The Daily Update - BoJ options

One hundred years ago today, “Little Willies”, or Lincoln Machines were introduced as the first ever tanks to be used in warfare at the Battle of Flers-Courcelette. Why would a dangerous machine be referred to as a “Little Willie” you might ask? Well, there was a very popular comic strip posted in the Daily Mirror at the time by William Haselden, called “The Adventures Of Big And Little Willie”... makes sense? Meanwhile, the word “tank” derived from the armoured vehicle’s initial reference of “water carrier”; which was used to befuddle enemy spies. How far this past century has taken us, with the announcement earlier this week that Japan has unleashed an aptly named “Prodrone”. Armed with two robotic claws, the drone is capable of lifting as much as 22lbs (10kg) each arm while flying almost as high as the summit of Mount Kenya, at top speeds of 37mph, in most weather conditions!

If only the Prodrone could be used to lift Japan out of the massive deflationary hole it has been faced with for the past quarter of a century. The deployment of stimulus and reform packages have apparently still not reached their limits despite little evidence of any upside; wage growth remains low and the “safe haven” yen’s relentless appreciation this year has left carnage in its wake. We have heard various chatter this week regarding BoJ action / inaction on MPC Thursday next week; whatever the central bank delivers it will no doubt disappoint markets; either because it is too little or too much.

All number of ideas have been thrown out this week, including sitting tight, unleashing an even deeper rate cut and the option of hoovering up shorter dated bonds to ease pressure off the long-end of the curve and the recent drain on market liquidity. The BoJ currently owns over a third of the outstanding JPY909tn (USD 8.85tn) JGBs this is estimated to increase to as much as 60% by 2018, or more if the BoJ increases its JGB purchases, possibly to around JPY 80-90tn. Also under the current scheme the central bank is only able to purchase JPY100bn of a company's debt, provided this stays below 25% of total outstanding issuance. Considering the Japanese corporate bond market stands at a small JPY57tn, well, small versus the country’s sovereign debt market, the 1-3 years maturity bracket, investment grade only and ex-financial company restrictions seem a bit tight. Seeing as issuance within the corporate bond sector has increased around 30% so far this year, according to sources, could it be time that the the BoJ widens its corporate bond purchasing scope?

Could the possibility of switching a small proportion of Japan’s current debt into very low coupon perpetual notes be discussed; although a change of law would be required. In most other cases this may not be desirable as it could be inflationary, but this is exactly what Japan is after. Increased policy cooperation between the BoJ and government could be announced. Another option could be for the government to use a proportion of its ~USD 1.26tn rainy day fx reserves, the second largest in the world after China (at USD 3.3tn), as, let’s call it a tax break rather than “helicopter money”. Tax credits on investment in infrastructure, tech and education could also boost inflation. In the world we live in, where lackluster growth and low inflation are the new norm, could it be a case that the central banks should actually stop chasing the 2% inflation target and instead look to stimulate nominal demand and seek to obtain better quality and more sustainable low growth.

We look to both the Fed and BoJ, who will deliver their policy decisions next Thursday, if both central banks maintain status quo, we expect a risk-on rally. The futures market is only pricing in a 20% chance of a rate hike in September, and 52% in December. The most likely scenario would be where the BoJ moves to steepen the JGB curve and Fed remains on hold. We remain comfortable with our highly rated single A portfolios with a bias at the long-end and ~3-3.5 credit notches of cushion.