The BoJ's monetary expansion and its impact on the yen

At the end of last October the Bank of Japan announced a large stimulus increase which was followed by a sharp decline in the yen. In 2015 however the declines have stopped as USD/JPY remains range-bound.

Source: barchart

Moreover, the trade-weighted yen index has been on the rise this year.

This seems inconsistent with the Bank of Japan's monetary expansion, which remains extraordinary. The nation's bank reserves - and therefore the monetary base - rose sharply in 2015.

Bank Reserves (source: BOJ)

Japan Monetary Base (source: BOJ)

Has the yen depreciation played out its course for now? The markets do not seem to be expecting significant further declines in the near-term, as the speculative accounts' net short yen positions are cut. It's almost as if we've reached what some have termed "quantitative easing fatigue": further yen depreciation requires ever more aggressive securities purchases announcements by the BoJ.

Source: Investing.com

In fact the yen has risen against the dollar for six consecutive sessions as of Friday - the longest winning streak for the currency since September 2012. As of Sunday night, the yen continues to strengthen.  Part of the issue has to do with softer than expected economic performance in the United States, which is stalling the US dollar rally. For example the US industrial production index declined by 0.64% last month - the largest percentage drop since May 2009.

In the long run however, further yen weakness seems inevitable. The reason has to do with the sheer relative size of Japan's quantitative easing. Based on the latest projections, the BoJ's balance sheet will be above 90% of Japan's GDP within a year or so. This dwarfs other major central banks' monetary expansion efforts, including that of the ECB. Furthermore, given the scope and size of this program, it is unclear if the Bank of Japan can ever effectively exit it without a massive disruption to the nation's economy. While we could see the yen strengthen briefly in the near-term, the currency will remain under pressure for some time to come.

Source: Goldman Sachs

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Bank of Greece expulsion from the Eurosystem could be especially damaging to the currency union

Risks to the euro area's ongoing economic recovery have risen recently as Greece once again takes center stage. The nation is about to become the first developed economy to default on its IMF obligation (joining countries such as Sudan and Iraq). Such outcome may also ultimately result in its exit from the EMU.

Reuters: - Cut off from markets and refusing so far to accept the terms set by its lenders, the Greek government may have to choose in the next few weeks to pay salaries and pensions or repay International Monetary Fund loans.

Its official creditors - the euro zone and the IMF - have frozen bailout aid until the new leftist-led government in Athens reaches agreement on a comprehensive package of reforms.

A deal had been pencilled in for an April 24 meeting of euro zone finance ministers in Riga, but it now seems too ambitious, officials said.

That has raised fears the Greek government will not be able to make its next payments to the IMF, which total some $1 billion over the next month. Missing an IMF payment could mean default and, eventually, an exit from the euro zone.

The fiscal situation in Greece has become untenable, with tax revenue collapsing and government cash position barely sufficient to pay government employees and cover pension obligations through the end of the month.

Reuters: - Greece will need to tap all the remaining cash reserves across its public sector -- a total of 2 billion euros -- to pay civil service wages and pensions at the end of the month, according to finance ministry officials.

Barring a last-ditch deal with its creditors, that is likely to leave no money to repay the International Monetary Fund almost 1 billion euros due in the first half of May, although Greece has said it wants to honor its debt obligations. Athens' scramble for basic funds shows how extreme the financial constraints on Greek Prime Minister Alexis Tsipras have become as he tries to convince skeptical foreign creditors to extend his country new financial aid.

Will we see a last minute compromise? Perhaps. But the Eurogroup is experiencing what many dealmakers would categorize as "deal fatigue" - the motivation to find an emergency solution is no longer there. Moreover, the political climate does not favor a compromise with Greece. While the focus has been on Germany, it is the smaller nations such as Slovenia that have argued vehemently that Greece must comply with the original bailout terms. Slovenia, who struggled through the downturn, cutting pay and shrinking expenditures, views Greece as using the bailout funds for pay increases - and then asking for debt forgiveness. Slovenia's taxpayers whose pensions are considerably lower than those in Greece will not look favorably upon such action.

The Slovenia Times: - Our exposure to Greece is 2.7% of GDP, which was in a year after we had a 8% fall in GDP and when we had to slash pay and economise in all areas."

This is why Slovenia will insist on Greece continuing with the restructuring and continuing to meet its obligations to Slovenia as well as international institutions, [Slovenia's Finance Minister Dušan] Mramor said.

"Given such an exposure Slovenia has toward Greece and such solidarity we provided, Greece has said it plans to raise pensions, raise pay, make employments in the public sector and demand an extra cut it its liabilities to Slovenia, while in Slovenia we are slashing pay and economising in all areas," Mramor said.

With little political will to provide additional financing, what happens after the IMF default by Greece? According to Bank of America, "it would trigger a parallel default to the Eurozone bail-out fund (EFSF) under the legal master agreement, and might force the EFSF to cancel its loan packages and demand immediate repayment. This in turn would trigger a default on Greek government bonds issued under the bail-out accord."

The markets are pricing the probability of default as a near certainty at this point, with credit default swap spreads blowing out.

Greek 5-yr and 1-yr sovereign CDS spreads (source: Barclays Research)

The Greek sovereign debt yield curve has inverted further, with the 2-year yield now above 25%.

It is not at all clear what will happen after the default, but the so-called Grexit becomes increasingly likely. Most analysts now believe that unlike in 2012 the Eurozone will be able to weather this storm due to its better capitalized banks, the ongoing quantitative easing by the ECB (coupled with other measures such as TLTRO), well established bailout mechanism (the ESM), and the OMT backstop facility designed to allow the ECB to support any state that is having liquidity problems. The Eurozone should be able to absorb the losses on some €330bn government exposure to Greek public debt.

French Finance Minister Michel Sapin (via Reuters): - "We have learned to build walls to protect ourselves, to protect the banking system, to protect other countries which could become fragile, if something happens in Greece. So Europe is much stronger. Europe has sheltered itself from turbulence. The danger is for Greece."

However, as discussed before, the nation's divorce from the European Monetary Union will be complex and fraught with more uncertainty than many realize. It's not just about Greece defaulting on on the public debt but also about extracting the Bank of Greece from the Eurosystem. By the time Greece imposes capital controls - which seems increasingly likely - the run on Greek banks will have taken its toll. Deposits have already declined sharply since late last year.

Source: Barclays Research

The Greek banks are replacing these lost deposits with emergency funds (ELA) from the Bank of Greece, who is in turn borrowing from the Eurosystem via TARGET2. With these banks increasingly dependent on central bank support, valuations are collapsing as the need for more bailouts becomes clear. This is especially the case if Greece defaults on its bonds which are widely held by Greek banks.

Greek banks share index

So if the Bank of Greece is borrowing, who is doing the lending? The funds come from the other euro area central banks (via the Eurosystem), particularly the Bundesbank. We can see the increase in this exposure to Greece on Bundesbank's balance sheet. As the Greek citizens are removing funds from their banking system (including taking out bank notes), this balance sheet item at Bundesbank rises further.

Source: the Bundesbank (the latest increase is almost entirely due to Greece)

In a Grexit scenario, as the Bank of Greece is expelled from the Eurosystem, it will default on its TARGET2 obligations. That in turn will force Bundesbank (and other core euro area central banks) to take a write-down. Of course a nation such as Germany should easily absorb such a loss and recapitalize its central bank. But at that point the Germans will surely want to know just how much more of such exposure their central bank holds.

The answer at this point is that nearly 70% of Bundesbank's assets are in TARGET2 claims - a half a trillion euro exposure to periphery nations' central banks. How much support for the EMU will the Germans have once they realize that a large portion of their central bank's assets could be at risk? After Grexit, the TARGET2 exposure will no longer be some abstract concept - the risk levels will become quite real and German politicians and the media will surely drive that point home.

Moreover, as Greece imposes currency controls, depositors in other periphery nations are likely to also begin shifting capital out of their domestic banking system - as they see the writing on the wall. Portugal, Spain, and Italy are particularly vulnerable. Such actions will of course end up increasing TARGET2 imbalances further (as was the case in 2012), putting more of Bundesbank's balance sheet at risk. Contagion could become a major problem again. We already see some early signs, as periphery bond yields rose last week in spite of all the QE buying efforts.

Certainly Grexit related damage can be managed by the national central banks and the European Stability Mechanism. These institutions will be promptly recapitalized. Such actions however will anger citizens of some member states, whose taxpayers' funds will be used to fix the damage caused by Greece. Given the chaos and the political backlash such an outcome will generate, it's unclear when - if at all - confidence in the currency union will be restored. As discussed before (see post), history is not on the Eurozone's side.


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Renewed demand for dollar funding in the Eurozone

In 2011, as the sovereign debt crisis engulfed the Eurozone, the EUR/USD swap basis was deep in the negative territory (see 2011 post). It was caused to a large extent by US money market funds who refused to roll dollar-denominated commercial paper issued by European banks. Just as the Lehman commercial paper exposure turned toxic for money market funds in 2008, so was the Eurozone bank exposure in 2011.

In late 2011, with limited ability to fund dollar assets on their balance sheets and no access to dollar deposits, many Eurozone banks turned to the foreign exchange markets. Given their access to euros (via deposits or loans from the ECB), banks converted euros to dollars and used the basis swap market to hedge their FX exposure. That demand for EUR/USD swaps pushed the basis into negative territory. The ECB's currency swap with the Fed alleviated some of the stress by allowing the ECB to lend dollars directly to the euro area banks.

Now the EUR/USD basis swap has turned negative again and some have suggested that the funding pressure on Eurozone banks is back.

Source: @acemaxx, Morgan Stanley

But that's not at all the case. The culprit this time around is the areas demand for yield. Eurozone banks can now access euros at negative rates (chart below) and are willing to pay up on the basis swap to obtain dollar funding - in order to access better yielding dollar assets (USD bonds and loans).

Source: MMI

Moreover, higher-rated US corporations have been actively issuing euro-denominated bonds this year as the demand for quality bonds spikes in response to ECB's QE. These US firms then convert the proceeds from the bond sales to dollars in order to fund US operations. But since they will need to repay euros in the future, they hedge themselves with EUR/USD basis swaps. That puts further downward pressure on the basis.

Demand for dollar funding in the Eurozone is likely to remain elevated, as the area provides extraordinarily cheap financing while access to quality fixed income product has become increasingly limited.

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First raw data on ECB QE show asymmetrical purchase patterns; yes, negative rates have a role in it.

Guest post by Marcello Minenna


As the first streams of data related to asset purchases are released by the ECB, we can begin to investigate trying to test different speculative theories that have circulated a lot in the past weeks.

Many words have been spent about the technical feasibility of the €1.1 tln ECB purchase program given that NCBs have to buy €800 bln of government bonds, potentially disrupting those market segments already affected by unbalances. We are referring mainly to the German Bund market, where negative rates up to the long part of yield curve have become the norm in the past three years: actually we observe negative yield for 7 years bonds (Figure 1). Many concerns are related with the potential eligibility of this growing class of debt securities. In fact the ECB has set a limit of -0.2% (equal to the ECB deposit facility rate), thus implying that government bonds with an implicit yield exceeding this threshold cannot be purchased. But also other core countries are potentially affected: France, Finland, Austria, Netherlands. Draghi has recently reassured the market declaring that he does not foresee a scarcity of eligible securities in the medium term.

Figure 1

A general overview of yield structure of the German debt says that over 40% of the negotiable bonds is trading at negative implicit yields; on the same boat we see the little open economies of core Europe and, to a lesser extent, France (Figure 2).

Figure 2

The last available ECB data tells of €32.8 bln of government bonds and €4.92 bln of ESM/EFSF/EIB bonds purchased by the NCBs, while €3.28 bln have been bought directly by the ECB for a total of €41 bln of asset purchased. This corresponds roughly to a mere 4% of the overall program. Despite the thin sample, interesting patterns can already be observed: some obvious, other less. If we look at the bonds purchased that were trading at a negative yield (Figure 3), we obtain a picture fairly correspondent to the scenario represented in Figure 2.

Figure 3

The ranking order of Figure 2 is somewhat respected; what we observe is that the sole starting of the program has driven the yields further in the negative territory, with the appearance of sub-zero yields also on Italian, Irish, Spanish and Slovak bonds. Furthermore, the NCBs seem to be not influenced in their purchase strategy by the increasing quota of bonds in the negative side, since the results of Figure 3 are compatible with a uniform purchase pattern that does not try to avoid negative yields.

In reality, negative rates matter. More complex considerations arise in fact when we decompose the data sample by looking at the maturity of the purchased bond (Figure 4).

Figure 4

It appears that the NCBs are prevalently using two purchase strategies. The most widely used, that we define for this reason the “standard” one provides a dominant quota (a bit higher than 40%) of medium term bonds up to 5 years, a lower quantity of medium-long term bonds hovering between 30% and 40%, and a residual part of long term debt securities that oscillates more but does not go much over 20%. Having considered that the major part of eligible assets are concentrated in the [2-5] years interval, it emerges that the NCBs that are following the standard strategy are purchasing in a uniform, predictable way. The NCBs of peripheral countries and, notably, of Austria and Netherlands are behaving in this regular manner.

Things change for what regards Germany, France and the related group of small continental countries (Slovakia, Finland and Belgium). In fact, these “core” NCBs are implementing a different strategy that sees the purchase of a prevalent quota of medium-long term debt securities (the threshold of 40% is always breached). The level of medium term bonds bought is significantly lower with respect to the other group of central banks, while the quantity of long term bonds swings a lot, clearly playing the role of a residual quantity.

The evidence hence suggests that something is altering the purchase strategy of these NCBs; negative yields have a role, but it seems strictly related to the impact of -0.2% lower limit. In other terms, the NCBs are willing to buy negative yields bonds, but they can only buy until they do not breach the bound imposed by the ECB; in presence of the -0.2% limit, the NCBs are forced to comply with the rules, by shifting to long-dated bonds that are characterized by an higher yield (even if always negative). In this perspective, the potential damage that core NCBs may suffer from negative rates in terms of a reduced flows of interests is not affecting (for now) their purchasing behavior, despite the problem has not yet been addressed by the ECB.

In summary, Bundesbank, Banque of France and the central banks of Finland, Belgium and maybe Slovakia are already suffering the impact of the -0.2% bound, while De Nederlandsche Bank, despite the high share of “sub-zero” bonds bought, is not under pressure to change its purchase strategy. And this is only the beginning: the situation is likely getting worse if we take a glance of the future net issues of debt securities for the Eurozone (Figure 5).

Figure 5

The projections clearly demonstrate the poor supply of core government bonds in the near future that could exacerbate the differentiated behavior of the central banks. In fact, a protracted asymmetry between the NCBs purchase patterns could potentially induce distortions in Eurozone government term structures, by pushing core long term yields lower than peripheral ones. This would imply a widening of spreads that does not appear coherent with the ECB target of restoring Eurozone yields convergence and that cannot be considered a sort of “proper” compensation for the minor profits endured by core NCBs.

In the not so distant future, the ECB may be forced to revise the -0.2% lower bound in order to match the monthly asset purchase target of €60 bln. Time (and data) will tell.


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