The BoJ and ECB’s Technical Tweaks

Hot on the Fed’s heels, the ECB and BoJ convened Thursday and Friday, respectively, announcing some rather curious policy tweaks. In addition to raising rates again, the ECB declared it will stop paying interest on bank reserves in September, annoying bank CEOs and investors alike. Then, Friday, the BoJ tweaked its “yield curve control” (YCC) policy of capping 10-year yields, causing a lot of handwringing about global bond markets. What does all this mean for markets? Let us discuss, starting with the larger of the two moves.

The BoJ Tries to Cure Its Policies’ Side Effects

Over a decade ago, the BoJ launched a massive asset purchase program it called “quantitative and qualitative easing,” as if adding an extra Q to QE gave it extra oomph. Three years later, it added YCC, which set a target for 10-year yields in order to preserve a positive yield curve slope. The target was 0.0% plus or minus 0.1 percentage point (ppt), and the BoJ’s intervention pushed yields toward the upper bound. But as long rates globally rose from generational lows the last few years, the BoJ’s actions started exerting downward pressure—the target became a cap. Proving the inherent instability of interest rate pegs, it subsequently raised the ceiling to 0.25 ppt in March 2021 and 0.5 ppt last December.

After a decade of aggressive bond purchases, the BoJ has come to own over half of the Japanese Government Bonds (JGBs) outstanding, effectively usurping Japan Post as The Bank That Ate Japan.^[i] In June 2012, banks (including Japan Post) held ¥410.2 trillion worth of JGBs, 43.6% of the total outstanding.^[ii] The latest data available, from September 2022, show banks down to ¥146.6 trillion, or 13.8% of the total, with the BoJ clocking in at ¥535.6 trillion and 50.3%.^[iii] It turns out defending a rate cap requires buying an awful lot of bonds almost indefinitely, which in turn hits liquidity. Hence, why we say rate caps and pegs are unstable and unsustainable.

So new BoJ Governor Kazuo Ueda announced a tweak. Officially, the 10-year yield ceiling will stay at 0.5%. However, the BoJ statement now says it will buy JGBs at rates up to 1.0%. Ueda insists that isn’t a change, but it is. And nearly everyone sees it as such, with many penciling in Japanese rate hikes and further loosening of the YCC target rate. But that seems very speculative to us and an overreaction to a shift few foresaw today.

Others say the real trouble is that Japan was the last bastion of low rates, so their move could drive rates elsewhere far higher. But folks speculated the same things back in December and it didn’t follow. We think this is what markets are telling you now: Yes, 10-year JGB yields rose about 0.11 ppt on the news and the TOPIX (the correctly constructed Japanese stock index) fell initially.^[iv] But the latter bounced back to finish the day down a measly -0.2%.^[v] And the global effect? Although US markets ticked down yesterday on the rumor of the shift, the move didn’t stop the S&P 500 from jumping nearly 1.0% on Friday.^[vi] US 10-year yields are down -0.04 ppt.^[vii] We don’t see anything there as such a hugely landmark shift, and we suspect the chatter will simmer down fast as it did in December.

The ECB Challenges Milton Friedman

Of this week’s monetary moves, the ECB’s seem more esoteric if somewhat curious, as it contradicts monetary economists’ long-held thinking on the topic of paying interest on required reserve balances. Not to mention, it could have a direct impact on banks’ interest income, which is why several big eurozone bank stocks took it on the chin on Thursday. Typically, markets tend to price developments like this in a jiff, so we don’t think this is a lasting market headwind, but it is worth exploring all the same.

In its announcement, the ECB said its “decision to reduce the remuneration on minimum reserves will preserve the effectiveness of monetary policy by maintaining the current degree of control over the monetary policy stance and ensuring the full pass-through of the Governing Council’s interest rate decisions to money markets. At the same time, it will improve the efficiency of monetary policy by reducing the overall amount of interest that needs to be paid on reserves in order to implement the appropriate stance.”^[viii] To translate this from wordy jargon to normal-person, the ECB is saying scrapping the interest payment will remove a barrier between its rate hikes and the real economy, as if paying interest on reserves were somehow responsible for commercial banks’ decision to pay savers much less than the ECB’s policy interest rates.

We doubt it is. To see this, take a trip through monetary theory. Many decades ago, Nobel prizewinning economist Milton Friedman and fellow economist George Tolley separately showed paying interest on bank reserves was essential to keeping real-world bank funding costs in line with central banks’ policy rates and eliminating the opportunity cost of requiring reserves. Theoretically, the interest rate on reserve balances serves as a floor for bank funding costs. If the central bank doesn’t pay interest on reserves, reserve requirements are an effective tax on bank balance sheets. When you tax something, the payer is incented to try and avoid it. It motivates them to hold little more than the required sum. That could leave some banks short temporarily, and it motivates those with excess reserves to lend them to such banks rather than back new lending. This is doubly true when central banks are hiking, as this makes the opportunity cost grow. So commercial banks can in theory continue getting funding much cheaper than central bankers intend from one another, boosting money supply and lending. Applying the policy rate to reserve balances, at least on paper, removes the incentive to undercut it. For instance, it doesn’t really make sense for MegaBank to lend to BigBank at 2% if it can park those same funds at the Fed for over 5%. Friedman’s research underpinned the Fed’s decision to start paying interest on reserves in 2008, a move many Fed officials had pushed for long before the financial crisis.^[ix]

But this rate hike cycle seems to be a counterpoint against Friedman’s research. Bank funding costs, overall, haven’t come close to matching policy rates in the US, UK or eurozone, despite the central banks paying interest on required reserves. The reason: Retail deposits are abundant and rates remain pitiful. So banks are emphasizing this cheap funding over more expensive wholesale funding (which, based on the Main Euro Area Interbank Market Rates, aka EURIBOR, have been undershooting the ECB’s main refi rate by over half a percentage point).^[x] So it seems clear rate hikes haven’t yet made their way to the economy.

Because banks are able to fund themselves via deposits cheaply, the risk of their severely undercutting policy rates seems rather low for now. That could change if competition for funding rises, which raises questions about why this policy would be desirable. But, because the amount of excess reserves is larger than required and excess reserves still receive interest, we doubt this is a huge shift. It mostly seems like a technical debate over how the recent deposit-and-rate-hike dynamics influence policy. And for investors, eurozone banks losing a few billion in interest income isn’t the hugest matter in the grand scheme of things.