Originally written on 16th May 2013
BoJ’s ambitious plan to simulate domestic economy by sloshing the system with monetary easing (printing yen and exchange these yen to buy bonds and mortgages of all maturities) in order to stimulate domestic demand and inflation (2% inflation in 2 years by expanding the monetary base by 2 times) will have repercussion far beyond Japan
For one, printing money to artificially sequester real interest rates will at some point make investors in JGBs reluctant to either buy more JGBs or continue holding existing ones in the portfolio-consider the plight of an investor who has sacrificed consumption in the past to buy these bonds now find its claims at par with those who have brought the bonds by simply printing the money!-That scenario, if it comes to pass, will spell doomsday for Japan as the country currently has the highest Debt to GDP ratio (>200%) in the world (to put it in context, struggling Italy and Spain have debt to GDP ratio near about 100% but unfortunately cannot print their way out of the problem) and public debt is mainly financed through domestic savings.
After the bursting of the real estate and stock market bubble in early 1990s’ Japanese retail investors have mainly preferred to invest savings in bank deposits which in turn are channelized to buying JGBs. Loosing investor confidence may result in steep rise in yields –no matter how much more the government keeps printing money. On the other hand, retail investors were comfortable buying JGBs near zero return given that inflation was negative in Japan for a very long time and stagnant economy subdued outlook for other asset classes (such as domestic real estate and equities), that may now change with inflation outlook becoming positive and Nikkei at 5 year high giving investor more options than putting money in boring JGBs
The aggressive stimulus may have unexpected impact on Japan something with which the world has no prior experience in recent history, If I were to make a wild guess, I suspect the impact will be mainly on driving up steeply Yen yield curve (the trick is plain to see for JGB investors) and the associated problem Japan may face to funds its unbridled public debt –a scenario which will see yen depreciating much more
What would this mean for global asset classes
1. First and foremost, selling one currency to buy another one eroding its value at a slower pace is not a solution, the ultimate hedge will remain hard assets such as real estate, commodities and metals
2. Secondly, even though global economic growth may be sluggish, equities are placed relatively better than bonds fundamentally, as they are natural hedge against hyperinflation, as well as, share any upside that monetary stimulus is purportedly suppose to achieve. In that case, equity valuation multiple may remain higher than can been the case in recent past even without encouraging topline or bottomline growth
3. Gold price correction in the recent past is puzzling when juxtaposed with the debasing of currency in Japan / US and maybe soon in EU due to competitive pressures. Gold has always and will remain a hedge against monetary debasing and threat of future inflation
4. As lower yen conquers market share at Germany’s expense, EUs incentive to debase euro further which will meet the interest of both northern and southern members will rise, the question is if all three major currency blocs (EU, Japan and US) desire a lower exchange rate for itself, the depreciation will be relative to which currency?
5. An event / catalyst which can trigger market to reject buying QE prone currencies and nominal bonds denominated in those currencies will be a milestone event for world monetary policy. And possibility of countries once again reverting to fixed exchange rates or exchange rates tied to gold reserves cannot be ruled out in next decade or so. Although this may sound far-fetched now, such arrangements and reversion from free floating to fixed exchange rates and vice versa have happened multiple times over the past 200 years. With each episode of reversion from floating to fixed exchange rates being subsequent to sharp episodes of inflation usually after rising wartime public debt
6. That view also explains why holding gold as long as printing presses at major central banks keep humming (and a few years after that to confirm status on ensuing inflation) is a good idea even though there may be opportunity costs involved here.
7. Also for the first time in a generation, equities might actually be a safer assets than the risk-free asset called government bonds we grew up learning about