The Mad Scientists of Monetary Policy
Victor Frankenstein was a promising young scientist who became obsessed with the notion of simulating life. After years of steadfast study and maniacal experimentation, he finally achieved his goal of imbuing life into inanimate matter. However, rather than marveling at the miracle of his achievement, he instead became horrified at his ignominious creation. Frankenstein’s monster was a terror who killed people Victor knew and loved.
Mary Shelley’s original novel, first published in 1818, is of course science fiction. But today, much like Dr. Frankenstein, central bankers are trying to create life in the financial system. Only unlike Frankenstein’s work, their financial experiments are all too real.
And unfortunately, there’s not just one mad scientist . . . but many. Who are today’s Drs. Frankenstein? Haruhiko Kuroda at the Bank of Japan (BOJ), Mario Draghi at the European Central Bank (ECB), and Janet Yellen at the US Federal Reserve. They each have a monster in their castle.
What do I mean? Central bankers have embraced extraordinary monetary policies to create economic growth where none would exist. How have they done this? By printing lots and lots of money and injecting it into the system through massive bond purchases. The aggregate bond market is growing, of course, but bonds are being purchased and locked away in central bank dungeons faster than new bonds are being issued.
At the present pace, central banks will soon run out of bonds to buy. The end game is in sight.
Beginning in March 2015, the ECB embarked on its own quantitative easing (QE) program, buying sovereign and agency bonds at an initial pace of €60 billion per month, which it then ramped up to €80 billion a month. Since then, the ECB’s balance sheet has grown from about €2 trillion to €3.4 trillion in just 18 months.
Though eurozone sovereign debt outstanding stands at €7.5 trillion, ECB rules dictate that it can only buy bonds between two and 30 years maturity and must yield more than -0.4%. According to Tradeweb, the maturity and yield restrictions renders €1.5 trillion in bonds ineligible for purchase by the ECB, bringing the total available for purchase down to €6.0 trillion. Also, the ECB cannot hold more than one third of a given issue or a given country’s debt.
Consequently, the problems at the individual country level are even more acute. Based on an analysis of the €1.13 trillion Bloomberg German bond index, more than 60% of German debt fails to meet the ECB’s yield criteria. According to UBS, the ECB will run out of German bonds to purchase within months.
The BOJ is pursuing a similar strategy, buying at a rate of ¥80 trillion (about $765 billion) Japanese government bonds (JGBs) per year. Against total debt outstanding of ¥1.1 quadrillion as of 30 June 2016, this translates into over 6.7% of the debt stock per year — and over 14.3% of GDP.
How does the Japanese government keep this game going? By issuing more bonds than the BOJ buys each year. You see, sovereign debt has a special relationship with money. When a government issues debt, it acts as a restraint on inflation. Conversely, when a government prints more money, as through QE, it acts as an inflationary force. (What exactly it inflates is a separate question.) For instance, the BOJ purchased ¥81 trillion of JGBs in 2015, however, Japan’s Ministry of Finance issued only ¥15 trillion in bonds — meaning the BOJ purchased more than five times what the government issued, as measured by the change in Japan’s government debt. Historically — before Abenomics — this relationship was reversed. The Japanese government issued about five times what the BOJ purchased. This program has been in place for three years. But can it continue?
The question is really one of agency. In order for Japan, the EU, or any country to continue propping up markets, it must be able to sell substantially more bonds than it buys (through the printing of money).
To sell bonds, these countries need willing buyers. By purchasing lots of bonds, the BOJ places a bid under bond prices, which gives private investors some assurance that bond prices will go up. This is the easy part.
Where it gets hard is once rates turn negative — and over $13 trillion of the global bond market is now priced with negative yields. Eventually, it will make more sense for investors to hold cash yielding 0% than to buy bonds at negative yields. When precisely storing and safeguarding cash becomes more attractive than the implicit security of buying bonds at a guaranteed loss is unclear. But there is a negative rate when the game will change and people will stop buying bonds and put their cash under their mattresses instead. This is when the monster runs loose in the city.
A central bank with the authority to print money can always print more. But this doesn’t mean that there will be enough bonds for the central bank to purchase. So as central banks run out of acceptable bonds, they will need to lower their standards or buy other types of assets. That is, central banks will buy risk assets like junk bonds and equities and private businesses and real estate. And in doing so, financial markets then reward risk taking — even when it ceases to be sensible. These are the incentives the mad scientists face and they clearly understand the writing on the wall.
Already, the ECB has widened its net by buying corporate bonds at a pace of roughly €2.5 billion per week (the ECB probably owns about €30 billion in corporate bonds as of 6 October 2016).
The ECB’s corporate bond buying has also spawned a second layer of agency costs: Investment banks and their corporate clients are now issuing corporate bonds tailor-made for the ECB corporate bond program through private placements. In such private placements, there is no prospectus, no press release, and no transparency. Moreover, the average yield on investment grade corporate bonds eligible for ECB purchase has fallen from 1.3% before the ECB announcement to 0.65% today.
Such low-cost financing encourages companies to take on risky projects that would ordinarily never come close to meeting return thresholds. The ECB has created a seller’s paradise that can be (temporarily) good for corporate management, but not necessarily for long-term value creation. It’s a classic case of build up now, blow up later.
Worldwide, low interest rates have pushed corporate debt to record levels. Nonfinancial corporate credit has risen to nearly 50% of GDP in emerging markets — an all-time high. The global corporate debt-to-EBITDA ratio has reached three — the highest ever recorded — in a supposedly healthy economy. In effect, companies are borrowing from the future to reward the present.
The BOJ has widened its net as well. In January 2015, it began purchasing equity exchange-traded funds (ETFs) and is on course to become the top owner of 55 stocks in the Nikkei 225 Index. In fact, in July 2016, the BOJ doubled its purchases of Japanese stocks. In some circles, the BOJ is now known as the Tokyo Whale.
Though the BOJ still owns less than 2% of all outstanding Japanese stocks, the devil is in the details. For instance, a company called Fast Retailing with a market cap of ¥3.6 trillion only has a free float of about 25% of outstanding shares. At the current pace, BOJ will own about 63% of Fast Retailing’s float by the end of the year. Incrementally, BOJ will encounter more and more limits to available assets. On the one hand, the shrinking supply will make it easier for them to drive up bond and stock prices. On the other, it will send interest rates lower (further into negative territory) and further separate security prices from underlying fundamentals. Not only is this a bad outcome for investors, these experiments are creating massive misallocations of capital.
But the BOJ isn’t just running out of stocks to buy, Japanese banks need to use JGBs as collateral in their day-to-day operations. Japan’s three largest banks, Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Mizuho Financial Group each cannot reduce their holdings of JGBs much beyond their current levels without harming their current operations. “Considering the need for collateral and other factors, we generally don’t envision cutting the balance any further,” Mizuho spokesman Masako Shiono said. Mizuho’s assets are currently about 5.4% JGBs. Historically, Japanese banks held about 5% of total assets in JGBs. This figure increased to 20% when the BOJ first introduced zero interest rates in 1999. According to UBS economist Daiju Aoki, in-bank holdings of JGBs typically amount to 12%–13% of assets today. Mitsubishi currently has 9% of their assets in JGBs and indicates that it needs a minimum of 5%, or ¥15 trillion. Sumitomo is already below the others at 3.8% of assets, suggesting that it too has no further room to sell JGBs.
Japan Post Bank, another major holder of JGBs, has already cut its holdings by 42% since March 2013 when Abenomics was implemented, leaving approximately ¥80 trillion in JGBs on its balance sheet — just one year’s worth of QE (assuming the Post Bank would be willing to drive their holdings of JGBs down to zero). At the end of March, Japanese banks collectively held ¥94.7 trillion in JGBs (with maturities greater than one year) on their balance sheets. But they need to retain about ¥30 trillion as collateral to conduct day-to-day operations. So that leaves roughly ¥64.7 trillion JGBs available for sale as of March. Today, it might be as low as half that.
As if that weren’t enough, the BOJ is already buying corporate debt at 4% of its annual ¥80 trillion QE program. However, it is publicly considering expanding their purchase of corporate debt to include riskier junk bonds.
All this suggests that if the strategy remains the same, then the tactics must change.
In the United States, Yellen has called a halt to QE. But that hasn’t stopped the US government from devising ways to grow the bid on US bonds. For starters, QE at both the ECB and BOJ only encourages European and Japanese investors to purchase US government bonds (USGs), so this provides cover for the United States so long as the other two Drs. Frankenstein continue their experiments.
So the question is: Have all these people lost their minds? It really takes extraordinarily smart people to do extraordinarily stupid things. At what point will they choose to stop?
At one extreme, central banks can return to normal monetary policy and bring on a severe recession over the next two to three years. At the other, central bankers can continue the madness until they own every last asset on Earth and the experiment of freedom and free markets is all but destroyed.
Frankenstein’s monsters are now in the dungeon laboratories of central banks in the United States, Europe, and Japan, and the mad scientists are jolting them with electricity. Do we really want to find out what happens when the monsters wake up and break out? I don’t think so. But I think we will.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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