Horseman Capital – Japanese Monetary Policy Monster
The most concerning thing in Japan yesterday was that bond yields fell, even as the Bank of Japan (BOJ) decided not to enlarge its destructive policies. It’s existing “three dimensional” (Quantity, Quality and MR?) JGB eating monster continued to pound yields lower to feed the current 180th program. Banks are bearing the brunt of the yield compression, many may not survive. Making matters worse, deflation is returning with the stronger Yen. The BOJ is having to choose between sacrificing the banks or letting go of the impossible 2% inflation promise and unsustainably weak Yen that has inflated equity markets. Either way some Japanese equities are appealing shorts.
As I previously highlighted in Japanese 00E Costs And Side Effects the BOJ will find it increasingly difficult to buy bonds, as financial institutions cling on to Japanese Government Bonds (JGBs) for collateral, liability matching and regulatory purposes. The graph below demonstrates the yield compression that has been required, and associated volatility, in order for the BOJ to shake out enough JGBs to keep the 180th program going , whilst also now charging negative rates on some over-night deposits. To shake out further entrenched holdings the BOJ will have to make JGBs even less attractive to their holders by pounding interest rates even lower with more volatility.
It is interesting to see banks try and make a stand against the “three dimensional” JGB eating monster japans Biggest Bank Criticize the 1141 and When bank criticisms were raised at yesterdays press conference BOJ Governor Kuroda admitted °monetary easing puts downward pressure on financial institutions earnings”and then added in the past three years under QQE, major and local banks achieved a high level of earnings despite lower interest rates on loans partly owing to lower credit costs and higher profits from portfolio investment’. Whilst it is indeed true that ‘,oniony investment gains” and lower credit costs-have papered over the impact of rate compression they are short-term one-off benefits that are now set to reverse. I will address these in turn:
The collapse of “Portfolio investment gain” is the issue most likely to come to a head in coming weeks As I highlighted in Japanese Banks Overstating Core Recurring Earnings, banks have been reporting one-off equity portfolio gains in investment trusts within their interest income line. This is highly unusual accounting by international standards and obscures the net interest margin compression.As such, more of last year’s measly 0.28% return on assets would have relied on rising equities than analysts think Unfortunately, Japanese equities fell by over 12% in the year ending 3P’ March 2016. Without these one-off equity gains, the upcoming bank results, starting next week, should start to show some of the real costs of the BOJ’s policies Banks may use one-off bond gains within extraordinary items to lift the net profit line, but I am yet tosee how they can stop the interest income, net interest income and core recurring earnings lines from collapsing without investment trust equity gains. I understand that the Value at Risk (VAR) shock that has come with JGB, currency and equity swings has forced some banks to close equity positions, meaning they may have realised equity losses to report in interest income.
The issue of lower credit costs” could take longer to play out but arguably presents a much greater shock when it does. As I highlighted in Non Performing Loan Time Bomb the credit cost ratio for regional banks has fallen to a staggeringly low 7bps (the US is at 40bps which is typically a cyclical low). The decline in regional bank credit costs have come as the banks modified over three million loans under the SME Finance Facilitation Act. A key objective of this policy was to ensure that modified loans ‘did not fall under the catergory of a restructured loan” but rather remained classified as pa-forming loans, this optically reduces “credit costs”. As my note highlights many of the loans are extended to elderly SME centers who are in negative equity with negative earnings that are struggling to find buyers of their businesses.
QE not only damages domestic asset returns, but also overseas asset returns. Japanese financial institutions now pay significantly more for foreign currency hedges than they receive on foreign sovereign bonds. As the Bank of International Settlements highlights, due to “increased policy divergence …the US dollar premium in FX swap markets widened substantially- in particular vis-d-vis the Japanese yen”. In simple terms, more Yen outflows are seeking forward FX hedges on investments in US dollar assets, overwhelming investment bank counterparties which face increasing capital constraints, so the price of hedges blows out The following graph updates BIS report graph 5. It means that a Japanese bank buying 5 yr US Treasuries with perfectly hedged currency and duration risk would loose 0 9% a year.
Full PDF below