Could BoJ policy be 'closer to home' than we think?

Wednesday, 1st August 2018 08:13 - by Shant

Stock markets were in buoyant mood again today, led by the Wall St indices which at the time of writing showed the NASDAQ up close to 1% today to hit fresh record highs, though gains have moderated.  Even so, we now have 8000 coming up on the horizon.

As US equities rise, the rest of the world follows, Allowing for periodic localised concerns, the varying degrees of risk appetite continues.  This is epitomised by the FTSE which is now also looking to multi year/decade highs and also has the 8000 mark in its line of fire despite the uncertainty over the UK departure from the EU next year.  

No surprise that Italy's FTSE MIB has been given a wide berth since the political overhaul earlier in the year, but losses are relatively tame given the lack of comparative recovery since the heavy losses from the financial crisis a little over 10 years ago.

Global trade flow is also set to be hampered by the imposition of tariffs and despite an escalation in retaliatory action, there seems to be little fear in the developed markets as yet another major development is brushed under the carpet for now.  Varying sources of demand have been cited, with buybacks a common source, though looking further afield, monetary policy in Japan looks to be another significant source of investor flow as local markets offer little or no yield. 

Pension funds and corporates continue to divest (in net terms) away from Japan, and as the BoJ continues to print money, it is clearly not going back into the domestic economy, which is reflected in the lack of pick up in domestic inflation.  This may be about to change with reports suggesting a long overdue rethink on monetary policy. At best, the asset purchasing program is keeping a lid on the JPY which aids exporters, but at what cost down the road.  At some point exit strategy will have to be addressed.  Debt to GDP may be largely internal, but rising well over 250%, the central bank will consistently be monitoring secondary effects though for the purposes of this article, we consider there to be material risk to the asset markets in the US, Europe and the UK.

Earlier in the year, we saw the impact of Japanese investment flow on US yields and the USD, though the losses in equities were distorted by funding concerns.  Even so, a principle source of demand is looking vulnerable.  As the TICs data showed, there was a heavy bout of liquidation in Treasuries out of Japan as the market narrative focused on the budget deficit in the US.  As the economy has since turned, and with buying resumed, long end yields have suffered as a function of this renewed appetite with US stocks moving in the same direction.  

The BoJ meet next week to discuss any changes (more so tweaks at this stage) to policy.  As above, with debt at such extreme levels, normalisation will be a constant risk theme over these meetings.  On the currency reaction alone, the BoJ will be reluctant to do so but this is fragile reasoning to believe they will sit on their hands perennially.  At some point they will have to admit the current program is not working, and in trying to change the dis-inflationary mindset - as BoJ governor Kuroda puts it - at what point do they concede defeat and 'cut their losses'. 

It is a long shot that they will choose the present time to upset the apple cart, but when it does we expect it to cause ripples in the equity markets.  Local funds are reportedly starting to increase their exposure to Japanese stocks, and if this dynamic starts to accelerate, this could be portfolio switching on a sizable scale.  BoJ policy is not one to ignore at 'once again precipitous' times.