The JPY dropped 1.3% against the USD this week for a greater-than-6% drop since its late-September highs as it appears the market is content pricing Abe's dream of a higher inflation-expectation through the currency devaluation route (and not - for now - through nominal bond yields - implicitly signaling 'real' deflationary expectations). In a 'normal' environment, Barclays quantified the impact of a 1ppt shift in inflation expectations from 1% to 2% will create a 'permanent inflation tax' of around 18% (which will be shared between JPY and JGB channels). However, as we discussed in detail in March (and Kyle Bass confirmed and extended recently), the current 'Rubicon-crossing' nature of Japan's trade balance and debt-load (interest-expense-constraint) mean things could become highly unstable and contagious in a hurry. When the upside of your policy plans is an 18% loss of global purchasing power, we hope Abe knows what he is doing (but suspect not).
Barclays: How low can the yen go?
A revision of the BoJ inflation target could pose a greater downside risk to the value of the JPY than most market participants think. The LDP, which is likely to lead the new government after the Japanese elections, has argued that it would revise the inflation target to 2% from the still unmet target of 1%. Discussions are likely to remain lively until a new government is confronted with the actual perils of reality, but we and many market participants believe politicians patience with the central bank may be running out.
The timing of the more aggressive stance to target higher inflation is likely to depend on global factors as well, but the stars appear to be aligning for the changes to take place in the early part of 2013. The pursuit of higher inflation targets may have a destabilizing effect on domestic yield curves. The added volatility that may be introduced in the curve may well delay the initiative, if it were to occur. For these reasons, we expect the process to be gradual and to occur once global risks for markets begin to dissipate.
That being said, a window of opportunity may open up as early as the first half of 2013, with a diminishing of fiscal cliff risks in the US and an initiation of the OMT program in Europe. Then, the question remains: how much can the JPY depreciate in response to the new inflation-targeting regime.
The inflation tax
A back-of-the-envelope calculation suggests the upward move in USD/JPY can be surprisingly steep in response to higher inflation expectations. The Japan sovereign linkers curve goes up to 2018, six years into the future, and liquidity is rather scarce, which means the information on inflation expectations conveyed by the implied breakeven curve is rather poor. Still, 6y breakeven inflation implied by linkers is currently at around 60bp.
Instead, let us assume that inflation expectations are actually already running at about 1%, and that the government will manage to implement changes to force the central bank to successfully target 2% inflation. To be conservative in our estimates, we would measure success as the public fully buying into the 2% target, from a prevailing, de facto 1% inflation target. We note that this represents a lower bound in the size of the shift, since current inflation expectations are running lower than 1%.
An estimate of the theoretical impact 1% permanent shock to inflation expectations can be computed by discounting the government's expected revenues from seniorage on each yen outstanding (the right to tax those holding yen). Assuming seniorage is already 1% a year, we estimate the difference in government revenues for permanently raising the inflation tax to 2%. Revenues are 1% in the first year, and then 1% of the leftover value of the yen two years from now, equivalent to 98 cents in real terms (given the 2 percent inflation tax), and then 1% of the remaining value by the third year, equivalent to 0.98*0.98 =0.98^2 and so on.
Following this logic, we then discount all these government cash flows by using the actual government yield curve (as a proxy for a discount rate at different maturities, Figure 1).
The NPV of all these cash flows give us a difference in fiscal revenues between a 2% and a 1% permanent inflation tax equal to 18%.
JPY on the move?
This NPV reduction would affect market prices of both JGBs and the JPY. There are potentially two limiting cases that can be considered for the impact of the policy change.
- In the first one, JGBs price in the higher inflation expectations entirely through an upward shift of the curve. In this case, real interest rates remain where they are and the JPY is largely unaffected by the impact of the higher inflation target, which is then compensated by higher nominal yields (perfectly netting the tax off). In this case, the JPY remains unchanged and nominal bond prices in domestic currency drop in value, depending on duration, to accommodate the 100bp uniform selloff in nominal rates (Figure 1).
- And the other limiting case is one in which all of the burden of adjustment is borne by the JPY. This would happen if the central bank aims to bolster growth by pushing real rates lower and achieves this by keeping JGBs from selling off by using tools such as increased asset purchases. In this case, where the term structure of nominal interest rates remains unchanged, the JPY should then depreciate by 18% in response to a permanent change of 1% in inflation expectations to 2% from 1%.
Likely, the final burden of higher inflation expectations will be shared by bond prices and the JPY. While initially the central bank may attempt to keep the nominal yield curve steady, eventually we expect activity and inflation expectations to react, as a cheaper JPY helps economic activity. How much is shared by bonds and by the currency will ultimately depend on how fast activity reacts. The slower the reaction, the bigger the burden that will fall on the JPY.
We would expect considerable uncertainty around the channel through which the higher inflation target is priced. For the time being, it appears that the market is content selling the JPY and buying JGBs – suggesting that the JPY weakness may be the primary outcome of the policy move. The longer-term impact is somewhat clearer cut, higher inflation should put downward pressure on the value of the JPY versus all other currencies.
And the alternate - non-normal 'rational' world view that in fact is more likely to occur should be read here, and why rates cannot be allowed to rise...
And just to show the sensitivity of the world's most indebted nation to interest rates, here again is Andy:
Even though the yield on 10-year Japanese Government Bonds (JGB) is only 1 percent, the interest expense is expected to top 22.3 trillion yen in the fiscal year that begins next month. This is one-quarter of the general account budget. If the bond yield rises to 2 percent, the interest expense would surpass the total expected tax revenue of 42.3 trillion yen.
Yup: a mere "surge" in interest rates to a whopping 2.00% will destroy the Japanese economy.
Be Careful what you wish for Mr. Abe.