A lot to process.

Photographer: Yuya Shino/Getty

Trump Bond Sell-Off Should Scare Central Banks

Christopher Wood is an equity strategist for CLSA Ltd. in Hong Kong. He is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s."
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The bond riot triggered by the election of Donald Trump, amid rising investor concerns about his aggressive pro-growth policies, means that a credibility test beckons Bank of Japan Governor Haruhiko Kuroda. This is because of the latest expression of unconventional monetary policy adopted by the BoJ at its September policy meeting. The key point for investors is that the BoJ has seemingly promised to buy enough Japanese government bonds so that 10-year yields remain more or less around zero.

The attempt at central bank price-fixing is an extraordinary development and has not received the attention it should have. In fact, it is the most important development in financial markets in 2016. With Kuroda unable to push further into negative rates because of political constraints, the Japanese central bank governor decided to steepen the yield curve by raising longer-term interest rates. The 10-year Japanese government bond yield was minus 0.06 percent before the BoJ's announcement, though this was “up” from the trough in negative yields of minus 0.29 percent in late July. The yield has since risen to about 0.03 percent. In adopting this latest policy, Kuroda took up one of the suggestions floated by Ben Bernanke in blog posts in March and April, namely targeting yields higher up the yield curve.

The point that investors should focus on is that the commitment by the BoJ to fix the price of 10-year money represents a massive hostage to fortune. In a world where government bond markets are selling off, the BoJ is seemingly committed to potentially unlimited balance-sheet expansion to hold the 10-year yield at zero. This is potentially very bearish for the yen since it would imply that the BoJ could soon run out of government bonds to buy in the secondary market, judging by the recent collapse in trading volumes. Monthly trading of Japanese government bonds by lenders and insurers has declined from a peak of 123 trillion yen in April 2012 to 16.1 trillion in October. It would also, importantly, put the Bank of Japan’s credibility directly on the line.

This is why a stress test is coming if bond markets continue to sell off in anticipation of Trump’s assumed pro-growth policies. Bond investors are concerned about his proposed $1 trillion infrastructure spending plan as well as aggressive tax cuts. It should be noted that the correlation between the U.S. 10-year Treasury bond yield and the 10-year Japanese bond since 1996 has been 0.85. Yet since Trump’s election on Nov. 8, the yield on the 10-year Treasury is up by 46 basis points but only nine basis points on the 10-year Japanese bond.

The result is that, sooner or later, markets are likely to challenge the BoJ’s pledge to hold the 10-year rate at zero. This process began last week, with the yield rising above zero for the first time since Kuroda announced his plan in September. This means the BoJ needs to increase its bond purchases if it wants to honor its commitment. That is, of course, unless Kuroda decides arbitrarily to change his yield target in light of the bond-market action triggered by Trump’s election. Still, a sudden decision to raise the price from 0 to, say, 0.2 percent could cause a loss of BoJ credibility, therefore accelerating a weakening of the yen. 

For now it should be assumed that Kuroda means what he says. This suggests the BoJ will be forced to buy more government bonds if the Treasury market sells off more and puts pressure on the yen. That in turn means the BoJ would be easing more at a time when the markets are anticipating a Federal Reserve rate hike in December. This process has already started, with the BoJ offering on Nov. 17 to buy an unlimited amount of one- to five-year government bonds at fixed rates for the first time since Kuroda adopted the new policy. This drove down the 10-year yield to 0.01 percent from 0.03 percent a day earlier. Meanwhile, it is also worth noting that foreigners now own 10 percent of the securities in the Japanese bond market, including Treasury discount bills. This means foreigners are well positioned to test Kuroda should the U.S. bond market continue to sell off.

So the risk is that this latest version of Kuroda’s high-beta monetary policy could work too well if inflationary expectations finally surge on a plunge in the yen and a related inability of the BoJ to hold its target yield level. What credibility the central bank has left would finally be lost.

In this respect, Japan is set up for a potential hyperinflationary scare on a surge in velocity if inflation expectations suddenly soar precisely because of the extent to which the monetary base has grown after so many years of ultra-easy monetary policy. Japan’s monetary base has tripled from 135 trillion yen, or 28 percent of gross domestic product in March 2013, when Kuroda became BoJ governor, to 414 trillion yen, or 82 percent of GDP as of October. This surge in narrow money should be seen as the equivalent of the piling up of kindling wood on a fire. But, to continue the analogy, the kindling wood is only set alight if velocity takes off. For now, velocity, or the rate at which the money supply turns over, has declined since the 2008 financial crisis in the U.S., Japan and Europe despite the implementation of unorthodox monetary policy; though bond markets have started to worry that Trump’s policies, such as the infrastructure spending plan and a tax-amnesty deal with corporate America to encourage the repatriation of an estimated $2.5 trillion held offshore, might cause a surge in velocity.

This is why the issue of central-bank credibility is so important: It is a change in mass psychology, not an economic model, that will trigger a U-turn in velocity. In this respect, it is worth quoting Jens O. Parsson's historical study of great inflations: "At the beginning of an inflationary cycle, velocity declines while money quantity increases, thereby offsetting one another and masking the true inflation potential." This process is precisely what has been happening in Japan for many years and in the U.S. and Europe since 2008, as central bankers have embraced ever-greater doses of monetary expansion. But the game has gone on long enough, and the catalysts for a loss of credibility are now visible. It is time for investors to focus on the growing likelihood of an imminent loss of central-bank credibility and what that might entail.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net