Kuroda's conundrum

Imagine that you are Haruhiko Kuroda.  Appointed by a once-failed prime minister keen to redeem himself, you have been given carte blanche to reverse two decades of stagnation and to attach a monetary defibrillator to the sclerotic heart of the Japanese economy.  Emboldened by this mandate, you embark on a program of shock and awe, injecting an unprecedented level of public sector involvement into bond and equity markets.

For a while, your quantitative and qualitative easing (QQE) program is a success, as the yen weakens, growth improves, and inflation moves higher.  Happy days!  You stay with the program, making a few minor adjustments along the way.

A funny thing happens on the way to escape velocity, however;  you find that you own an uncomfortably large swathe of financial assets, some of which (JGBs) are desired and needed by the private sector.  At the same time, your economic recovery runs out of puff; sure, some weakness was to be expected after the consumption tax hike, but not the tepid, stop-start pattern of the last couple of years.  Meanwhile, consumer price inflation has headed back south; yes, oil prices have played a part, but core ain't lookin' too hot, either.

While markets expect you to deliver some further easing, you realize that you may be coming close to doing more harm than good by taking JGBs out of the market.   So you decide on a little more shock and awe (well, more shock than awe) by surprising the market by imposing a negative interest rate on some central bank excess reserves.   Let's see how the banks like that one....

...whoops, that's more like shock and awful.

Meanwhile the yen surges, inflation continues to slide, and pressure mounts for you to do something.  However, you've been around a long time and know that engaging in half-assed measures simply for the sake of being seen to do something isn't the way to succeed.   So you take the summer off....but thanks to the shilly-shallying of the Federal Reserve, the dollar's on the back foot and pressure on the yen is pretty unrelenting.

So now it's September, and after the disappointments of the last couple of meetings, what do you do?   More bond purchases would seem to be a non-starter, especially as generating a flat yield curve at or below zero is a disaster for a nation of elderly savers such as yours.  Your organization has let slip that a steeper yield curve could offer some benefits (to both savers and banks), but how do you manage that?

*  Do you simply quit budgeting your bond buys across various maturity buckets, which would presumably allow you to focus on buying short dated paper, thus allowing long end yields to drift higher?

* Do you actively look to shift the composition of your portfolio by actively selling duration to the market while buying that short dated paper?

* Do you shrug your shoulders and say "in a for a sen, in for a yen" and cut rates again?

* Do you try more of the same and check yourself into the local asylum?

It's a tricky one, to be sure; many of the policy options facing the BOJ either risk being dismissed as trivial or  carry side effects that could have a bigger impact than the medicine.  Complicating matters, of course, is the collapse in foreign bonds' yield premium over JGBs when hedged back into yen.  This indicator has gotten a fair amount of air time recently, given that the hedged yield on 10 year UST briefly turned negative a few weeks ago and remains perilously close to zero today.

This isn't actually all that rare, as it is simply a function of relative yield curve shape and cross currency basis.  Obviously it's just another reason to shake one's head in an era of ZIRP and NIRP, but the Japanese have faced this situation on several prior occasions.   Their options are either to sell the Treasuries and bring the money back home, buy back some of their currency hedges, or accept the temporary negative carry.   Of these the last is unpalatable over long periods of time and the middle one is a lot easier when yields are 6.5% instead of 1.5%; there simply isn't enough interest income to pay for currency risk.   Perhaps that's why we've seen Japanese investors sell foreign bonds over the last couple of weeks.

 
So the million dollar question is whether this matters for the yen.   Historically, it does...unless it doesn't.   Over the past 25 years, several big cycles in USD/JPY have coincided with shifts in the yield premium of hedged USTs over JGBs.  Then again, there was a lengthy period from 2005 to roughly the beginning of Abenomics in which there was no correlation at all.

Perhaps we can chalk this up to shifts in Japanese investor behaviour.  Certainly in the middle of the last decade, Japanese investors were considerably more comfortable running unhedged bond positions than they are now, both because of the gross yield of USTs and the perception of the yen's trajectory.

Should the BOJ move to steepen the domestic curve, that would, all else being equal, strengthn the yen under this framework.   Of course, all else is rarely equal, be it hedge ratios or, perhaps more pertinently in this case, the yield on Treasuries.  Of course, if the BOJ does nowt, a rally in longer dated JGBs could remove some of the selling pressure that's assailed the Treasury market in recent weeks, particularly if the Fed is anodyne tomorrow.

For choice, Macro Man reckons that they will do something to try to juice back end yields, perhaps accompanied to a modest deposit rate cut.  On balance, that would probably be a negative for the yen, but not a table pounder.  he could easily see a scenario where spot jumps around a tremendous amount and doesn't end up too far from where it started.

Either way, strap in.  it should be a fun ride.