When I first heard about the Bank of Japan’s (BOJ) recent announcement that it would inject roughly $1.4 trillion into the Japanese economy by the end of 2014, three thoughts immediately came to mind. First, I wondered how high the Nikkei might soar over the next couple of years in response to the extraordinary liquidity being provided by the Bank of Japan. My second thought concerned bond yields and how long-term Japanese government bonds were responding to the announcement. And finally, I wondered how the rating agencies would respond to the massive money printing operation.
In terms of the Nikkei, I suspect it can go much higher. When money is being printed on the scale of the Japanese experience, and the central bank is explicitly targeting higher stock prices (as the BOJ is), then the directional bet one should favor on the corresponding equity index is up. If you are concerned about earnings (a noble, if old-fashioned concern in the age of money printing), the history of money printing and equity price responses thereto tell me that you may end up in the minority. That is, until the money printing ends—if it ever does.
Regarding bond yields, for those who live in the world of “bond yields can’t possibly go lower,” Japan continues to amaze. The post-announcement plunge in intermediate- to long-term JGBs was certainly eye-opening with the 30-year government bond falling to 1.12%. Two months ago, it was at 2%, and the day before the announcement, it was trading over 1.50%. The 10-year Japanese government bond actually dropped to under 0.40%. Yes, that’s 40 basis points for a 10-year fixed income security. Given the scale of the money printing upon which Japan has embarked, there must be a few bond vigilantes somewhere who are ripping their hair out in frustration.
Those bond vigilantes must be further incensed by the fact that the rating agencies still think so highly of Japan’s creditworthiness. Moody’s has Japan’s sovereign rating at Aa3. S&P has Japan at AA-. Those are the fourth highest possible ratings. How is that possible? In my opinion, those ratings are a bunch of nonsense. But not for the reasons you may think. The Bank of Japan has made it crystal clear that it will do whatever it must to ensure that yields stay low. It is planning to buy more than 7 trillion yen per month of government bonds. The BOJ appears to have every intention of printing as much money as it must to make sure that Japan can make good on its government debt obligations and to make sure that yields stay very low. In that regard, Japan’s sovereign rating should be Aaa/AAA.
Don’t get me wrong, I would be surprised if Japan can ever again stop printing money without the entire country’s fiscal situation imploding. It might collapse nevertheless. And that is why I think the rating agencies should either remove their ratings on Japan or have a three-part rating system whereby they rate it according to the likelihood of Japan’s making good on its obligations in nominal terms (Aaa/AAA) as well as two other ratings.
The second rating would concern the real return to bondholders. If Japan is actively targeting a particular inflation rate that is higher than any part of the current JGB yield curve and simultaneously running a quantitative easing program, a part of which involves purchasing bonds in the portion of the yield curve that has a lower yield than the inflation target, the rating would be “Default.” If any other circumstance exists, including a scenario in which the real yield on a part of the JGB yield curve is negative, but the BOJ is not running a QE program, then the rating would be “Not in Default.”
This three-part system would also have a rating that reflects the likelihood of default should quantitative easing stop in a country in which the central bank is in the midst of a multi-year (or no end date provided) QE program. In other words, this rating, which would be based on the already-in-existence rating scales, would provide insight into what the country’s rating would be if money printing operations weren’t monetizing deficits and distorting financial asset prices. In effect, this rating would attempt to quantify the benefits of ongoing QE operations.
In case you are wondering, yes, I think this three-part rating system would be a good idea for other countries as well. Am I even the slightest bit hopeful the rating agencies will ever implement such a system? Not in the least. But we can all dream, can’t we?
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