The Bank of Japan has reminded investors that a central bank can always surprise with preemptive action. Its decision to abandon hitherto reservations against negative interest rates will generally add support higher-yielding risk assets, without materially weakening the yen.
If the other central banks follow through with similar actions soon, it might even help restore of the global bull market. But for now, our bias remains rather cautious, as explained last week.
“When the facts change, I change my mind. What do you do, Sir?” John Maynard Keynes once asked. Whatever one might think of his economic models, this particular comment remains universally valid, especially for investors. By introducing negative policy rates, BOJ Governor Haruhiko Kuroda just showed precisely this kind of pragmatic flexibility. That is why global equity and bond markets initially responded so positively to what is, in practical terms, a relatively modest policy shift that primarily affects Japan’s domestic economy. At the same time, cries that Tokyo is launching another “currency war” are not credible, as the yen merely gave back some of its more excessive recent gains. The underlying broader trend continues to point to a stronger yen (see chart on page 2).
But what did actually happen? On Jan. 26, in a five-to-four vote, the BOJ decided for the first time to use negative interest rates. Starting on Feb. 16, newly accumulated excess reserves of Japanese banks will be charged -0.1%. However, existing excess reserves, accumulated during the BOJ’s ongoing quantitative easing program (QE), will pay 0.1%, while required reserves will be interest-free. The move is potentially inflationary, because it reduces a financial incentive for banks to hoard cash in exchange for what is, effectively, a risk-free subsidy from the BOJ. Banks could now start putting more funds to work in the economy at a higher risk.
Still, the near-term practical impact is rather small. At the end of 2015, Japanese banks’ reserves stood at ¥230.6 trillion ($1.93 trillion) with, 96% representing excess reserves. Thus, the BOJ will continue to pay considerable interest on reserves for some time, even if banks decide stash away all of the cash they receive from the BOJ’s ongoing QE program (¥80 trillion per year). Thus, investors are clearly anticipating that Kuroda is prepared to go further if need be - i.e. his policy signal is considered credible.
From a global viewpoint, the initial market responses can be derived from the lesson offered by the action, rather than the action itself. Importantly, Kuroda in early January appeared to dismiss the idea of negative rates. But after three weeks of international market turmoil, he demonstrated that the BOJ is flexible, determined to stay ahead of things, willing to do whatever it takes, when-ever it is needed, and without worrying about losing credibility - even if it is forced to admit a mistake and change course.
With the European Central Bank already willing to do more, the BOJ thus offered more hope that the US Federal Reverse would also not hesitate to change course, despite the fact that it began raising rates last December (after hesitating throughout most of last year). Were it not such hopes, it would not make sense for global equities and bonds to rally. Without a substantiation of these hopes, it would not even make sense for equities in Tokyo to keep rising, as Japan cannot remain in a bull market alone amid a deteriorating global outlook.
Of course, the BOJ decision is still generally welcome - it could still prove the first in a series of positive policy and/or economic sur-prises that might be able to revive the old bull market. Overall, however, given the damage caused by the January financial turmoil, a cautious bias with regards to the medium-term market outlook remains appropriate in our view.
Read about the resulting investment positioning changes in our portfolios in the LGT Beacon below. To subscribe to a weekly newsletter, click on "Abo".
Note: The next LGT Beacon will be published on 17 February 2016.