With the Fed contemplating whether to hike again next month and start “normalizing ” its balance sheet before the end of 2017, the two other major central banks are facing far bigger problems.
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Two months after the BOJ quietly started tapering its QE program, when it also hinted it may purchase 18% less bonds than planned…
… Governor Haruhiko Kuroda admitted last week that the Bank of Japan’s bond holdings are currently growing at an annualized pace of only ¥60 trillion ($527 billion), 25% below the bottom-end of its policy range, and confirming that without making any formal announcement, the BOJ has quietly followed the ECB in aggressively tapering its bond buying program.
Under questioning from opposition party lawmaker Seiji Maehara, who noted that the pace of bond accumulation by the BOJ had slowed, Kuroda said the trend could continue, without elaborating. He noted that the central bank’s target is to control interest rates rather than the amount of bond purchases. “This development signals to me that they are going with rates without talking about a quantitative target,” said Atsushi Takeda, an economist at Itochu Corp. in Tokyo. “That will be better when they think about an exit.”
While the BOJ’s purchase slowdown has been visible for months in data released by the central bank, Kuroda’s confirmation of this reality in parliament last Wednesday marks a stark change. As Bloomberg notes, until now he’d struggled to emphasize that the annual pace could vary from an indicative 80 trillion yen, depending on the state of the economy and financial markets. He now appears to have thrown in the towel. Meanwhile, investors are watching for any hint of tightening in monetary policy amid speculation that the central bank’s bond purchase regime is unsustainable and as consumer prices in Japan are expected to pick up later this year. The most likely way for the BOJ to begin tightening would be scrapping the 80 trillion yen guideline altogether, especially since the central bank is no longer following it.
“The Bank of Japan appears to be ramping up its efforts to improve communication with the market to lay the groundwork for its next move – tapering,” Bloomberg Intelligence economist Yuki Masujima wrote in a report on Kuroda’s remarks.
What was surprising to markets is that Kuroda’s unexpectedly hawkish comments had virtually no impact on the market last week; if anything they led to an even weaker Yen, something which on the surface would seem paradoxical; however it was reassuring for the BOJ and could boost arguments in favor of dropping the 80 trillion yen reference point.
Speaking in an interview with Bloomberg in April, Kuroda said the BOJ would keep as a reference point the aim of increasing its holdings of government bonds at a pace of around 80 trillion yen per year. After four years of aggressive monetary stimulus, and with his term set to end in April 2018, Kuroda is still far from his goals while his Federal Reserve counterpart Janet Yellen is taking rates higher and policy makers in Europe debate tapering. These three central banks have all run up huge balance sheets since the financial crisis after buying bonds and other assets.
In an unexpected admission that even central banks are subject to simple math, Kuroda also revealed some of the BOJ’s modeling on balance sheet risks, indicating that a BOJ simulation found that a 100bps increase in long-term yields could mean a valuation loss of ¥23 trillion on its bond holdings, equivalent to a DV01 of roughly a $2 billion.
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And while the the BOJ is quietly tightening ahead of an inevitable official taper which it will have to commence over the next year as it runs out of monetizable private bonds to purchase, the ECB finds itself in a far worse situation as it may have just 4 months before it runs out of eligible German bonds to purchase. According to analyst calculations based on ECB bond-buying data published at the start of May, the European Central Bank bought roughly 400 million euros fewer bonds in Germany in April than its rules allow.
According to ABN Amro’s Kim Liu, in April the ECB deviated from the capital key in Germany by around 400 million euros when excluding corporate and covered bond purchases and adjusting for Greece.
The shortfall raises questions about how close the ECB is to hitting its bond-buying limits in Germany, the euro zone’s benchmark issuer and (at least until now) the deepest and biggest source of bonds under the ECB’s QE program which is currently scheduled to run until the end of 2017.
“It was by far the largest deviation, at least for Germany, and for me suggests that on top of the political stress and smoothing of purchases, there are scarcity constraints for the Bundesbank,” said Pictet Wealth Management senior economist Frederik Ducrozet, quoted by Reuters. “What it means is that the ECB has to be very cautious with its exit and if they don’t taper within less than six months (of ending the programme) something might have to give.“
ECB asset purchases are based on the so-called capital key, meaning the central bank buys a country’s bonds in line with the size of its economy, making Germany the biggest source for the scheme. According to Barclays, if the ECB maintains its buying program as is, it will hit its mandated, 33% ceiling on German Bund holdings as soon as October, or just over 4 months from now.
Furthermore, according to calculations shown previously, based on ECB data in just six months the average maturity of monthly German debt purchases by the ECB has dropped to under five years from more than 10. That suggests that a shortage of longer-dated eligible debt is forcing the Bundesbank, which buys securities on behalf of the ECB, to take advantage of recent rule tweaks to buy more shorter-dated bonds. Reuters adds that while that shift was expected after last December’s change allowing the ECB to buy bonds yielding less than the -0.40% depo rate, “the speed at which the Bundesbank put that to use has taken markets by surprise.”
According to ABN’s Liu, “this means that the average maturity of monthly German purchases remains much lower than those of other countries and that the Bundesbank continuously is forced to buy short-dated bonds with yields that are below the ECB’s deposit rate.”
Germany is not the first country whose bonds are becoming scarce: the ECB has already deviated from the capital key in Ireland and Portugal, where it is running out of bonds to buy. However, the latter two countries are tiny in terms of supply compared to the budgeted monthly purchases from Germany. The German bond scarcity shows that the ECB would struggle to extend the scheme without further changes to its own bond-buying rules, and one option is simply to raise the 33% self-imposed ceiling, although that would likely require a substantial political intervention, and it would also make the European bond market even more illiquid as the ECB ends up owning half of German bonds.
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For now, the ECB has been lucky: the economic situation in Europe has been improving, with inflation posting a modest pick up, and all signs suggesting that Mario Draghi will be able to taper – not because he wants to but because he has to. Last Monday, ECB board member Yves Mersch said the ECB was close to replacing its negative view on whether the euro zone economy would reach growth targets with a neutral one, providing yet another justification to reducing its unsustainable bond purchases.
As a reminder, in December the ECB already tapered its monthly purchases by €20 billion to €60 billion in April, while money markets price in roughly a 70 percent chance of a rate hike in early 2018.
“The ECB can always get around its rules, it has the flexibility on whether to buy central government or local government or agency debt to fulfill its quotas,” said Marchel Alexandrovich, senior European economist at Jefferies. “But the longer QE goes on, the more the ECB will have to think about changing the rules again … And the issue now is the willingness to carry on with QE.”
Indeed, and as for European false dawns, just ask Jean-Claude Trichet and the infamous rate hike of 2011 which launched the most serious leg of the European sovereign debt crisis. Should Europe’s economy turn south again and the central bank be forced to keep or even boost its QE, Mario Draghi bank may suddenly find itself in very big trouble. That, or simply do what the BOJ has been doing for years, and start buying ETFs and single stocks.
One final point: even if all goes according to plan, recall that the only reason stocks are at all time highs, is due to the $250 bilion per month, or $1+ trillion YTD – an all time high – in central bank purchases; purchases which are only thanks to the ECB and BOJ. With both banks now having no choice but to trim their asset monetizations, the outlook for risk assets is anything but good.
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