It would be naïve to feel that the Bank of Japan’s (BoJ) move to charge financial institutions 10 basis points (or 0.1%) on new reserves held with the central bank is not hugely significant.
In my opinion, this marks a turning point for the BoJ in the greatest monetary experiment ever. It also has sizeable bearings on central bank policy more broadly, specifically that of China. If the near-term positivity seen in markets is to abate, it will be driven from renewed yuan devaluation. In effect, the BoJ have shifted its central focus from ¥80 trillion annually in asset purchases to one now backed by negative interest rates. It’s logical to think that the ¥80 trillion of newly created reserves over the coming year (now being charged 0.1%) will be offset by institutions moving money into foreign assets, such as US treasuries.
What’s more, they have made it clear that they can take interest rates deeper into negative territory from here and, given its current quantitative easing (QE) program seems deemed to fail, one should expect the use of negative interest rates far more prominently. This is no different to what we have seen in Europe, Switzerland, Denmark and Sweden. In fact, as the Wall Street Journal points out, over 20% of the world’s GDP is covered by a central bank who have imposed negative interest rates on their economy.
Incredible moves in fixed income markets
The effect on bond markets has been remarkable and close to 70% of all outstanding bonds in Japan now trades with a negative yield. Negative yields effectively mean that when a country issues bonds (debt) to fund spending that they are paid to do so - Imagine taking out a mortgage and getting paid for the privilege of borrowing funds! We have even become quite accustomed to QE, which 10 years ago was considered extremely radical.
It looks more and more likely that we are going to see a situation where central banks use interest rates much more aggressively to flatten the yield curve and drive down the currency and these days market players don’t even batter an eyelid; in fact they demand it.
One has to question whether the Bank of Japan just raised an already elevated bar in what is an escalating competitive devaluation of one’s currency, bordering on a full blown currency and interest rate war? In my opinion it seems they have.
There is now much debate on who moves next. The European Central Bank has given a clear hint it could cut its deposit rate deeper into negative territory at the March meeting. The Bank of England have also been arguing for months that we could see negative interest rates in the UK. The Bank of Canada threatened to impose negative interest rates in December, as have Ben Bernanke and Bill Dudley in recent communications about future Federal Reserve policy.
US treasuries look like a buy
The natural beneficiary of this newfound stance in dovish rate settings is the bond market and, if interest rates are going lower, then it’s hard to argue against being long US treasuries right now. US bond yields, specifically in the five to 10 year maturity are going lower from here in my opinion, which is certainly an out-of-consensus call. Keep in mind that just over 70% of rebalancing from Japanese funds (out of Japanese government bonds) since 2008 has been into US treasuries. That trend should continue.
When bond yields and volatility fall it makes conditions more favourably for risky assets and traders will tend to search out yield and income. This means being long carry trades in the FX market and high yielding stocks, and I expect gains to be more prevalent here in the coming weeks.
How this all doesn’t end badly I am not sure, especially with inflation expectations (as measured through the bond and swaps market) in the US, Europe and Japan trending clearly lower. There is a huge credibility issue at hand and, if traders and investors genuinely lose faith that central banks can’t get close to achieving the inflation part of their mandate, then it’s hard not to see equities getting savaged. Bonds and to a lesser extend gold will be the best place to be invested.
Moves have been made and we should all watch with great interest as new opportunity presents itself.
How to trade the changing market dynamics:
As mentioned, charging Japanese banks should push capital abroad and specifically into the US treasury market. These inflows should support USD/JPY, especially as the fed funds future curve is not pricing in any hikes in 2016 and the market is the most long JPY since 2012 (source: Commitment of Traders report).
With US payrolls in focus this Friday (consensus 190,000 jobs) the USD could see volatile trade this week. I see the USD/JPY trading in a range of ¥115 to ¥125 throughout 2016 and would be trading the pair accordingly.
The Nikkei 225 (Japan 225) has rallied 10% since the 21st January and would be the clear pick for the equity bulls right now. The daily chart is overbought, but I would look at buying pullbacks into 17,500 for a move into 18,500 in the coming weeks. Again, this requires a stable CNY.
The biggest beneficiary of the lower volatility will be the high yielding currencies, so long AUD/JPY and AUD/CHF should do well. Keep in mind that Australian 10-Year bond holds a 250 basis point (or 2.5%) premium over Japanese bonds – It’s not hard to see further flows into the Australian dollar.
I don’t expect the Reserve Bank of Australia to use tomorrow’s central bank meet to give a clear signal on future easing like the ECB, for example. Short GBP/AUD looks compelling from a fundamental and trend perspective and a move through a$2.00 looks likely in the short term.
With the highest dividend yield in developed markets (around 5%) I would stay long the ASX 200 for 5130, even 5200 on this run. I would look to cut back on a move back through 5000. Australian banks should see another 3-5% on this run in my opinion.
The iShares MSCI Emerging Markets ETF (N:EEM) has rallied 10.8% from its 21 January swing low and looks like it can push higher from here. A renewed CNY devaluation from the PBoC is the key risk and would likely see a strong reversal. How the Chinese respond to Japan and Europe’s action remain key.