In last week's post (Super Mario to the Rescue?) Evidente recommended that investors take a tactical overweight position in global equities on the expectation that the Bank of Japan and European Central Bank would have little choice but to deliver more monetary stimulus given the persistent weakness in their economies and the continued shortfall of underlying inflation measures relative to target.
The announcement from the Bank of Japan of more stimulus was therefore not surprising to Evidente, but the introduction of a negative interest rate was. Gauging by the deprecation of the yen and lift in global stock markets, the announcement was a shock to investors more broadly. An interest rate of -0.1% will effectively apply to incremental or new reserves that commercial banks hold at the BOJ.
As Evidente read through the BOJ's press release on Friday, I was struck by the complex nature of the framework. It has adopted a multi-tiered system in which the outstanding balance of each commercial bank's current account at the BOJ will be divided into three tiers in which a positive rate of +0.1% will apply to the basic balance, a zero rate will apply to a macro add-on balance and a negative rate of -0.1% will apply to the policy rate balance (see chart).
This might account for why the volatile reaction of the Topix following the announcement, as investors clearly sought to digest the news. The index ended up strongly, suggesting that investors gradually understood that the negative interest rate on incremental commercial bank reserves would be unambiguously stimulatory for the economy by encouraging financial institutions to lend out funds to households and businesses.
The scale of the market reaction was probably disproportionate to the quantum of the negative interest rate. But I suspect that the reaction reflects two developments. First, the BOJ effectively drew investors' attention to another unconventional policy tool it has at its disposal at the zero lower bound to complement its asset purchase program, including 80 trillion yen a year in government bond purchases. The market would have more easily processed an expansion of the BOJ's asset purchase program. But the already large scale of the program meant than any such announcement might have had a muted market reaction due to concerns about diminishing returns. Second, the recent experience of the Swiss National Bank, which has a target range of its policy rate of -0.25% to -1.25%, suggests that the BOJ has ample scope to lower its negative interest rate further if deemed necessary.
Despite the narrow 5-4 majority vote in favour of the negative interest rate, the BOJ's announcement should provide investors a timely reminder of Mr Haruhiko Kuroda's determination to rid Japan of its fifteen year long deflationary mindset. The next two central bank developments to watch for are the prospect that the FOMC members have little choice but to downgrade their internal projections for a further three hikes to the federal funds rate this year, and the next monetary policy meeting of the ECB's Governing Council on March 10th, in which Evidente expects the ECB to deliver more monetary stimulus. With the prospect of more central bank stimulus globally, Evidente continues to recommend that investors take an overweight tactical bet in global equities and risk assets more broadly.