In January 2016, Japan’s central-bank governor, Haruhiko Kuroda, told parliament that he is not thinking of adopting a negative interest rate policy as he believed that the U.S economy was a testament that inflation could be achieved with low interest rates policy alone. Less than a month later, the Bank of Japan backtracked and brought Japan into an unprecedented negative interest rates environment. Since then, the yen has surged to 18-month highs against the US dollar.
Following in the footsteps of Denmark, Sweden and Switzerland, Japan moved into an environment that was once thought to be impossible by many economists and investors. In Ben Bernanke’s last term at the Federal Reserve, investors’ belief that zero is the floor for central bank’s interest rates drove the taper tantrum, which sent treasury yields higher and lead many to believe that the 30 year bond market rally was over. 3 years later, the fed funds rate only moved by 25 bps to 0.50% while negative interest rates are fast becoming the norm.
The problem with negative interest rates
For central banks, negative interest rates policies are made in order to incentivize risk taking behavior, which would hopefully drive inflation and create economic recovery. The truth however, is that while consumers might have less of an incentive to put their money in the bank in a negative interest rate environment, the bulk of the world’s money supply is held in banks and financial institutions, including asset managers. Such institutions have access to the swap markets which allows them to hedge against negative interest rates.
In the swap markets, financial institutions in countries with negative rates facilitates money flows to countries with higher interest rates through cross currency swaps. For example, in the case of Japan and the US, Japanese banks would look for American banks to swap Japanese Yen for US dollars and invest in higher yielding assets in the USD bond market. To provide this service, American banks would charge a higher interest rate as demand for US dollar from Japanese investors grows. For American banks that are already earning higher spreads from strong demand, they would be getting a risk-free trade by parking their JPY into Japanese government bonds (JGBs) even though they might be getting negative returns from JGBs as a result of NIRP. The spread which they make from providing the swaps would be more than enough to make up for the loss from JGBs.
Such activities means that even though Japanese investors are taking more risk abroad, their money gets reinvested back into Japanese government bonds, creating an environment for a strong yen, which hinders businesses of Japanese manufacturers. The latest Tankan  shows that Japanese manufacturers expect USDJPY to trade at 117.45-117.46 for 2016 even though the Yen has strengthened to a low of 107.94 since the announcement of negative interest rates policy. In an environment of low oil prices and strong yen, there is a real probability of Abenomics coming to an end should the BOJ do nothing.
What the BOJ should do
There is no doubt that the strength in the yen could be driven by risk aversion or as Morgan Stanley and Societe Generale  suggests, a tightening of inflation-adjusted interest rate differentials between the United States and Japan. These reasons however, cannot be resolved by the Bank of Japan’s policies unless it involves direct intervention in the currency markets or unleashing fiscal stimulus to drive up inflation.
For the swap markets however, there are 2 things which the BOJ can do to increase the effectiveness of NIRP.
- Restrict access to JGBs by increasing their purchases of Japanese government bonds
- Cutting the supply of JGBs to the swap market by directly purchasing JGBs from the government.
Increasing the purchases of Japanese government bonds is likely the BOJ’s next policy move. Currently, the BOJ owns 34.5% of the entire JGB market  and while such holding levels might be high when compared to the Federal Reserve or Bank of England’s bond buying programs , it is inadequate for a country that is running NIRP. In the case of Sweden, the Riksbank increased its purchase of Swedish government debt to 15% by the September of 2015 , the year which Sweden implemented NIRP. Initially, the Swedish Krona weakened against the Euro, but by the end of September 2015, the Riksbank’s purchases were proven to be inadequate as the SEK resumed its upward momentum against the EUR. Therefore, if the BOJ were to embark on a similar strategy in their first year of negative interest rates, a similar outcome can be expected. Rather than increasing purchases of stocks through ETFs , the BOJ should focus its resources on the supply of JGBs. The best alternative is therefore, cutting the supply of JGBs to the market entirely, with the BOJ effectively acting as a lender to the Japanese government.
While such a solution would raise doubts about the central bank’s independence and increase Japan’s already heavy debt burdens, it would deter market makers from reinvesting JPY swaps back into JGBS and force them into riskier assets or at least, cool the demand for cross currency swaps and prevent the JPY from strengthening. No matter how much tools central banks claim to have at their disposal, it is clear that a growing trend of NIRP by different central banks reeks of desperation.
For Japan, memories from the Plaza Accord in 1987 should serve as a strong reminder that should Abenomics fail, they will be in for another “lost decade”. The time is now or never, for Japan to be bold with its policies and keep the JPY weak. If the BOJ continues to be bothered by G7’s pressure and allow the JPY to continue strengthening, Japan will not just face the risk of losing the chance to build submarines for Australia, but a real possibility of plunging into another lost decade with an aged population and a weakened United States as an ally.