On the uncharted journey into unconventional monetary policy, negative interest rates are proving to be a step too far. Simply put, negative interest rate policy (“NIRP”) is failing: negative interest rates destroy capital, undermine the financial system and have so far failed to generate sufficient nominal GDP growth to reduce already very high levels of debt.
With disquiet about policy growing, policymakers, led by Japan, are edging further down the path towards outright monetisation of debt.
While its impact on growth was limited, to a degree quantitative easing (QE) worked in the US through portfolio preference. Investors were forced out of risk free government bonds and into risk assets such as equities and credit, putting upward pressure on Treasury yields as money flowed out of bonds into stocks. Higher yields supported investors’ belief both in the prospect of reflation and the effectiveness of policy.
In contrast, by pushing rates into negative territory the ECB and the BoJ are sending the wrong price signal and are undermining investors’ faith in the efficacy of monetary policy. We believe investors have good reason to be concerned: despite policymakers’ efforts, Japanese credit growth is running at only USD 50 billion a year, in the context of a USD 4.5 trillion economy and in the Eurozone is even more anaemic, with credit expansion of USD 45 billion in a USD 16 trillion economy. In our view, The benefits from reducing interest rates have been exhausted.
Given the failure of NIRP to reflate their economies, policymakers are now preparing for the next stage, which is to reduce the stock of debt as a share of GDP to kick-start nominal GDP growth. At the end of March, Japanese Prime Minister Shinzo Abe requested that FY2016 budget spending should be front-loaded where possible and that a new plan of economic measures should be put in place by May. While perhaps not as close to action as the Japanese, the ECB appears to be thinking along similar lines.
At the March ECB meeting press briefing president Draghi was questioned about the possibility of helicopter money – continued fiscal stimulus – and did not dismiss it out of hand. When questioned on the same subject a week later ECB chief economist Praet sounded sympathetic towards the policy.
Japan is leading the way, both because of the time the economy has spent mired in deflation, but also because it is well placed through its position in the regional economy to be aware of the growing risks from China. The Chinese economy accounts for 12% of global GDP, but nearly a third of global money supply and credit is growing at between 30%-40% a year. At some point we believe this discrepancy will have to be closed by either a sharp devaluation of the Renminbi and/or a rise in domestic inflation that reduce the real value of China’s excess money balances.
We believe Japan is considering a policy shift as protection against the threat from China. There is a growing awareness that taxing cash holdings does not work, particularly given Japan’s ageing demographic profile. Speculation has quickly spread that Japan is preparing a fiscal policy stimulus package of between 5 trillion-10 trillion yen, including postponement of the proposed consumption tax hike. Such a policy would probably require the government to issue additional bonds.
If, for example, this was structured as a fiscal expansion funded by the issuance of zero coupon perpetuals, which the BoJ were required to buy, it would be equivalent to helicopter money – freely distributing money to the public. QE alone is not helicopter money, because in exchange for giving money to banks, central banks receive government bonds and other assets; a helicopter drop also requires government fiscal stimulus.
Under more normal circumstances, governments have shied away from this policy path, fearing the upward pressure on long-term yields of higher bond issuance and the adverse impact on the budget deficit with the consequent potential for sovereign debt downgrades. In our opinion the policy of requiring the BoJ to buy zero coupon perpetual, would be one way to mitigate these negative consequences.
Clearly, a move towards debt monetisation through helicopter money would represent a very significant break with current government and central bank strategy. A policy shift on the scale that would warrant the term helicopter money may not be imminent, but the direction of travel in policymakers’ thinking is becoming clear and informs our longer-term market views. This unfolding picture is also set against a market backdrop where the consensus view is that with yields so low or negative, investors need to take more risk – liquidity, carry and credit risk – to generate any yield. A helicopter drop would potentially reduce the value of money and further destroy wealth and some asset markets are not priced to withstand a massive policy shift without permanently destroying capital.
Against this backdrop investors need to consider how their portfolio should look when policymakers’ focus is turning towards debt monetisation. We believe This new level of financial repression would clearly be an environment that supports a move away from traditional long-only portfolio allocations and is one in which it would be appropriate to be invested in liquid rather than illiquid assets.
In our view the appeal of gold will increase and investors might want to raise their cash holdings given the far greater uncertainty around the future direction of monetary policy. Asset market volatility is likely to increase significantly. If Japan does lead the way in embarking on a helicopter drop the yen will likely depreciate (Japan’s previous experiment with fiscal stimulus funded by JGB issuance in the 1930s prompted a sharp devaluation of the yen) and investors need also to consider the likely sharp rise in long-term yields when and if central banks move towards monetisation.
We are aware that these views, until very recently, would have appeared extreme. Also, given that the potential for a significant shift in policy is only beginning to enter investors’ mindset, we believe it remains prudent to maintain a dynamic approach to positioning since, as ever, timing will be an important element in successful exploitation of any investment opportunity. However, helicopter money has entered the mainstream policy debate. Major investment banks are now publishing research reports on the potential for its introduction and journalists are quizzing central bankers about whether they have considered it. As investors we need to be aware of the risks that this looming potential policy shift could create.
Federico Belak, co-portfolio manager LO Funds–Absolute Return Bond and CIO of Tactical Trading Funds & Fixed Income