One glance at the chart below and it is very clear that there is a glaring difference between the market’s reaction to the Fed’s QE and the BoJ’s QQE. Aside from the magnitude and velocity of the equity market response that is, the Fed has been inherently volatility-suppressing (with VIX near all-time lows as stocks rise) while (aside from the last week or so), as the Nikkei surged, Japanese implied volatility also surged. As UBS’ Larry Hatheway notes, fundamentally, Japan’s policy settings and preferences (moving from deflation to inflation, which is the stated objective of ‘Abenomics’) embed a great deal of implied volatility, only some of which has already manifested itself in asset prices. The proverbial cat has been thrown among the pigeons – scatter they must – the Fed’s QE has dampened volatility while the BoJ’s QE has boosted volatility.
Via UBS’ Larry Hatheway,
Japan will face vast challenges that will be the direct consequence of ending deflation. The biggest will be the re-allocation of fixed income portfolios away from assets which have been priced for ‘perpetual’ deflation, including Japanese government bonds (JGBs) and other yen-denominated deposits and debt instruments (e.g., corporate bonds). Moreover, that asset re-allocation could well be discontinuous (i.e., abrupt). That is because current yields in Japan are too low for a world where inflation moves from minus 50-100 basis points to plus 200 basis points.
More subtly – yet more powerfully – the move is unlikely to be smooth because of the shift between two remote equilibriums. The first, which is where Japan has resided for more than a decade, is a world of deflation, where real yields are positive even when nominal interest rates are at or near the zero bound, as is the case for the entire JGB yield curve today. Investors will willingly hold low-yielding bonds in that environment, provided they are confident deflation will persist. The second equilibrium is found at much higher nominal yields—high enough to maintain positive real returns as positive rates of inflation are restored.
But Japan can only be in deflation or inflation – ‘no-flation’ is a transitory stage between them. Hence, if inflation expectations shift, asset prices are likely to move rapidly and significantly, most probably in de-stabilizing fashion. The move is likely to be large for another reason. As we noted in our earlier research, Japanese financial and household sectors are heavily exposed to their own bond market. For example, according to the IMF, roughly a quarter of Japanese bank assets are comprised of Japanese government debt. Worryingly, in the initial stages of any sell-off, it is difficult to imagine any group of private-sector investors that would be willing to step in to smooth the asset re-allocation. Most probably only the Bank of Japan could stand on the other side of any large-scale Japanese asset allocation shift out of bonds.
Yet for at least two reasons the BoJ would probably be a reluctant buyer. First, the scope of selling could be massive. After all, the gross stock of Japanese government debt outstanding that is not already or prospectively held by the Bank of Japan is nearly 200% of GDP, while total Japanese corporate debt (financial and non-financial notes and bonds) amounts to another 60% of GDP. Even if investors only shed a tenth of their aggregate debt holdings, the sum to be absorbed by the BoJ would roughly double again the size of its already swollen balance sheet.
But that’s not all. In acquiring those assets, the Bank of Japan would be creating another surge in high-powered money, but now in an environment of stronger growth, positive inflation and a probable rise in bank lending. Surely, at that point, even more large-scale monetary easing would be contrary to the Bank of Japan’s policy aims. After all, the BoJ has pledged to achieve 2% inflation—not a significant overshoot.
Of course, the BoJ could prevent leakage of more high-powered money into the economy by raising reserve requirements or hiking interest rates, but that would also create considerable risk of policy error—either doing too much or too little. An alternative would be to prevent the asset re-allocation in the first place. For some classes of existing bondholders—for instance, banks, insurance companies and pension funds—that could be accomplished by introducing regulations requiring them to hold government debt as ‘liquidity buffers’, ‘eligible collateral’ or for ‘macro-prudential reasons’. In other words, it could be possible to engage in financial repression to smooth the Japanese bond market adjustment in the move from deflation to inflation.
Of course, if Japanese policymakers throttle the asset allocation shift via financial repression, banks, insurance companies and pension funds would find themselves holding assets with very low yields, potentially below their cost of funds. Their share prices could plummet as a result.
In sum, the price of success—where success is defined as ending deflation in Japan—is likely to be significant volatility in Japanese asset markets. But the spillovers might not end there. Given their historic (and demographic) preference for income, Japanese investors shedding yen-denominated bonds might be inclined to re-allocate a significant fraction of their wealth to foreign notes and bonds, inducing a large capital outflow which could send the yen sharply lower in foreign exchange markets.
The bottom line is that Japan’s policy settings and preferences embed a great deal of implied volatility, only some of which has already manifested itself in asset prices. The proverbial cat has been thrown among the pigeons—scatter they must.
As is clear – the impact of these actions across varying asset classes is widely varied:
The data lead to a few stylized facts:
- A USA-Japan split: The first point is that measures of volatility in the US and Japanese markets have diverged markedly. While volatility behaviour was correlated during the post-Lehman crisis and during the European crisis, divergence is now plainly evident. It illustrates the point made above: The Fed’s QE has dampened volatility while the BoJ’s QE has boosted volatility.
- Not all markets are equal: The main movements are in fixed income markets. We note that the JGB futures market has been closed at various times due to excessive intra-day volatility. And swaption volatility is much higher than in the aftermath of the Lehman crisis. Meanwhile, currency implied volatility remains moderate compared to previous highs, as is the case for long-term equity volatility.
- Short-term volatility has reacted more than long-term volatility: Although a typical feature of the volatility curve, long-dated volatility has remained subdued, particularly for equities. That outcome is at odds with our view that the market volatility will remain elevated for an extended period for time.