By John Vail, chief global strategist, Nikko Asset Management. Nikko is the second largest ETF provider in Asia with over ¥4 trillion in ETF assets under management.

John Vail, chief global strategist, Nikko Asset Management.

Differences in interest rate policy

Despite all the fanfare, Japan never did truly move to a negative policy interest rate. When announced in January 2016, negative policy rates were only applied to bank reserves at the BOJ that were deemed excessive. The measurement of what was excessive was generous and also allowed for reserves to grow alongside QE, such that only a handful of banks, virtually all quasi-sovereign ones, ever experienced a negative rate on reserves.

That said, the 2Y Japan Government Bond (JGB) yield fell from about 0 to around -20bps immediately afterwards and to a bit lower than -30bps by June of that year. Since then, it has gradually risen to -13 bps. Similarly, the 10Y JGB fell from 20bps to near zero fairly soon after the announcement, to -30bps by June and rose back to zero towards the end of that year and has hovered slightly above such since then, with the BOJ fixing that rate in September of that year at “around zero” in a policy called “Yield Curve Control (YCC).” YCC was one in a long string of new monetary inventions by the BOJ. Indeed, faced with low inflation for ages, it invented modern QE in the early 2000s.

Why didn’t Japan adopt a heavily negative policy rate like the ECB?

Firstly, there was no banking crisis in Japan (see the relevant text below) and second, while allowing inventiveness, the Japanese generally disdain outlandish moves. The business and banking communities were shocked with the BOJ’s “quasi-negative” rate policy at its inception and successfully pushed for no further rate cuts. Indeed, on the day of the announcement, the Yen initially weakened but ended up strengthening as domestic institutional investors seem to have considered the BOJ move to indicate some kind of panic and, thus, repatriated assets to be safe.

As for YCC, the Japanese also have a much more accepting attitude of price fixing and do not consider such actions outlandish. For decades, both governmental and business associations attempted to maintain prices without volatility, and while such maintenance has decreased with time, as the bureaucracy has become less powerful, it remains fairly well entrenched in Japanese culture. YCC has allowed for stability, but at some point, the BOJ will likely have to hike its target. We expect a 20 bps hike in the 2Q18, with related prior guidance pushing the rate to that level even before it is officially changed. Indeed, it seems quite likely, partially due to cultural factors, but also due to the danger of a taper tantrum, that the BOJ will be fixing long-term rates for the foreseeable future.

It is important to note that Japanese banks have been very careful since the late 1980s property and stock market bubble. Unlike European banks, they did not engage in aggressive financial investments (virtually none were affected by foreign CDOs and speculative financial products were never introduced domestically) and there was no bank-fueled property bubble or other kind of speculation. Partly due to the trauma of being blamed for the last bubble, Japanese bankers (who are not rewarded much with stock options or other corporate profit-linked incentives) are conservative, as are banking regulators. Japanese culture abhors mistakes, crisis and most of all, blame. In the bubble, there was collective madness and decades of remorse, so avoiding the repetition of such trumps all.

Meanwhile, the ECB opted for highly negative nominal rates, which were meant to incentivize capital towards investment in the real economy and spur bank lending along with the related TLTRO program. It is also no coincidence that the EUR plummeted in value during this period, which the ECB believed would aid the economy.

Lastly, a severe banking crisis of some form in nearly every Eurozone country increased the monetary urgency and the conservative concerns of North-ex France Eurozone countries (NEFE) were overruled, especially when Draghi became President. Along with policy rates, 2Y bond yields moved into strongly negative territory for NEFE, and to very low levels for the rest of the Eurozone, as well. 10Y Bunds only briefly traded below zero, but along with other countries, have experienced yields highly suppressed by QE. So far, the ECB, likely due to greater European free market tendencies than Japan, shows no interest in an official YCC to prevent a taper tantrum, but rather will likely adjust its taper if yields rise too high.

Quantitative Easing

Both central banks are running out of bonds to buy for their QE programs (without changing the rules, at least) at the same time that substantial confidence in their economies is returning. The BOJ has been buying fewer bonds than its goal for a while, which is tapering in a way, but only made possible because it is succeeding in its main goal of YCC at around 0%. Indeed, if it matched its QE goal, it would likely force the 10Y yield well below its YCC goal as liquidity is so thin now due to the BOJ owning a large proportion of outstanding long-term JGBs.

For the ECB, the fact that the last major country’s banking crisis had greatly diminished and its economy was finally growing well above 1% incentivized the shift toward gradual removal of monetary accommodation. Indeed, Italy’s underlying conditions have been the nightmare of Draghi and other Eurozone policymakers for a decade and the resolution of some of its most distressed banks in early summer very likely played a role in his newfound optimism. Accordingly, the EUR USD rate then also broke above its two-year resistance at this time as investors started to accept tapering would occur sooner rather than later.

Inflation

Japan has experienced “no-flation” for many decades, whereas Eurozone inflation has been positive for all but a few crisis months. There are many differences between the methods of index calculation, but explaining them is too extensive to be reviewed herein. In sum, both have factors that make it difficult to rely too heavily on them. Indeed, questions about capturing quality improvements in goods and services and about housing rent inclusion plague nearly every country’s CPI calculation these days. Indeed, with all the technological improvements (including shale oil drilling) now and likely ahead, is a 2% CPI actually achievable for developed countries without necessitating a dangerous property bubble? Knowing this, perhaps the best that can be said is that there is confidence in a reasonable amount of inflation ahead for Japan and the Eurozone, which allows both central banks to declare success and remove strong accommodation.

Unorthodox Policies

The ECB and BOJ engage in even more unorthodox policies than the ones described; namely, the purchase of large amounts of Equity ETFs by the BOJ and of corporate bonds by the ECB. One would think that these would be the priority for tapering, but at least for now, the BOJ is not indicating any ETF taper, while most economists think the ECB’s corporate bonds will be tapered in proportion to sovereign bonds. This parallels the Fed’s tapering of MBS, its most unorthodox QE asset, in line with sovereigns.

Forex

There is little doubt that forex rates play a major role in a central bank’s optimism about its economy. The BOJ and ECB are clearly aware that their countries compete in nearly every market, including their own, so neither wants a strong currency. Since the end of 2009, there has been considerable volatility of the EUR JPY rate, but it is now nearly exactly the same as it was then. It is highly likely that relative monetary policies will react if this rate deviates too strongly from its present level for an extended period.

Conclusion

Cultural factors have contributed to differing BOJ and ECB policies and will also contribute to the unwinding of such. We expect the BOJ to raise the YCC rate in the 2Q as it follows Japan’s preference for controlled prices and stability. Meanwhile, the ECB should taper throughout much of 2018 and indicate in late 2018 a rate hike ahead. Clearly, this indicates that Japanese bond yields should be much less volatile than Eurozone ones. As for the longer term, the BOJ may even stop reinvesting JGBs if yields are managed upward to a level that attracts significant market demand. The ECB will not officially manage its bond yields due to free-market tendencies, but it will likely adjust its taper if necessary and may allow run-off if private sector demand allows for such. These actions will be guided to some extent by forex considerations as will the likelihood that both will concurrently raise policy rates to close to the rate of inflation in 2019.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)