Will The JCB End Its Addiction to Government Bonds?

Bank Of Japan Is In Trouble

The unwind potential of the central banks’ assets that is about to hit the market is remarkable in its scope; the fact that it’s all happening at once only adds to the drama. There could be currency implications if the ECB decided to increase its bond buying while the Fed unwound which is why it is globally coordinated. It’s like the Fed is trying to lead the central banks out of the wilderness. Clearly my worry is not being picked up by market participants as the stock market has had little reaction to the guidance. The survey below gives you a picture of what you can already figure by the action as about 55% think the Fed’s unwind will be a non-event or possibly a boon to stocks, particularly banks. I wish the question included 2018 because that’s when the results will play out as the Fed takes baby steps and the ECB begins to taper then. It’s also an awkward thing to say that the Fed unwinding is a policy mistake because this can be the correct action and simultaneously cause weakness in the economy. Every Fed hike weakens the credit market, but not all hikes are mistakes. I think this is the right thing to do, but it has consequences.

A great explanation of what is expected to happen is shown in the two charts below. First, we have the bank of Japan’s holdings of government debt and then we have the Credit Suisse forecast for the JCB to stop purchases in 2020. At face value, that forecast seems improbable. If you look at Fed forecasts of its own policy on interest rates, reality is always much lower than what the Fed sets out. In this case, I expect the JCB to either slow its buying less than expected or not at all. At the same time, the JCB is also running out of assets to buy so it might not be a voluntary decision. As you can see, there was a slight unwind in the mid-2000s, but the JCB has never held this much bonds and equities.


As I mentioned the Bank of Japan also owns stocks. At the end of June, the Bank of Japan owned a shocking 71% of all shares in Japan listed ETFs. The financial regulators have been trying to get shareholders to take a more active role in businesses like free market investors do in America. Obviously, a big problem is that the JCB is a passive investor. The JCB doesn’t care about how businesses operate which creates a morale hazard. Companies don’t get rewarded for good behavior and penalized for bad behavior, so they don’t operate as efficiently as possible. The Bank of Japan will own 75% of the free-floating shares of the company Fast Retailing which is the largest weighted stock in the Nikkei index which the JCB is buying. The chart below is a breakdown of the estimates done by NLI for how much of the free-float the JCB will own. Some say the JCB should switch to the more diversified Topix index, but that will only delay the inevitable. The most interesting question is what the JCB will do when it owns everything. There are clear dangers to buying stocks, but the JCB hasn’t shown any signs of stopping.

Economic News

One of the key economic reports released this week was the July Empire State Manufacturing survey. It showed deceleration as you can see in the chart below. The headline number fell 10 points to 9.8. It looks like this could be a temporary blip in an upturn, but this indicator has vacillated sharply, so it’s tough to draw conclusions about future results by just looking at this chart. The new order segment performed better as it only fell from 18.1 to 13.3.

One of the indicators which was positive was the prices paid index which was up 1.3 to 21.3. This is consistent with the new trend of reflation. It’s not much, but the 10-year breakeven inflation rate has been rising lately. It’s at 1.77% which is 11 basis points higher from the bottom. I’ve been monitoring inflation closely because some murmurs are that the Fed can’t raise rates a third time if it stays low. If inflation stabilizes and possibly rises in the July and August PCE and CPI reports, the murmurs will be silenced. There’s currently a 47.3% chance the Fed will raise rates by at least 25 basis points by December which means the increase in the breakeven inflation hasn’t affected results. The breakeven inflation helped me call the trend of disinflation months before the Fed recognized it. Ironically, the Fed’s tacit acknowledgement of disinflation came at the low. Either the Fed is terrible at timing or it’s change affected inflation. Either way the quarter point hike may be back on the table when the inflation reports come out. I am looking for modest improvement.

Getting back to the Empire State survey, one of the worst parts was the employee workweek index which fell 8.5 points to 0. That’s a bad sign for the labor market which may see sequential declines in July as the government won’t hire as many employees as June. The headline number for expected general business conditions fell 6.8 points to 34.9. The worst future category was new orders which fell 8.8 points to 33.4. This may indicate that the weakness will continue into August.

Conclusion

The Bank of Japan owning 71% of stocks is a problem which will dog the efficiency of Japanese corporations. I believe any talk of the JCB selling stocks is lip service. They recognize the problems they are causing, but aren’t willing to face the music which would be painful as selling ETFs would cause a correction.

In America, the economic hopes in April about Q2 have been dashed. The Empire Fed survey shows that manufacturing in the northeast is slowing in the beginning of Q3. That’s not hopeful for Q3 GDP growth. If the Q2 GDP report comes in below 2%, it could further the push to not raise rates again this year.

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