I have long held the belief that to create inflation, Central Banks must be as Paul McCulley describes, “responsibly irresponsible.” In a balance sheet constrained economic environment, quantitative easing causes a momentary uptick in economic activity (and also long term yields), but the market quickly figures out how to discount the Central Bank’s actions.
The private sector realizes the moment the Central Bank takes its foot off the accelerator, the previous debt delevering deflationary vicious circle will reassert itself. Anticipating that inflation has no chance of “getting away on them,” the private sector does not fall for the Central Bank stimulus. Knowing it will be withdrawn at the first sign of inflation dampens the private sector’s animal spirits.
That is why Central Banks need to be “responsibly irresponsible” by introducing a fear of inflation getting away to the upside.
I don’t care whether these Central Bank policies are correct or not, they are what they are. I am not interested in arguing about the morality about Central Banks trying to stimulate economies through monetary policy. I am focused on how these policies affect markets and merely commenting on their actions.
In the aftermath of the 2008 credit crisis the United States engaged in four different quantitative easing programs -dubbed QE1, QE2, Operation Twist and QE3. Operation Twist’s goal was to change the shape of the yield curve as opposed to directly injecting funds into the financial system, so I will avoid it and instead focus on the three quantitative easing programs.
Here is a chart of the US 10 year yield during this period:
The first QE program worked exactly as you would expect. It caused long term yields to rise with yields peaking just as the program was ending. Once the Fed took their foot off the accelerator the economy slowed, and yields plummeted.
Faced with a declining economy, the second QE program was announced. This program’s size and composition, like the first, was fully announced ahead of implementation. But this meant the market realized when it would end, and discounted the withdrawal ahead of time. Yields did not peak at the end, but half way through the program. The market had adapted.
Realizing the dilemma that markets’ discounting was negating the policy’s efficacy, Bernanke introduced a third QE program a year later. This time instead of giving the program’s total size in advance, the Fed Chairman said the Fed would continue expanding their balance sheet by X amount until economic conditions were met.
Fed critics went bananas at this development. They labeled it “QE infinity” and worried inflation would spin out of control. Yet these worries are precisely why the program worked so well. The Bernank was being “responsibly irresponsible.”
Fast forward to today. Although many Central Banks have followed the Fed’s lead with massive quantitative easing programs, they have done so with the constant reassurance they would not allow inflation to get out of control. Their foot is down on the accelerator, but the market is confident the Central Bankers will quickly brake at the first sign inflation takes off.
Well, I should say that was the case. Recently the Bank of Japan committed to pegging the 10 year JGB yield to zero. This is a different policy than Bernanke’s QE infinity program which committed to expanding the Fed’s balance sheet by a set nominal amount, but it could potentially be even more aggressive.
What are the consequences of pegging a part of the yield curve at a specific rate?
As interest rates move, the Bank of Japan will be forced to either buy or sell bonds in the 10 year area of the curve to keep rates pegged at zero. Stop and think about the ramifications of this development.
If JGBs rally then theoretically the BoJ will be forced to sell JGBs to keep the interest rate from dipping too low below zero. This would be contractionary. Now granted the BoJ could just play games and expand their balance sheet through purchases of other parts of the curve or risk assets.
But what about if rates rise? What if JGBs sell off? What will the Bank of Japan do?
The Bank of Japan has committed to keeping the 10 year JGB rate at zero, so if rates naturally rise, then the BoJ will be forced to buy JGBs. That would be expansionary. And unlike Bernanke who committed to buying a set amount each month until the economic conditions were met, the Bank of Japan has instead targeted an interest rate.
This means the Bank of Japan could be forced to buy virtually infinite amounts of 10 year JGBs! Talk about an expansionary development.
Wait, that’s not quite right. Pegging an interest rate out the curve is expansionary if it is pegged too low. Peg it too high, then it has the opposite effect.
So setting the rate becomes even more important. But don’t worry - there is no way 0% for 10 years is the wrong rate. No way the Bank of Japan has just committed to one of the most expansionary developments in the history of developed economies. Yeah, right… I am sure 0% is the right rate.
I am not as confident on the next part of my theory, so if you don’t buy this next leap, please don’t dismiss the previous argument. I know the US 10 year yield is often highly correlated to the Yen, but over the last month they have basically traded on top of one another.
As global bonds have sold off, the natural consequence should be for JGBs to follow their brethren lower. Yet the BoJ has committed to keeping the 10 year at 0%, so they have most likely been buying JGBs.
This buying of JGBs is expansionary, and should cause the supply of Yen to increase, thus sending the Yen lower (higher USDJPY rate). This is maybe why the Yen is trading so tight versus global yields.
Stop to think about what happens when the Bank of Japan expands the money supply through potentially infinite purchases of 10 year JGBs. It is inflationary which only causes more selling of the long end of the JGB curve, forcing the BoJ to expand the money supply even further.
The main difference between this policy and every other Central Bank QE program is that the amount of purchases is infinite. This BoJ policy is the true QE infninity.
It is no wonder the Yen has been going down. And don’t think this won’t affect global bond markets. This is all highly inflationary. The Bank of Japan has gone “responsibly irresponsible” and as long as 0% is an expansionary rate, then this might be the policy that finally ushers in the Japanese inflationary spiral.
Last week I wrote about how everyone believes inflation and interest rates will stay low forever. Some of my pals took exception to this comment and claimed there were many more bond bears than I claimed.
As I hit the send button, this great story went across my Bloomberg.
Far be it from me to criticize Mr. Memani’s forecast as I am just some hack with a Bloomberg and a futures account while he is managing $200 billion of fixed income, yet I submit his opinion that “rates are going to remain low for the rest of my career, and I look forward to having a long career” represents the overwhelming consensus attitude. Yeah maybe some of the fast money has gotten a little negative on bonds, but the big slow money is all long fixed income out the hoop, with absolutely zero fear of it ever going down…
Thanks for reading,