In the uncharted journey into the world of unconventional monetary policy, negative interest rates have gone one step too far. In summary, the negative interest rate policy (NIRP) is failing: negative rates destroy capital, undermine the financial system and have so far failed to generate sufficient nominal GDP growth to reduce the already very high levels of debt. Amid concerns about broadening monetary policy, monetary policy makers, led by Japan, are further advancing along the road that leads to debt monetization.
While its impact on growth is limited, quantitative easing (QE) has worked to some extent in the US. Conversely, by pushing rates into negative territory, the ECB and the BoJ are sending the wrong price signal, eroding investor confidence in the effectiveness of monetary policy. We believe investors have good reason to be concerned: Despite the best efforts of policymakers, Japan's credit growth stands at just $50 billion a year in an economy worth $4,5 trillion. . The eurozone is even more anemic, with a $45 billion credit expansion in a $26 trillion economy. In our view, the benefits of lower interest rates have run out.
Given the failure of the NIRP to reinvigorate the economy, policy makers are preparing for the next phase, namely the reduction of debt as a share of GDP to kick-start nominal GDP growth. In late March, Japanese Prime Minister Shinzo Abe called for fiscal 2016 spending to be concentrated earlier in the year where possible, and for a new economic package to be in place by May. . While perhaps not that close to action, the ECB appears to be following a similar line of thinking to the Japanese. During the press conference at the ECB meeting in March, President Draghi was asked about the "helicopter method" (a continuous fiscal stimulus) and did not explicitly rule out the possibility. Asked about the same issue a week later, ECB economist Praet seemed in favor of this type of policy.
We believe Japan is considering a policy change as a hedge against the threat from China. Awareness has grown that taxing cash positions doesn't work, especially given Japan's aging demographics. There has been rapid speculation that Japan is preparing a fiscal-based stimulus package worth between 5 and 10 trillion yen, which includes the postponement of the proposed consumption tax hike. Such a policy would likely require an additional government bond issuance. If, for example, it were structured as a fiscal expansion financed by the issuance of zero coupon perpetuals, which the BoJ would be obliged to buy, it would be "helicopter money", ie money distributed free of charge to the public. QE by itself is not helicopter money, as in exchange for giving banks money, central banks receive government bonds and other assets, while the helicopter method also requires fiscal stimulus from the government.
Clearly, a move towards debt monetization through helicopter money would be a major break with the current government and central bank strategy. A policy shift on a scale to involve the use of the term helicopter money may not be imminent, but the direction taken by the thinking of policy makers is becoming clear and is influencing our long-term market views. All of this is emerging in a market environment where the consensus believes that, with yields this low or even negative, investors need to take on more risk (liquidity risk, carry risk and credit risk) to generate returns. A “helicopter drop” could reduce the value of money and further destroy wealth; some markets are not ready to face a major policy change without permanently destroying capital.
Against this backdrop, investors are having to think about how to structure their portfolio as the focus of policy makers shifts towards debt monetization. We believe this new level of financial repression would clearly create an environment conducive to moving away from traditional long-only portfolio allocations, where investing in liquid rather than illiquid assets would be appropriate. We expect gold to increase in its attractiveness and investors may want to increase cash positions given the much greater uncertainty about the future direction of monetary policy. Market volatility will likely increase significantly. If Japan pioneers the helicopter method, the yen is likely to depreciate (Japan's previous JGB-financed fiscal stimulus experiment in the 30s caused a sharp devaluation of the yen). Investors will also need to factor in the likely sharp rise in long-term yields when and if central banks move towards monetization.
