By Vatsal Srivastava
With another round of a massive bond buying program unleashed by the Bank of Japan (BoJ), Nikkei bulls are most likely having the best time of their lives since the late 1980s. It is easy to ride in a sea of liquidity. Although, Currency Corner fears that the BoJ exit from its quantitative easing program will be a more complex scenario than the US Fed’s exit, the current upward bias towards Japan is likely to remain for the coming few quarters at least.
The BoJ seems highly committed to achieving its two percent inflation target — the surprise decision to ease monetary policy further last Friday indicated that policymakers are more strongly committed to the target than the average market participant had assumed. As a result, financial markets reacted materially with the Nikkei and the USD/JPY reaching multi-year highs. But, this inflation target is by no means an easy level to reach no matter how big the BoJ’s ammunition is. An unanswered fundamental question remains whether and how further increases in the monetary base and the BoJ’s holdings of government bonds and risk assets (REITs and ETFs) can cause a sustainable convergence of Japan’s inflation to two percent – apart from their direct impact on the FX rate.
Firstly, one has to understand that the second round of QE by the BoJ was a response to weaker aggregate demand (caused by the sales tax hike) and plummeting oil prices (as cheaper oil means importing deflation). Governor Haruhiko Kuroda said in his press briefing after the decision: “There is a risk that conversion of deflationary mindset, which has so far been progressing steadily, might be delayed if actual inflation continues to stagnate. In this sense, we stand in a critical moment.” One has to appreciate the aggressiveness of the BoJ at this juncture which in turn shows and that the lessons of past few deflationary decades have been learnt.
Also note that the latest round of QE comes on the back of structural reform. The latest QE salvo came after the announcement of aggressive rebalancing of Government Pension Investment Fund (GPIF) portfolio in favor of domestic and foreign stocks. This is expected to trigger further reallocation by private pension funds. Pension funds loading on to stocks and other inflation hedges is an important precondition for the success of the BoJ QE. The move could make the portfolios of Japanese households more similar to the holdings of their US counterparts, according to Citibank.
Thus, if all goes well, the Japanese consumer is likely to see his or net worth increase much like his American counterpart in the US Fed’s QE era. After a couple of decades of deflation in Japan, the households seem to prefer cash over inflation hedges (equities/stocks). The end of deflation in 2013 and the sharp acceleration of inflation in recent quarters has likely reduced the real value of the cash holdings, leaving households vulnerable, according to Citibank.
The Japanese households will continue to suffer capital losses so long as they do not hold the right asset. The US households’ holdings could be used as a template as Citibank research shows. US households invested the bulk of their savings into stocks and other inflation hedges as did the US institutional investors. Successive rounds of Fed QE since 2008 increased the value of these equity holdings. Coupled with growing housing prices this helped household net worth rapidly in recent years. Fed’s QE further kept rates low helping households repay debt. As a result, domestic demand recovered and remains the primary driver of the US recovery. This argument may however be looked at as too simplistic as Japan has an aging population which may not prefer to put its money in risky assets such as stocks. This is something Abe will have to address in the coming days and weeks.
There is a fear in the markets that the enthusiasm towards Japan feels a lot like the late 1980s and this may be yet another bubble in the making. This column believes it is too early to make this call and remains positive on the land of the rising sun.