The Japanese bond market has been very interesting in the last week proving yet again that private bond markets cannot set yields on government bonds if the government does want then too. Next time you hear some mainstream economist claiming a currency issuing government is running deficits at the will of the investors (read bond markets) politely tell them they are clueless. Japanese once again provides the real world Modern Monetary Theory (MMT) laboratory – every day it substantiates the underlying insights contained within MMT and refutes the core mainstream propositions. The financial media referred to the Bank of Japan as putting a whipsaw to the bond markets, which in context means that the BoJ is forcing the ‘markets’ into confusion (Source). The bond markets have misinterpreted recent Bank of Japan conduct in the JGB markets (less purchases than expected, and even missing a scheduled buy up) as a sign that the Bank was weakening on its QQE commitment from last September that it would hold the 10-year JGB yield to zero and thereby allow the longer investment rates to fall. Why they doubted that commitment is another matter but within a few days over the last week the Bank demonstrated that: (a) it remains committed to that target; and (b) it has all the financial clout it needs to enforce it; and (c) the bond market investors do not call the shots.
For background to this discussion, please see this blog – Bank of Japan is in charge not the bond markets.
Essential summary points:
1. If the demand for government bonds declines, the prices in the secondary market decline and the yield rises (see blog link above to understand why).
2. Once bonds are issued by the government in the ‘primary market’ (via auctions) they are traded in the ‘secondary market’ between interested parties (investors) on the basis of demand and supply. When demand is strong relative to supply, the price of the bond will rise above its ‘face value’ and vice versa when demand is weak relative to supply.
3. Any central bank has the financial capacity to dominate the demand for any specific maturity bond in the secondary markets and thus can set yields.
Updating the recent empirical yield history for Japan
The following graph shows the history of the Japanese 10-year bond yield since it was first issued on July 5, 1986 to February 6, 2017. The daily data (all 10,953 observations) is available from the – Japanese Ministry of Finance).
There have been constant predictions since the early 1990s, that the government of Japan would run out of money because the bond markets would eventually stop buying bonds.
Well, the bond markets could stop buying bonds any time they choose to get off the corporate welfare bottle but the government of Japan would happily continue spending as much as it chose to. That is because it can always buy its own debt and even more clearly does not even need to issue the debt in the first place.
In May 2013, there was a little upturn in the 10-year bond yields, which gave the financial market commentators conniptions and the headlines in all the financial news outlets indicated that the bond markets were finally calling in the piper and unless the Japanese government instituted a major fiscal austerity campaign all hell would break loose with respect to yields.
At the time I noted that these dire predictions were nonsensical.
Please read my blog – The last eruption of Mount Fuji was 305 years ago – for more discussion on this incident.
Just before that (April 4, 2013), the Bank of Japan had announced they were resuming their program of Quantitative and Qualitative Monetary Easing (QQE), which involves the Bank entering the secondary JGB market and more recently corporate debt markets and using its endless capacity to buy things that are for sale in yen, including government bonds and other financial assets.
They announced they would spend around “60-70 trillion yen” a year (see Statement Introduction of the “Quantitative and Qualitative Monetary Easing”).
On October 31, 2014, the Bank of Japan announced it was expanding the QQE program.
It would now “conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen (an addition of about 10-20 trillion yen compared with the past).”
Then on January 29, 2016, the Bank issued the statement – Introduction of “Quantitative and Qualitative Monetary Easing with a Negative Interest Rate” – which augmented the QQE program – continuation of the annual purchases of JGB of 80 trillion yen and the application of “a negative interest rate of minus 0.1 percent to current accounts that financial institutions hold at the Bank”.
I considered that decision in this blog – The folly of negative interest rates on bank reserves.
Here is what has happened to the 10-year JGB yields since 2010 to February 6, 2017, with the announcements demarcated by the red vertical lines.
The explosion in yields clearly did not pan out as the financial press predicted. The yields followed exactly the course that Modern Monetary Theory (MMT) predicted – down and then up more recently as the Bank has seemingly varied its QQE program (more about which later).
The fact that the Bank of Japan has been buying up government debt at its leisure is because it can add bank reserves denominated in yen anytime it chooses and up to whatever amount it chooses – without constraint.
The next three surface charts let us see the evolution of the JGB yield curve as the policy position of the Bank of Japan has changed over the last year.
For readers unfamiliar with reading surface charts of yield curves, the vertical axis shows the yields (depicted in the coloured legend at the bottom of the graph). The horizontal axis shows the maturity of the debt instrument issued from 1-year to 40-year JGBs.
The depth axis shows the date – which in the first case is from January 4, 2016 to February 29, 2016.
The shifting coloured patterns and the descending values across all maturities indicates that the Japanese government bond yield curve has flattened considerably since the beginning of 2016 and negative yields have spread out to the 10-year bond issues and even more negative yields have spread from the 1-year bonds out as far as 7-year bonds.
The flattening and the negative yields is a quite extraordinary occurrence. It has never been as flat as this across the maturities span.
At the February 23, 2016 auction for 40-year bonds, the Yield at the Lowest Accepted Price was 1.130 per cent – that is, people were prepared to ‘save’ for the next forty years (until March 20, 2055) at 1.130 per cent!
At the February 16, 2016 auction for 20-year JGBS, the yield accepted was 0.792 per cent (these bonds will mature on December 20, 2035).
Even at these returns, the bond market dealers were clearly still queuing up to get as much Japanese government debt as they could get their hands on (as evidenced by the Bid-to-Cover ratios).
But, further to that, the Bank of Japan was clearly demonstrating its capacity to control yields at whatever level they choose.
Now consider the next graph, which shows the surface chart for the Japanese government yield curve between September 1, 2016 and October 31, 2016.
it depicts the extraordinary situation where the yield curve has continued to flatten throughout the year (compare the two surface graphs) and the yields up to 10-year bonds are more negative than previously.
At October 31, 2016, the 15-year bond was yielding just 0.127 per cent down from 0.599 per cent at the start of the year.
30-year bonds were yielding 1.282 per cent and 40-year bonds 1.402 at the start of the year. By October 31, 2016, they were down to 0.505 per cent and 0.574 per cent, respectively.
So investors are only requiring a return of 0.574 per cent to invest in bonds that will mature in 40 years time. That is, they will take whatever corporate welfare is on offer. Mendicants!
In line with the decisions at the Monetary Policy Meeting on April 4, 2013 (Introduction of the “Quantitative and Qualitative Monetary Easing”), the Bank bought JGBs worth between 10 and 12 trillion yen per month in the secondary bond market – that is, after they are issued to the authorised dealers who participate in the auction process and begin to be traded.
That amount escalated with subsequent announcements.
At the September Monetary Policy Meeting (MPM) which was held over September 20-21, 2016, the Bank of Japan’s Announcement introduced what they called a “New Framework for Strengthening Monetary Easing: ‘Quantitative and Qualitative Monetary Easing with Yield Curve Control’ (QQE)”.
On September 30, 2016, the Bank of Japan released the – Summary of Opinions – of the MPM attendees.
We understood this summary in greater detail when the Bank publicly released the – Minutes of the Monetary Policy Meeting on September 20 and 21, 2016 – on November 7, 2016.
The Bank’s growth strategy aimed “to achieve a sustainable increase in private consumption” and to help in that regard they considered they should:
… should strengthen monetary easing … and exert upward pressure on wages together with the government’s growth strategy.
Accordingly, the Bank (in pursuit of its “price stability target of 2 per cent … decided to introduce QQE with Yield Curve Control.
The Bank said that “yield curve control” was “consistent with monetary easing measures that the Bank has been implementing thus far” but (along with its “inflation-overshooting commitment” represented:
… a paradigm shift in monetary easing policy, which is appropriate in terms of achieving the price stability target at the earliest possible time.
‘Yield curve control’ will see “the Bank … control short-term and long-term interest rates”. Yes, read that again – the central bank will control interest rates at the short- and long-ends of the market.
The Bank said that its analysis had shown that economic activity had responded well to the “decline in real interest rates” (the nominal interest rate minus the rate of inflation) and Japan had ended its period of deflation as a result.
They saw ‘yield curve control’ as the way it could lock in the further “decline in real interest rates” by controlling nominal interest rates at all parts of the yield curve.
If you want a quick primer on yield curves go to these blogs – Operation twist – then and now and Japan – another week of humiliation for mainstream macroeconomics.
I have a video in the first of these blogs showing movements in the yield curve and you can relate the current Bank of Japan policy to the way in which the US Federal Reserve Bank successfully flattened the yield curve (controlled all rates).
The Bank of Japan set the following “guidelines for market operations” under this policy:
1. In terms of its short-term policy interest rate, the “Bank will apply a negative interest rate of minus 0.1 per cent to the Policy-Rate Balances in current accounts held by financial institutions at the Bank.
2. In terms of the long-term interest rate, the “Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB
yields will remain more or less at the current level (around zero percent).”
In this regard, the Bank said it would “introduce the following new tools of market operations so as to control the yield curve smoothly”:
(i) Outright purchases of JGBs with yields designated by the Bank (fixed-rate purchase operations)1
(ii) Fixed-rate funds-supplying operations for a period of up to 10 years (extending the longest maturity of the operation from 1 year at present)
This means that it will stand ready to buy unlimited amounts of Japanese government bonds at a fixed rate whenever it desires.
On November 1, 2016, the Bank released an announcement – Outline of Outright Purchases of Japanese Government Securities – which operationalised the plan.
The announcement told us (among other things) that in relation to the “fixed-rate method”:
1. The BoJ would purchase bonds across the maturity range (2-year, 5-year, 10-year, 20-year, 30-year and 40-year bonds).
2. “The Bank will conduct the auction as needed, such as when the level of the yield curve changes substantially”.
3. “Depending on market conditions, the Bank may set the purchase size per auction to a fixed amount or to an unlimited amount.”
4. “Purchasing yields will be set per auction, by indicating the yield spreads from the benchmark yields which the Bank determines separately.”
In a speech (November 14, 2016) to some ‘business leaders’ in Nagoya – Japan’s Economy and Monetary Policy – the Governor of the Bank of Japan, Haruhiko Kuroda reiterated the decision taken at the September Monetary Policy meeting that:
The new policy framework consists of two major components: the first is “yield curve control,” in which the Bank facilitates the formation of the yield curve that is deemed most appropriate with a view to maintaining the momentum toward achieving the price stability target of 2 percent …
On January 31, 2017, the Monetary Policy Committee of the Bank of Japan met and reaffirmed in the – Statement on Monetary Policy – that:
The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain at around zero percent. With regard to the amount of JGBs to be purchased, the Bank will conduct purchases at more or less the current pace — an annual pace of increase in the amount outstanding of its JGB holdings of about 80 trillion yen — aiming to achieve the target level of the long-term interest rate specified by the guideline.
The Financial Markets Department of the Bank released its updated – Outline of Outright Purchases of Japanese Government Securities – which described how it would continue to conduct its “outright purchases of Japanese government securities”.
We read that:
1. The Bank would continue buying bonds across the full maturity range (2-year to 40-years).
2. They would be in the markets 8-10 business days per month but stands ready to change that frequency.
3. They plan to purchase “Approximately 8-12 trillion yen per month”
What does this all mean?
In this blog – Operation twist – then and now – I explained how the US Federal Reserve Bank in the 1961 began selling short-term government debt to drive down prices and drive up yields (to attract capital inflow) and buying long-term government debt to drive up prices and hence drive down yields (to encourage private investment).
Remember this was in the context of the fixed exchange rate system.
Operation Twist essentially flattened the yield curve, which in normal times would be upward sloping. It demonstrated categorically that the central bank was able to control all yields.
Mainstream economists have eschewed this sort of strategy and claim that the only way this could be successful would be if it ratified the market.
They claim that the central bank can only achieve this outcome if the targeted yields are consistent with what the bond markets want anyway.
That is, of course, a false claim.
In reality, the only consequence of a discrepancy between the targeted yields and the market expectations of future yields held by bond traders would be that the central bank would eventually own all of the bonds in the target range.
There would be no problem arising from that eventuality.
The bond traders might boycott the issues and force the central bank to take up all the volume on offer. So what? This doesn’t negate the effectiveness of the strategy it just means that the private buyers are missing out on a risk-free asset and have to put their funds elsewhere. Their loss!
Eventually, if the government bond was the preferred asset the bond traders would learn that the central bank was committed to the strategy and would realise that if they didn’t take up the issue the Bank would.
In 2004 paper published by the US Federal Reserve – Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment – the authors concluded that:
If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say a Treasury security, at a fixed price, there is little doubt that it could establish that asset’s price. Presumably, this would be true even if the Federal Reserve’s commitment to purchase the long-lived asset was promised for a future date. Conceptually, it is useful to think of the Federal Reserve as providing investors in that security with a put option allowing them to sell back their holdings to the central bank at an established price. We can use our term-structure model to price that option.
There is no doubt about that.
The Bank of Japan’s current policy is demonstrating that it runs the show not the bond markets.
Here is the reality
1. The Japanese government can never run out of money (yen). It is impossible. Therefore it can never become bankrupt.
2. The Bank of Japan can maintain yields on JGBs at whatever level it chooses, at whatever maturity range it targets, and for as long as it likes. The bond market investors are incidental to that capacity and are supplicants rather than drivers.
3. The size of the Bank of Japan’s balance sheet (monetary base) has no relationship with the inflation rate.
4. If the Bid-to-Cover ratios at bond auctions fell to zero – that is, private bond dealers offered no bids for an auction – then the government could simply instruct the Bank of Japan to buy the issue. A simpler accounting device would be to stop issuing JGBs altogether and just instruct the Bank to credit relevant bank accounts to facilitate the spending desires of the Ministry of Finance.
5. If private investors choose to buy other assets once the risk in international markets subsides then the Japanese government (the consolidated central bank and treasury) could just buy more of its own debt – to near infinity. End of discussion.
Now consider the third surface graph which covers the period since the start of 2017 up to February 6, 2017 and compare it to the previous graph.
What you see is a slight steepening of the curve in the maturities below 10-years but also a rising level within that range. As at February 6, 2017, 6-year bonds and below were still trading at negative yields but the longer maturity bonds were now just in positive territory.
On February 2, 2017, 10-year yields were at their highest level since January 29, 2016. I will come back to that.
Increasing Bank of Japan holdings of Japanese government debt
The secondary JGBs market has been very thin since the QQE program began and the fact that sellers in that market are declining.
Why? Because as the auction yields have gone negative, current bond holders who purchased the debt instrument at positive yields, will worry about having funds (from sales) which are only going to attract negative returns (losses). The smart strategy in that case is to maintain long positions.
The following graph shows the proportion of total national government debt in Japan that is held by the Bank of Japan from January 1990 to September 2016.
In February 2011, the Bank of Japan held 7.1 per cent of all the outstanding JGBs (across most maturities). By September 2016, that ratio has risen to 44.2 per cent and will rise further as the QQE program continues.
Since the April 2013 announcement, the monetary base has risen from 1,495,975 trillion yen to 4,352,054 trillion yen (as at January 2017). Where is the accelerating inflation? Answer: in flawed Monetarist textbooks!
The monetary operations really just mean that the Japanese government is spending by using credits created by the Bank of Japan, whatever else the accounting structures might lead one to believe.
With inflation low (to zero), these dynamics surely put paid to the various myths that a currency-issuing government can run out of money and that central bank credits to facilitate government spending lead to hyperinflation.
Latest Bank of Japan monetary policy gymnastics
Why are yields rising in recent weeks?
The following graph shows JGB yields from the beginning of 2017 to February 6, 2017 for maturities between 1-year and 10-year (inclusive).
What explains the apparent sudden and uniform (across the maturity range) shifts in yields on various days?
The answer is largely due to the variable conduct of the Bank of Japan.
For example, on January 25, 2017, after some days of robust Bank of Japan purchasing within this maturity range, the bond markets were anticipating that trend to continue.
The Bank had other ideas and didn’t participate as expected and so the yields rose across the board (see shift in direction after several days of declining yields).
My contacts in the Japanese bond markets told me last Thursday that despite the announced yield curve control they thought the Bank of Japan was easing that policy to allow yields to move higher.
But then, the suprises continued, and January 27, 2017, the Bank of Japan reentered the bond markets and substantially increased its purchases of JGBs in the 5-year to 10-year maturity range, which drove yields down again.
The 10-year bond yield fell from 0.09 to 0.08 on that day, quite a shift.
On February 3, things got more interesting.
The actions of the Bank on that day put it beyond doubt that the bond markets are powerless in the face of central bank action to control bond yields.
In early trading on that day, the Bank bought less bonds in the 5-year to 10-year range than was expected and as a consequence the 10-year bond yield rose as demand fell sharply in the market.
This was even though the Bank had announced around 10.00 am that it was increasing its purchases within that range from 400 billion yen to 450 billion yen. The bond traders guessed wrongly that the purchase volumes would be even larger than that. They were wrong.
A few hours later (12:30 pm), the Bank indicated it was going to introduce a beefed up “fixed-rate bond purchase program” (signalled as an option in earlier releases outlining the operation of the QQE).
It hadn’t participated in the bond markets in this way since November 17, 2016.
Essentially it was telling the bond markets that it was going to buy unlimited quantities of bonds within certain maturity ranges so as to maintain complete control over the yields.
It was reasserting its intention to keep the 10-year bond yield around zero per cent
And as day follows night, the yields fell again.
Once you appreciate the fact that the central bank can control government bond yields at any level it chooses, the next step in the transition is to realise that such interventions are, in fact, redundant.
The best thing that a sovereign government can do is consolidate its treasury and central banking operations (make them consistent in a policy sense) – which would make macroeconomic policy totally accountable to voters unlike today where the central bankers do not face election.
Then the treasury should net spend as required to ensure that the economy achieves and sustains full employment and price stability. This may under some circumstances (very strong external surpluses) require a fiscal surplus, but normally for most countries it will require continuous fiscal deficits of varying proportions of GDP as the overall saving desires of the private domestic sector varied over time.
The treasury should issue no debt at all. Even those who argue that the government should issue short-term paper to allow the central bank to reach its target interest rate via liquidity management operations now realise that interest payments on excess reserves accomplishes the same end.
No increased inflation risk would be introduced by the government refraining from issuing debt to match any fiscal deficits it might be recording. The monetary operations that accompany fiscal policy changes have very little impact on increasing or decreasing the inflation risk of continuously running an economy close to full capacity. The risk is real but can be managed.
Further, there is no financial reason for issuing the debt because the sovereign government retains monopoly control over the currency. The practice of debt-issuance is a hang-over from the gold standard era where governments had to fund their spending in order to retain control over the exchange rate.
The practice has lingered because it is now a convenient ideological cum political tool used by neo-liberals to limit the size of government and to give the corporate sector access to corporate welfare (the risk-free government debt) that they use to create profit.
If everyone knew that there was no functional (financial) reason for the government to issue debt and that it just transferred public funds into the hands of the speculators then I think attitudes might change.
That is enough for today!
(c) Copyright 2017 William Mitchell. All Rights Reserved.