One Day Reprieve (Use It Wisely)
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
• By surprising markets with a move to a negative deposit rate, the Bank of Japan gave investors temporary reprieve, providing a much needed opportunity to pare portfolio risk at better prices. Unfortunately, the improvement in financial asset prices will be short-lived; except, of course, for long-maturity Treasuries.
o As I wrote on January 4th, “Investors should be careful not underestimating just how far long-maturity Treasury yields can fall”. These conditions still exist. (See my Jan 4 note, “The Bond Awakens”)
• The BoJ action to drop its deposit rate from 0% to -0.10% will likely prove to be more symbolic than impactful. However, it is understandable why the BoJ wanted to take action. In January, the TOPIX was down 10% and the traded-weighted Yen appreciated by 3.5%. Currency strength and the fall in oil prices conspired to push Japan’s preferred inflation measure back into deflation. However, if Japan (which only strips out food) stripped out energy from its measure (like other countries do), then its inflation measure would be above 1%.
• The BoJ issued a highly informative and clear 4-page explanation of its action (China could use this clarity as an example of effective communication). It introduced a three-tiered system for rates, similar to that used in some European countries. The BoJ made it clear that the negative rate is not applied to outstanding balances of current accounts, but rather applied only to marginal increases in current account balances.
• Since the money base is growing at an annual pace of 80 trillion yen, outstanding balances of current accounts will increase on an aggregate basis. However, in order to limit harm to earnings of financial institutions from the negative deposit rate, the BoJ will increase the tier thresholds accordingly. In other words, the current balance to which the zero interest rate will be applied will increase, so that the threshold to which a negative interest is applied “will remain at adequate levels”.
• When a central bank hits the 0% lower bound in rates, the impact of any further unconventional easing actions is felt via a weaker currency. Therefore, the diverging policy actions between the hiking Fed and the easing BOJ and ECB, means that the upward pressure on the USD versus the Euro and Yen will continue. The effect of a stronger dollar is counter to the perceived and kneejerk market euphoria that arose today; and which seem to arise during easing actions. A stronger USD will act like a magnet for global deflationary forces. Investors beware.
• A strengthening USD has numerous consequences. The Yuan‘s peg to the USD has certainly damaged China’s competitiveness. The trade-weighted Yuan has dropped by over 25% during the past three years. Moreover, Chinese wages have risen considerably in the past decade, further lowering their competitiveness. China is no longer viewed as the world’s low-cost producer. China is currently trying to find the tricky balance between finding new sources of growth, remaining competitive, stabilizing financial markets, and limiting capital flight.
• The move by the BoJ makes this balance more difficult. It increases the pressure on China to devalue its currency further. However, with China’s rise as the world’s second largest economy and its acceptance into the IMF SDR basket, its global responsibility has escalated accordingly. Currency devaluation by China (or by Japan for that matter) steals growth from the rest of the world; such action is clearly non-beneficial to US risk assets.
o A strengthening US dollar has already damaged US corporate earnings - around 50% of S&P 500 earning comes from overseas (and global trade has dropped ominously).
• China and Emerging economies were growing above 10% in 2010, but are growing at less than 4%. Clearly, the global economy has lost an important engine of growth. Moreover, the world has never been more indebted and the developed world demographics are simply terrible. For several years, China’s debt has been growing at the unsustainable rate of over 2 times its GDP. Enormous indebtedness has borrowed too much from the future. High indebtedness and low rates globally means there is far less fiscal slack or monetary ammunition with which to respond.
• The savings rate in China is 40% to 50%. This is partially due to a lack of confidence in the future, but mainly due to China’s very poor retirement and health care programs. After several decades of the one-child policy, many Chinese are not just trying to save for their own retirements, and potential future health care costs, but are saving for two sets of grandparents who did not receive the benefits of recent wage hikes.
• Low interest rates initially cause investors to desperately search for yield. However, eventually risk assets become too mispriced (and thus skewed to the downside). When this occurs, portfolio preferences switch to cash alternative or ‘return of capital’ strategies. During such an environment, the pressure on savers to save more to reach retirement goals intensifies. If, for example, interest rates fall from 4% to 3%, an investor would have to increase savings by more than 20% each year to reach the same goal over 30 years.
• I maintain that central banks are miscalculating the non-linear cost-benefit equation of their policy actions. Prudent investors should use today’s month-end BoJ gift to pare portfolio risks and to buy long-dated Treasuries.
• “The change, it had to come / We knew it all along / We were liberated from the fold, that’s all…” – The Who
Guy Haselmann | Capital Markets Strategy
Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
Scotiabank is a business name used by The Bank of Nova Scotia