hoping to increase inflation in the service sector we wonder how increases in inflation expectations will increase demand, as most services are not hoardable. A consumer who anticipates the cost of haircuts going up cannot go and get his hair cut 20 times now in order not to have any later. The same applies for most of the service industries that we can think of. Entertainment, accountants, lawyers, medical services, transport, maintenance - it's all time spaced. So what do you do if you are a consumer who thinks inflation is going to go up. You don't buy tech as that depreciates faster than jpy can. Once you have bought a car a year early, and the furniture you were putting off, maybe had a holiday, there is little else apart from putting on financial hedges. Property? Japan considers property as a depreciating asset and "An unusual feature of Japanese housing is that houses are presumed to have a limited lifespan, and are generally torn down and rebuilt after a few decades, generally twenty years for wooden buildings and thirty years for concrete buildings" and is taxed as such. However this could imply that the price of the land that they are built on rises.

5) Real rates are very important to the investor as a measure against returns, but TMM would suggest that to the man on the street the cost of a loan on something he isn't going to sell again (so won't consider for asset growth - see furniture, household stuff) is the cost of loan against how much more he thinks he will earn in the future. Wage inflation rather than CPI. So if wage inflation stays flat (as it has in the UK) then his real interest rate will not be negative. This is where the investor, who is always looking at resale value is very different to the consumer, who as a "consumer" by definition won't have anything left to sell on.

6) And where do they save? Overseas where the yields are and you are hedged against the expected FX driven inflation. BoJ policy change does not remove the incentive for Mrs Watanabe to borrow locally and buy Aussie bonds. It may even increase it.

7) Domestic investment will react to FX moves as wage costs become more competitive. We see no problems with this last fence. In fact once this occurs the finish line of growth is clearly insight. We just have to hope that all the other fences have already been cleared.

We will not know the result of this race for a few years but market punters are piling in to the bookies backing their horses .

So where is the money is going? Or our question B)

Looking ahead, TMM reckons that the BoJ is probably done for a few months, as it watches to see the results of its announcement today. The next step for the markets is likely to be dependent on the evolution of retail inflation expectations. This will all take time to properly assess, but in the meantime, there is little (at least domestically) that stands in the way of a continuation of recent trends.

With respect to the Nikkei, it's a bit like 1999 internet stocks, to the point that we could say that stock prices are showing stronger inflation expectations that anything else. But this is from the investment community, not the man on the street. TMM also have their money on Nikkei but not at these prices. We would like to see the 5 minute macro crowd get bored, get washed out and then join for wave two. We are acutely aware that were it not for the BoJ action equity markets would be on an even clearer downward move.

FX - We are also of the opinion that jpy has to depreciate. Either through first round liquidity transfers (as seen above) or second round inflation rallies (if they get them) moving faster than growth pushing real yields even lower.

JGBs - "The Battle of Kyle Bass". The huge JGB purchase program from the BoJ will see leakage as domestic JGB holders diversify for yield and currency fears. But this probably leaves a curve trade in play, short the short end for rate differentials (European spreads) against long the longer end for continued government QE purchases and as it becomes more apparent that this is a long race and that policy will not have the swift response that some are trading on.

In summary, the BoJ may have muddled causality and correlation and mistakenly picked inflation as the waypoint on its GPS route to growth. Its problems are demographic and a shorter route to growth, rather than the monetary response, may be the UK "Gordon Brown" response. Encourage immigration to rebalance both the demographic imbalances and maybe even some cultural ones.

However the monetary race has begun and it is a tough course.
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23 comments

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Anonymous
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April 5, 2013 at 2:32 PM ×

entire onshore AM industry 10% decrease in JGBs allocation vs foreign fixed income, keeping everything else constant (inc. overall bonds/equity allocation) would be easily absorbed by BOJ purchases. though for sure yen negative - as BOJ intends.

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Anonymous
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April 5, 2013 at 4:20 PM ×

C Says
I was most interested in the concluding para re immigration. Often thought perhaps the Japanese are simply a bit too 'tribal' to go that route and resolve at least some of their demographic issues.

MY favoured historic solution was always the WillyMeter. In essence this measured and invoiced the govt for each bout of unprotected sex with an annual bonus for actually producing something by way of output. Not only would the increasing levels of sex have produced a far happier nation. Bby now they would have also had new wave of young adults ready and willing to go.Unfortunately, few seem to want the longer term policy options.The short term invariably seems more attractive and aligned to terms of govt office.

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Anonymous
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April 5, 2013 at 10:02 PM ×

Adopt a Nordic model with child benefits and free day-care. Give each family a substantial one-time bonus for each newborn child. Free education from cradle to grave. Massive ad campaigns to change the attitudes.

Fund it all with printed money.

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Anonymous
admin
April 5, 2013 at 11:37 PM ×

Excellent post thank you. My understanding is that the vast majority of any population growth in Japan is from younger Japanese who have moved abroad only to realize they prefer the comforts of home. I guess the California Roll never quite cut it.

But while the larger countries export and import their QE back and forth, are there specific short opportunties form smaller Asian exporters? And does mutual debasement world suck in everyone but the Bhutan?

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Fatboy
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April 6, 2013 at 1:46 AM ×

How mant srarving and cold Japanese will this policy bring on? The bottom could easily drop out

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theta
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April 6, 2013 at 9:21 AM ×

Regarding the JGB trade, isn't the curve significantly flatter in Japan than anywhere else in the developed world?

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theta
admin
April 6, 2013 at 9:44 AM ×

On another note, Japan seems to be a template ( yes, I used the t word, and no, I'm not Dutch) for where things are going in pretty much the whole developed world. People seem to be worried about both the GDP decline and the population decline (to the point of suggesting attacking both "problems" with one strike - start reproducing - as a previous comment said). But what's the point of increasing both the numerator and the denominator? is there any benefit in the living standards (even approximated by GDP per capita)? And from a more general point of view, in the absence of a huge technological breakthrough, real GDP growth seems to come from population growth, which doesn't do anything for living standards of the increased population. Most of the developed world has lower population growth (most of it from immigration anyway) whereas the developing world has higher, which increases its GDP more, but it didn't really increase its population's living standards. If civilization/technical progress has reached a point where additional progress is qualitative, i.e. better smartphones/services rather than more stuff, and people everywhere start having fewer kids, like most westerners do, it would seem reasonable to expect global GDP to remain flat and people still prosper and progress. I don't think that Japanese people are worse off today than twenty years ago in terms of living standards etc. even on a relative basis compared to the world average. So why do we still have this obsession with GDP growth?

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Polemic
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April 6, 2013 at 10:18 AM ×

Theta - Re jgb curve .. whatever. That question is swamped by the q you ask about GDP. I totally agree with you. Totally. Its back down to Benchmarks are bollocks. And more importantly - pick the right benchmark. Targeting population comfort via GDP via inflation makes some massive assumptive links.
This need for growth (which we assume must be population led if all else fails) smacks of the demographic Ponzi schemes that pensions rely on which then leads us to Malthusian consequences.
I am with you. If you want lifestyle improvements, or just to maintain what you have, target that. Not some mismatched benchmark. And before you ask. No I don't know which current number I'd pick instead!

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Polemic
admin
April 6, 2013 at 10:25 AM ×

And while we re at it, its about time money supply figures (or where they are used) included all assets that that have effectively become money these days- Whatever new bubble people pay each other with. shares, property, bitcoin, mobile phone credits, etc

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Anonymous
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April 6, 2013 at 10:29 AM ×

C says
I understand "Friday was a heartbreaker for bears"?
No,not at all imo. Only fools were in there betting it all on a huge slide.The bid held up much better than I thought it would,but even had it gone I would still have been expecting dip buying.Tops take time to form and by the time they have formed they have done so eroding breadth of support and that is what I am still watching.

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Anonymous
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April 6, 2013 at 10:38 AM ×

C Says
Pol,
Years ago I was in a very deep discussion with someone about inflation.I recall being ridiculed when I said that inflation was not being measured accurately if it focussed predominantly on simply the pricing of consumption. That in fact since we started building eocnomic activity (GDP growth) based primarily upon monetary expansion it should also account for asset price inflation otherwise we were only partially measuring true inflation.
You would have thought all of this was blindingly obvious by now given events of recent years.

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Polemic
admin
April 6, 2013 at 11:52 AM ×

Yes C , totally with you. then everyone starts scratching their heads over new money printing not producing inflation. But its fairly simple. We are just replacing what we considered new money ( shares, property vlue etc) which had a collapse in value, with old fashioned money. Just filling the hole, not adding.

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Anonymous
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April 6, 2013 at 1:28 PM ×

Ding ding ding this is the winner.

This is really a key point for us.

We have had very serious professional arguments over this, but we have been convinced for a while that the main objective of "reflation" policies is/was to validate asset prices ex post.

There was, and probably still is, such a gap to fill that the notion there would be enough to print over and above that to create inflation always seemed not only wrong but a gross misconception of how much funny money (credit, securitization etc ...) was required to bring assets to these levels in the first place.

Our question back then was, what makes you think that a couple of tn$ of electronic Fed money is going to be more inflationary than the few tn$ of monoline/leveraged credit/securitization money it is in fact replacing?

DD

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abee crombie
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April 6, 2013 at 1:41 PM ×

Great comments and great post. Re c and asset inflation, I think that is the central issue these days for all cb's. How do we stimulate the working class vs the investor class. No amazing ideas from me but targeted fiscal policy seems better suited. However politically and investor unfriendly it is. Or how about a twist on the uk's. Lending for services only.

I did hear that the rich are getting the spending message as they bought the most ferraris in 12 years.


Long gold/jpy seems like a logical trade.

Japan is certainly going to be a very watched case study for cb's and politicians world wide, both hawks and doves.

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Anonymous
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April 6, 2013 at 1:44 PM ×

C Says'
Taking this argument back now to main street rather than wall street. Exactly what do we think this policy and and it's consequences does for 'trickle-down' ?. Let us remember that most of what we see by way of monetary policy is sold to the general populace on the basis of 'trickle-down'.
I find it excruciatingly funny ,because I suspect it actually works more like 'trickle-up' favouring those with most ability to use leverage which of course is a million miles away from the lower socio-economic groups. Hence,over time I would expect such a policy long run would extend the skew in wealth distribution.

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Polemic
admin
April 6, 2013 at 2:02 PM ×

Not "trickle down", more like "gush sideways". Normally to a peers pocket in same sector but different regime.

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Polemic
admin
April 6, 2013 at 2:09 PM ×

I heard a brilliant idea the other day. Think it was actually associated to a BBC R4 comedy program strangely. UK Working Tax Credits for the low paid should be reclaimed back to the state from any final profits the employing company makes.

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abee crombie
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April 6, 2013 at 3:05 PM ×

I was doing a little thought exercise on how the current policy would work under a gold backed system. I used to think Jim grant was a real bugabear but the simplicity of the gold system was the main beneficiary even though it put limits on growth and money supply expansion.

Looked at from the gold system view we really are going down the rabbit hole.

Under the gold system japan would be a country with large reserves but low growth. Now a new Japanese government wants to increase growth (disregard the reasons even though they may be important). It figures that a currency devaluation may be a good idea. The paper yen, backed by gold, drops against other currencies but prices in japan rise by an equal amount. Nothing gained because everyone knows of the exact devaluation and prices are anchored to gold to the paper yen.

Now assume instead of telling the market that japan is going to devalue by x% the govt decides instead just to quietly print more money than whatever gold ratio it is supposed to adhere to. Sometime after, the currency drops ( as we assume a higher than normal gold call arises along with increased money base) and prices of certain items rise. Which prices/assets rise? We don't know for sure but it depends on where the newly printed money goes into. Like pol said it gushes sideways and in today's global financial markets likely outward as well. So who is the big loser in this regime? Those who don't realize the game is being played on them and most likely owners of labour and scared capital. Ironically the ones japan is trying to stimulate. At the end japan as a whole is no better off vs scenario 1 but the winners and losers are.

Granted this is a simplification and there are more complications given net exports, and the boj is not stealthy at all but I think it leads to some interesting observations.

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Anonymous
admin
April 6, 2013 at 9:55 PM ×

No need for tariffs to protect against a falling Yen. China has a better idea...

http://www.bloomberg.com/photo/japan-bashing-fallout-in-china-/230805.html

Now it is Apple's turn...

http://www.globaltimes.cn/content/772527.shtml#.UWCLTatASdE

Those guys are real slick.

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Anonymous
admin
April 6, 2013 at 11:19 PM ×

Abee 1.41 and C 1.44

Back to the old mantra of TMM's commentary space ... "solving fiscal problems with monetary solutions"

(that's for the west though ... one could argue Japan has tried to do it the other way around for the past two decades)

also abee, I would very wary of any idea with a gold long leg. if the point above about how gov funny money simply replaces private credit funny money is one day understood more broadly, looks to me like the entire thesis collapses ... and I am not sure how tightly some of the owners will holdthis

DD

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LXDR1F7
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April 7, 2013 at 12:54 AM ×

In order to defeat deflation the BOJ needs to bypass the saturated and stagnant credit channel in conducting policy. If the BOJ conducts policy directly with the public liquidity can enter the economy directly and create demand.

internationalmonetary.wordpress.com

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Leftback
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April 9, 2013 at 1:53 AM ×

Fascinating piece on Japan, TMM. Demographics still a huge hurdle to overcome as large scale immigration is basically unimaginable to the culture, and unless the Japanese government mandates higher wages it is hard to see a stable inflation generator. As you point out, a likely response (especially in the Japanese culture) to goods inflation is demand destruction and then a retracement to a stronger yen.

As you can see with the US middle class, this latter dynamic isn't unique to one country but it might be considered a common feature of black hole economies. Once you enter ZIRP, not even printing can help you escape beyond the event horizon.

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Leftback
admin
April 9, 2013 at 3:48 AM ×

Tax time in the US:

US Tax Madness

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