A new, so-called thriller called The Directive concocts a tale of stealing the Federal Reserve’s policy directive before its release to gain a market advantage. A Japanese version might work better.
After the Fed did what virtually everybody expected by announcing the end of its bond-purchase program, the Bank of Japan stunned the financial world on Friday by sharply ramping up its own version of the scheme, adding to its purchases of bonds and stocks, while that nation’s pension fund said that it would shift its portfolio holdings away from bonds and toward stocks.
With the BOJ picking up the money-printing baton handed off by the Fed, stocks soared around the globe, while the yen plunged against the dollar and the euro. Extending the previous week’s surge, the major U.S. equity gauges ended at records on Friday, while stocks in Tokyo jumped more than 7% on the week to the highest level since November 2007. Not to be left out, European stocks gained 3%, their best weekly showing since last December.
Except for machine-driven high-frequency traders that might transact millions of orders in milliseconds, it’s virtually impossible to gain a beat on Fed decisions. For the past two decades, the central bank has announced policy changes when they’re decided upon. And in recent years, in the name of transparency, Fed officials have been increasingly explicit about the direction in which they expect to take policy. If the markets have been surprised, it has been because the monetary authorities also have been surprised when their best-laid plans have gone awry.
The Federal Open Market Committee’s latest policy statement said the central bank would maintain the current near-zero interest rates for a “considerable time” after winding up its quantitative easing. If employment improves faster or inflation climbs closer to the Fed’s target, the bank would move up the first rate hike, and vice versa. As those incessant commercials about saving 15% on car insurance in 15 minutes assert, everybody knows that.
What markets didn’t know and didn’t expect was that Japanese officials would move so dramatically to try to spur that nation’s flagging recovery. Specifically, the BOJ upped its goal for the expansion of its monetary base, to 80 trillion yen ($720 billion) from ¥60 trillion to ¥70 trillion, a move the central bank’s governor, Haruhiko Kuroda, said is aimed at ending Japan’s “deflationary mind-set.” As a result of the plan to print more yen, the Japanese currency weakened to nearly 112 to the dollar from just under 108.
Meanwhile, Japan’s $1.1 trillion pension fund said it would shift its portfolio strongly toward equities—allocating 25% each to domestic and foreign stocks, up from 12% each—while trimming domestic bonds to 35% from 60%. In gambling terms, this is going all in on Abenomics, as the stimulus plan is called, after Shinzo Abe, Japan’s prime minister.
This is truly a dazzling example of 21st century government finance. The government runs a deficit covered by IOUs, or bond borrowings. The central bank buys those bonds to fund the budget shortfall and also purchases bonds sold by the pension plan, all with reserves it creates out of thin air. The pension fund uses the newly printed yen it receives from the BOJ for its bonds to buy claims against the future earnings of private industry—that is, common stocks.
Those are the financial impacts. In the real world, the effect is to make Japanese exports cheaper and to export deflation to Japan’s trade partners.
Friday’s 2.5% drop in the yen is equivalent to a $1,500 price cut on a $60,000 Lexus, the luxury brand of Toyota Motor (ticker: TM), or on an Acura, Honda Motor ’s (HMC) high-end marque. That would exert competition for BMW, Daimler ’s (DDAIF) Mercedes-Benz, Volkswagen ’s (VOW.Germany) Audi, Tata Motors ’ (TTM) Jaguar, General Motors ’ (GM) Cadillac, and even Hyundai Motors (005380.Korea), which is trying to break into that league with its Equus sedan.
The cheap yen would give less of a boost to the Toyota Camry or Honda Accord versus the VW Passat, Hyundai Sonata, Ford (F) Fusion, or Chevrolet Malibu, most of which are assembled in North America. That is a reflection of the globalization of the automobile industry in general, but more particularly the offshoring of Japanese industry over the past two decades, spurred by the overvalued yen.
A shift in exchange rates won’t get Toyota to move from Kentucky or Honda from Ohio, where they’re long established. And with the higher cost of imports—especially for fossil fuels needed to replace shuttered nuclear-power plants—Japan’s once-vaunted trade surplus has become a deficit.
Meanwhile, the higher prices from the weaker yen are weighing on Japanese consumers, along with the consumption tax hike enacted this year. This suggests that the monetary “arrow” of Abenomics “may now be having a negative impact” on Japan’s economy, according to a report by Richard Koo, chief economist of the Nomura Research Institute, written before the BOJ moved to drive the yen still lower.
And with 10-year Japanese government bond yields down to just 0.462%, equities’ allure is further increased.
None of this is working out as economics textbooks say it should. A lower yen should spur exports to narrow the deficit and stimulate growth. Expectations of higher prices should induce consumers to spend.
But it all makes for a good thriller novel.
AHEAD OF TUESDAY’S midterm elections, it’s apparent that a lot of Democrats running for Congress also have been running away from President Barack Obama. Indeed, Comedy Central, where a large swath of Young America gets its news, ran some hilarious clips about Democratic candidates not so artfully evading the question of whether they actually voted for the president in 2008 or 2012. Shades of “Have you now or have you ever been an Obama supporter?”
The odds narrowly favor Republicans gaining control of the Senate and adding to their majority in the House of Representatives, although as the great philosopher, Yogi Berra, reminds us, it ain’t over til it’s over. And that might not be Tuesday night if there are runoffs in one or more Senate races.
But that doesn’t mean investors aren’t pondering possible outcomes. On that score, a savvy investor tells our colleague Andrew Bary that financial companies could be winners if onerous regulatory burdens are eased by a GOP-controlled Congress.
Mid-cap banks such as First Republic (FRC) or Zions Bancorp (ZION) could benefit if the so-called SIFI limit—the size to be designated a Systemically Important Financial Institution—is lifted, freeing them from the scrutiny accompanying that status. Fed Governor Daniel Tarullo, the central bank’s key board member on regulation, has voiced support for lifting the minimum asset level to $100 billion from $50 billion. Another winner, one investor says, could be MetLife (MET), which has been fighting a SIFI designation, arguing that as a life insurer, it doesn’t pose the same risk as big banks. Giant banks such as Citigroup (C) and JPMorgan Chase (JPM) could also get regulatory relief.
The counterargument is that Republicans might be reluctant to loosen the reins on the banks, given the strong support garnered by Sen. Elizabeth Warren, the Massachusetts Democrat whose popularity in large part reflects her anti–Wall Street stance. Being pro-banker could also backfire on the GOP in 2016, both from Warren’s supporters on the left and the Tea Party on the right.
Other beneficiaries of Republican control of both houses of Congress could be Trans- Canada (TRP), which seeks approval for the Keystone XL pipeline that has been delayed by Obama’s vow to veto the project. As noted here last week, Republicans won’t have the 67 votes needed to override a veto, but who knows how things could go after the election?
Finally, beleaguered for-profit education outfits, such as Apollo Education (APOL), DeVry (DV) and Graham Holdings (GHC), owner of the Kaplan higher-ed business, also could fare better under a GOP Congress.
PERHAPS THE MOST important vote on Tuesday won’t be in Washington, says longtime Beltway insider Greg Valliere. In a note to Potomac Research Group’s clients, he writes:
“There are several crucial gubernatorial races that will have national implications— Wisconsin, Illinois, Florida, Kansas, etc.— but perhaps the most important one is in Rhode Island, where moderate Democrat Gina Raimondo is in a cliff-hanger against Republican Allan Fung. Raimondo is a rare Democrat who has vowed to curb public employee union benefits, which has earned her the deep enmity of organized labor.
“If Raimondo loses, it would be a warning to other Democrats that they could pay a price if they seek changes in COLAs, retirement ages, etc. If she wins, it would send a signal that voters want to reform pension benefits. Our sense is that voters want reform (the Illinois gubernatorial race, where Republican Bruce Rauner is closing fast, will be a key litmus test). This is a crucial and underappreciated issue—the greatest long-term threat to the U.S. economy is under-funded pension liabilities.”
Public pensions are of particular concern to muni-bond investors. In particular, bondholders don’t come before pensioners when the bankruptcy court decides how bankrupt cities’ obligations are to be met.
Quoting a Bank of America Merrill Lynch analysis of the Detroit bankruptcy, our colleague Michael Aneiro recently noted on Barrons.com that the city’s pensioners got haircuts of no more than 4.5% and elimination of annual cost-of-living increases. In contrast, the haircuts for unlimited-tax general-obligation bondholders and limited-tax GO holders were 26% and 66%.
Moody’s Investors Service says that Stockton, Calif.’s recent exit from bankruptcy set a precedent for higher recoveries by pensioners than by bondholders. Bankruptcy is the last recourse for overly indebted municipalities. But, as the Rhode Island vote shows, the competing claims of creditors and pensioners, and their effect on taxpayers who are on the hook for them, is only getting bigger. And it resonates far beyond the muni market.
