Euro Forecast to Strengthen if European Central Bank Follows BoJ and Changes Policy Tactics
Were the European Central Bank to mimic the latest stimulatory tactics deployed by the ever-creative Bank of Japan we could well see a notably stronger Euro on the horizon.
At their September policy meeting, the Bank of Japan (BoJ) decided to change tactics again, focusing on strengthening the ‘organs’ of lending in the real economy: banks and other financial institutions, rather than just on interest rates and quantitative easing (QE).
The move could suggest the traditional method of stimulus adopted by central banks - lowering interest rates and embarking on Quantitative Easing programmes (QE) may be coming to an end.
Analysts have suggested we are potentially looking at the end of QE (which itself was developed in Japan) and the dawning of a new age of monetary policy which takes its cue from the latest model recently developed by the BoJ.
Now analysts are asking whether this a template for other central banks to follow – primarily the European Central Bank (ECB) which is seen by many to have exhausted its presently-deployed monetary policy tools.
Importantly, were the ECB to copy the Japan, what impact would this have on the Euro?
What has the Bank of Japan Done?
The new model focuses on providing support to Japanese banks, who’s profitability has suffered because of the low interest rates they can charge, especially, more recently, on longer-term loans.
This has not just raised concerns about the strength of the banking system but also the ability of pension funds and insurance companies to meet their obligations, since they are primary dealers in long term debt.
“Kuroda recently acknowledged that negative rates had cut into financial institutions’ profits by driving long-term yields lower, while pointing out that borrowing costs for businesses and consumers had also fallen.
“He also expressed concern about expected declines in returns on insurance and pension products, and the impact this could have on people’s confidence,” said a report on Bloomberg.
The strategy has important ramifications for currencies since it does not tend to depreciate them as much as QE or rate cutting.
The replacement of old policy with new, may therefore also spell a period of strength for the yen and the currencies of any other central banks who adopt it.
The Flat Yield Curve
The BoJ set base lending rates, which are currently at -0.1%, with the deposit rate also at a negative (tiered) rate.
This means that not only to banks have to pay the BoJ to deposit money with them, they are also unable to earn interest when they lend money out.
The situation has worsened recently after borrowing costs on long-term loans also fell to very low levels.
Traditionally longer-term loans earn more interest but the low interest environment, in part caused by thre central bank’s own purchases of longer-term debt via QE forced down longer-term rates as well as the already low short-term rates.
This caused a phenomenon called a ‘flat yield curve’.
In order to lift longer-term rates and thereby enable banks to generate more profit the BoJ decided, at their last meeting, to target their bond purchases and sales, so as to lift rates at the ‘longer end’ of the yield curve.
This in effect means buying less longer-dated debt and instead focusing on purchasing shorter-term debt.
This results in the flattened yield curve steepening again.
“The BoJ’s decision to steepen the yield curve showed they are taking into account the situation of financial institutions,” said Takeshi Minami, chief economist at Norinchukin Research Institute, quoted on Bloomberg.
As a result of the action, shares in Japanese banks surged as investors bet that the BoJ’s new framework would be less likely to erode commercial banks’ profits.
Another unforeseen side effect of the new strategy of ‘yield targeting’ was analysts speculating as to whether other central banks with bloated balance sheets, unprofitable banks and flat yield curves would also follow the BoJ.
One central bank in particular seemed to fit the profile for being most likely to target yields, and that was the ECB in Frankfurt.
A Stronger Euro if the ECB Adopts Kuroda’s Policy
A recent research piece by Deutsche Bank asks the question of whether the BoJ’s recent change in tactic’s provided lessons for the ECB?
“Central banks can and do learn from each other's experience. The ECB is also increasingly acknowledging the potentially counterproductive ramifications of negative deposit rates and of low, flat yield curves. However, we think that the ECB will not see the BOJ's new strategy as necessarily superior to what the ECB is currently doing,” note Deutsche Bank.
Whether or not the ECB adopts Kuroda’s yield targeting policy is significant for the euro, as if they do, the euro will probably appreciate.
The main reason they see for the ECB not adopting the policy is as a result of the possibility of a ‘legal’ challenge.
They also expect the ECB to choose to simply expand their QE policy in December.
Nevertheless, it is possible that Eurozone banks are struggling, and if the current hostile monetary climate continues, they might decide to embrace the BOJ’s bank friendly mechanism as an alternative.
“The negative impact on banks is an increasing concern and could cause an impairment of the policy transmission mechanism but the ECB will need evidence this is happening to bring a change in its framework,” said Deutsche’s chief economist Mark Wall.
Although the ECB has followed the BOJ in many policy areas, such as negative rates, and QE, it has not followed it in all – for example, the ECB did not follow the BOJ into a tiered negative deposit rate policy since it might have signalled the possibility of even deeper cuts, which Draghi himself said was not on the ECB’s agenda.
Wall, also says the inflation risks are different in Japan to Europe and deflation is more of a threat of Japan, therefore yield targeting suits it more.
Although the ECB acknowledges that banks have suffered as a result of low interest rates, they have not said that they have yet reached the threshold for policy being net negative – or the “reversal rate”.
The chances of the ECB embracing ‘yield targeting’ are not as high as it looks on the surface according to Deutsche, who’s views contrast with Citibank, however, given the fragile state of Eurozone banks and the need for a strong banking sector to drive the recovery in the region, there is still a reasonable chance the policy might be adopted and, if so it would almost certainly be accompanied by a strengthening of the euro.
