Bank of Japan is in charge not the bond markets

I read a report on the American news network CNBC the other day (November 15, 2016) – The bond vigilantes are back, and Trump better pay attention – which included some so-called experts in a video claiming to know something about bond markets. The report asserted that “bond vigilantes” might return to force the new US President to “tone down his spending” (as they allegedly did when Bill Clinton was in office). One expert said “we’ve got fiscal policy again and … the prospect of higher interest rates and inflation could even herald the return of the bond vigilantes”. Idiot is a polite term for him. The journalist and the commentators invoked should take time out and learn about what is happening in Japan, which remains the best Modern Monetary Theory (MMT) ‘laboratory’ there is. The Bank of Japan in now putting into operation the decision it took in September 2016 to buy unlimited amounts of Japanese government bonds at a fixed-yield. Which means? In short, it will control the yields across all bond maturities from 2-year out to 40-year and will set them at whatever level they choose. Oh, won’t the bond markets prevent that happening? How? For the bond markets it is a case of “like it or lump it”. Once again Japan demonstrates that mainstream macroeconomic theory is devoid of understanding.

Those swooping bond vigilantes …

Apparently, ‘bond vigilantes’ are:

… bond investors who sell their holdings in an effort to enforce fiscal discipline. Fewer buyers drive prices down – and drive yields up – in the fixed income market. That in turn makes it more expensive for the government to borrow and spend.

The article actually spent words speculating on whether the ‘vigilantes’ might “swoop in”. So like big eagles or something.

The article did note that:

… the Fed and other central banks … could adopt a whatever-it-takes approach to keeping yields in check and thwarting an economic downturn.

The Fed has been at the global forefront for ambitious and unconventional monetary policies, but the Bank of Japan’s recent move to target its 10-year note yield at zero took the game to a new level.

Which if you understand what that means makes the whole tenet of the article meaningless and a waste of effort.

All these ‘experts’ in financial markets who are claiming a big ‘swoop’ is imminent which will drive currency-issuing governments bankrupt apparently “don’t know shit about fuck” (Source), which according to the dictionary is “a hardcore dis meant to bring the person it’s directed at to complete silence”.

If only.

At least the Pimco spokesperson cited knew what he was talking about. He said:

To prevent a bond tantrum, the central bank may want to limit the rise in yields by intervening in the bond market directly. The cleanest way to do this is to announce a cap on yields and stand ready to buy unlimited amounts to preserve the cap if needed

Which in simple English means that the central bank (that is, the government) can always set bond yields at whatever level it chooses including zero.

The bond markets do not have the power to set yields unless the government allows them that flexibility. The government rules, not the markets.

Not to mention that the government doesn’t even need to issue debt in primary markets any in order to spend.

Please read my blog – Who is in charge? – for more discussion on this point.

Bond yield primer

If the demand for government bonds declines, the prices in the secondary market decline and the yield rises. How come?

In macroeconomics, we summarise the plethora of public debt instruments with the concept of a bond. The standard bond has a face value – say of $1000 and a coupon rate – say 5 per cent and a maturity – say 10 years. This means that the bond holder will get $50 dollars per annum (interest) for 10 years and when the maturity is reached they would get $1000 back.

This is what is referred to as a fixed-income yielding asset. The $50 per year is fixed at the time of the issue and does not vary with subsequent price fluctuations of the bond instrument prior to maturity.

Why does the price of the issued bond (with a face value of $1000) fluctuate?

Bonds are issued by government into the so-called ‘primary market’, which is simply the institutional machinery via which the government sells debt to the authorised non-government bond dealers (some banks etc).

In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the the institutional machinery is voluntary and reflects the prevailing neo-liberal ideology – which emphasises a fear of fiscal excesses rather than any intrinsic need for funds (of which the currency-issuing government has an infinite capacity).

Once bonds are issued in the ‘primary market’ 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.

Clearly secondary market trading has no impact on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. Please read my blog – Deficit spending 101 – Part 3 – for more discussion on this point.

Most primary market issuance is now done via auction. Previously, governments (such as in Australia) ran what were called ‘tap systems’ of bond issuance.

Accordingly, the government would determine the maturity of the bond (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds) that was being sought. If the private bond traders determined that the coupon rate being offered was not attractive relative to other investment opportunities, then they would not purchase the bonds. The central bank, typically, would then step in an buy up the unwanted issue.

This system, which was very effective and allowed the government to completely control the yield (it set the coupon) was anathema to the neo-liberals, who considered it gave the central bank carte blanche to fund fiscal deficits.

Tap systems were replaced by competitive auction (tender) systems, where the the issue is put out for tender and the private bond market determine the final yield of the bonds issued according to demand.

When demand is high, the yield will be lower, whereas, if demand is low, the auction will push the yield up on the issue.

Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.

Imagine that the market wanted a yield of 6 per cent to accommodate risk expectations (inflation or something else). So for them the bond is unattractive and they would avoid it under the tap system.

But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.

The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.

The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.

When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).

When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.

Further, rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this).

But they may also indicate a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the risk free government paper.

So you see how an event (yield rises) that signifies growing confidence in the real economy is reinterpreted (and trumpeted) by the conservatives to signal something bad (crowding out, increased cost of government spending).

The yield reflects the last bid in the bond auction. So if diversification is occurring reflecting confidence and the demand for public debt weakens and yields rise this has nothing at all to do with a declining pool of funds being soaked up by the bingeing government!

The recent empirical yield history for Japan

You might like to refresh your memory of the history of the Japanese 10-year bond yield since it was first issued on July 5, 1986 to October 31, 2016. The daily data (all 10,890 observations) is available from the – Japanese Ministry of Finance).

In May 2013, the little upturn in the yields sent financial market commentators apoplectic and we heard a volley of predictions were that the end-game for the Japanese government was finally manifesting.

The story that headlined in all the financial news outlets was 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 commented – noting this was all nonsense.

Please read my blog – The last eruption of Mount Fuji was 305 years ago – for more discussion on this point.

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 last 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 29, 2016, with the announcements demarcated by the red vertical lines.

I will comment on the latest decision (September 20-21, 2016) later in this blog.

The explosion in yields clearly did not pan out as the moronic financial press predicted. The yields followed exactly the course that Modern Monetary Theory (MMT) predicted – down.

The fact that the Bank of Japan has been buying up government debt at its leisure clearly allows us to conclude that it is a monopoly supplier of bank reserves denominated in yen.

Now before we determine how much the Japanese government has been buying of its own debt consider the next extraordinary graph, which doubles as a nice piece of art.

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 this 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.

If that isn’t extraordinary then I don’t know what would be.

The curve has continued to flatten since earlier in the year (compare the two surface graphs). The yields up to 10-year bonds are more negative than previously and as 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.

The secondary JGBs market is very thin at present given the demand from the Bank of Japan 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 43.7 per cent and will rise further as the QQE program continues.

Since the April 2013 announcement, the monetary base has risen from 968,904 trillion yen to 4,138,966 trillion yen (as at October 2016). 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.

The conservatives who have been totally blindsided by these developments have started to introduce a new spin to regain credibility.

They now claim that there are no incentives for the government to engage in ‘necessary’ fiscal austerity and as a result Japan will go bankrupt more quickly than they predicted – forgetting to mention they have been predicting bankruptcy for 20 or more years.

Latest Bank of Japan monetary policy gymnastics

But it gets worse for the conservatives. They now have to face the fact (which knowledgeable people knew all along) that the bond markets are powerless in the face of central bank action to control bond yields.

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 …

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.

Any problem with that? Answer: none.

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.

Please read the following blogs – Building bank reserves will not expand credit and Building bank reserves is not inflationary – for further discussion.

Conclusion

The next step in this transition is to realise that the QQE policy is, 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.

But this case is made by those who argue that monetary policy should be used as a counter-stabilisation tool. I think monetary policy should be put to bed and all counter-stabilisation be performed via fiscal policy.

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 2016 William Mitchell. All Rights Reserved.