Expectations – Forex Academy

The Bank Of Japan Financial System Report

The Bank of Japan publishes the Financial System Report twice a year in order to assess the stability of the Japanese financial system and facilitate communication with interested parties who are concerned about such stability. The bank provides a regular and comprehensive assessment of the financial system with emphasis on detailing the structure of the system and the policies taken to achieve a robust system.

The bank uses the results of the report to plan the policy to be followed, ensuring the stability of the financial system and provide guidelines and warnings to financial institutions. The bank uses the results of international regulation and supervisory discussions.

In the April 2017 report, the bank reported a notable rise in the prices of the main stock indices and interest rates after the election of the new president of the United States. In Japan, there was also a rise in the stock market and the Yen depreciated. The bank continued with its policy of Quantitative and Qualitative Monetary Easing with Yield Curve Control

The internal loans of the financial institutions in circulation had increased close to 3% annually. There were no signs of overheating in the activity of the financial system nor the real estate market. In general, the financial system had maintained good stability since the crisis of 2008. The capital ratios required by financial institutions were above the level requested by the central bank and had sufficient capital for the risk to which they were exposed.

The results of the macroeconomic stress test indicated that financial institutions as a whole could be considered strong and resistant to economic stress situations. Developments in profits and capital of each institution in these situations of stress varied showing more robust institutions than others.

For the bank, the rise in the US stock market reflected better expectations of the economy and the administration of the new government. As a result of these better expectations about the United States, the dollar appreciated against the major currencies of the world.

In terms of the European financial markets, the stock market had maintained a good general performance coupled with low volatility. The most volatile period of the last two years occurred after the referendum of U.K.

Regarding the monetary policy of the Japanese central bank, the short-term interest rate remained close to 0% or in negative territory. The yields of the Japanese Government Bonds (JGB) continued to show a normal behaviour with the guidelines of market operations where the interest rate had been set at -0.1% and the target on yields on 10-year bonds was 0%. In the following graph, you can see how the yield curve of the JGB was.

Graph 82. Long-Term JGB yields (10 years) and JGB yield curve. Retrieved 5th March 2018 from https://www.boj.or.jp/en/research/brp/fsr/data/fsr170419a.pdf https://www.boj.or.jp/en/research/brp/fsr/data/fsr170419a.pdf

As for the Japanese stock market, it had shown an upward trend thanks to the good global performance of the shares, mainly in Europe and the United States. Since the end of 2016 and in 2017, the Japanese index had shown a stable behaviour without major changes.

The amount of credit risk of the main financial institutions had shown a downward trend. This was the result of improving the quality of the loans, which reflected a better dynamic of the economy in general. The following graph shows the decreasing trend of the risk of the main banking institutions.

Graph 83. Credit risk among financial institutions. Retrieved 5th March 2018 from https://www.boj.or.jp/en/research/brp/fsr/data/fsr170419a.pdf

In the second report of the year in October 2017, the bank noted that global volatility in the main financial markets remained low, along with positive but moderate economic growth, despite geopolitical tensions with North Korea and the United States. There were no significant changes in capital flows including flows destined for emerging markets.

In Japan, the monetary policy followed an accommodative path and the trend of loans granted had slowed due to a higher cost of loans in foreign currencies. Regarding the local financial market, the rate of growth of loans grew to 3%, and the demand for loans by small companies had improved.

The bank did not observe any financial imbalance in the assets and the financial entities. They continued using accommodative policies granting loans without major restrictions to the economy.

The real estate market showed no signs of overheating, but there was evidence of high prices in some places in Tokyo. In the stress scenarios applied by the central bank, if the financial market faced complex situations and the risk spread to the real economy, this could affect the real estate market.

The bank also did not observe greater imbalances in financial institutions or economic activity, so most commercial banks had good ratios between debt and capital, which made them resistant to stress situations as in the first delivery of 2017. The banks were robust in capital and liquidity regardless of the scenario in which the economy was located, due to a good rebalancing of the portfolios of the banks that have faced a greater demand for loans.

The benefits of Japanese banks have been decreasing, but this is happening at a general level in developed economies due to an environment of low-interest rates which was implemented by banks after the 2008 crisis. In Japan, they have also seen a decrease in the margins of profit of the banks due to the high competition between banks by the market, and in recent years have seen more exits of the market than entries of new banks.

A significant risk that the bank observed was the continuation of low-interest rates in the main economies in the world, which led to greater liquidity in the markets and investors taking more risk than desired by the bank’s board. Given the above, stocks in the United States and Europe had reached record highs, and valuation indicators P/E (Price/Earnings ratio) had reached historically high levels.

As in the April report, the volatility of the financial markets was low, which could mean an excess of market confidence at current valuations and an excessive risk taken by investors, coupled with greater investor leverage. All this generated a greater risk than desired by the bank’s committee.

In terms of financial markets, the short and long-term interest rates remained stable as programmed by the monetary easing policy and share prices had risen moderately. The short-term interest rate remained in negative territory.

The Yen had depreciated against the Euro reflecting a decrease in uncertainties concerning political situations in Europe, and expectations of a reduction in the monetary policy of the European Central Bank (ECB). On the other hand, the Yen remained stable against the Dollar since the second half of 2017 and some investors expected an appreciation against the Dollar due to some political risks in the United States.

Finally, in the bank’s report, the committee stated that financial institutions had continued to increase their balance sheets reflecting an increase in deposits and the rebalancing of portfolios including risky assets. Assets and total debts of financial institutions increased to 236 trillion yen since 2012, and the portfolio was continuously balanced between bonds and shares.

In conclusion, with the reports issued in 2017 by the Bank of Japan, the financial system was resistant to stress situations tested by the bank, although as in most countries there are banks with better asset quality and portfolios, there are always recommendations for some specific banks. The economy grew moderately during 2017, and monetary policy remained accommodative to encourage banks to grant more loans and thus generate more growth which in the medium term would lead to inflation at 2%.

As mentioned previously, the bank saw some risks in international markets due to a euphoria unleashed, mainly in the stock markets, which could generate imbalances in the real estate sector of the economy. Regarding the Yen with respect to other currencies, the behaviour was stable during the year, although there were slight depreciations concerning the Euro and the Dollar.

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Abstract

There are a great many intertwining variables that influence the current state of the economy at any given time; such as unemployment, wages, internal production, investments and many more. But with all of them, it is the expectations of people, and investors that generate certain effects, that explain the behavior of some of these variables and which will affect future conditions. For example, if people expect future interest rates to be higher, they will consume or ask for more loans in the present because in the future it will be more expensive to consume. But without rising interest rates, consumption varies today due to expectations. Another example is the expected interest rates in a country, depending on these expectations the investors decided where to place their capital without waiting for this to happen.

The economy in its short-and long-term models must consider the expectations of consumers, companies and all representative agents within an economy. To consider the subject of expectations first the interest rate variable must be introduced. Interest rates expressed in units of a national currency are referred to as nominal interest rates and these rates appear in newspapers and financial pages. Interest rates expressed in a basket of goods are called the real interest rate and are called that because it is beyond inflation and reflects the cost of acquiring goods that will be consumed by people, what is truly important.

There is an equation that establishes that the real interest rate equals (approximately) the nominal interest rate minus the expected inflation. That is why in some media, although they mention a decrease of the interest rates it is said that the interest rate is still contractionary or it may be that the nominal is lower one year than another, but that does not indicate that loans are cheaper than the previous year, so you should consider real interest rates. The interest rate directly affected by the monetary policy is the nominal interest rate. The interest rate that affects spending and production is the real interest rate. Given this difference, it will be possible to see in the news that they contradict the potential effects of monetary policy on the economy and financial markets. In the following graph, you can see the real interest rate of some countries.

Graph 6 Real interest rate. Data were taken from the World Bank.

To summarize the issue of interest rates it should be clarified that the nominal interest rate indicates how many euros must be returned in the future to obtain a euro today and the real interest rate tells us how many goods must be returned in the future to obtain a good today. Nominal interest rates will affect investment decisions between bonds, stocks, and money, while the real interest rate will affect project investment decisions. In the short term, an increase in the growth of money leads to a decrease in both nominal interest rates and the real rate, in the medium term, an increase in the growth of money will not affect the real interest rate, but if it raises the nominal interest rate.

The bonds issued by a country are differentiated in two aspects: their risk of default and the time of their pay. There are some bonds that have better coupons than others, which are riskier by defaults and that ends up affecting the price of bonuses. But for economic purposes, this part of the article will focus on the bond term. Bonds with different times of paid have different prices and different interest rates that will be called yields. The yields of short-term bonds, usually a year or less, are termed short-term yields and, if the bonds are more than one year, they are called long-term yields.

The interesting thing about analyzing the bonds is to determine the curve of the yields and the relationship between short-term and long-term rates. The price of a one-year bond varies inversely with the nominal interest rate at one year that is in effect at the present. The price of a two-year bond depends both on the interest rate to a current year at the present, as well as the expected interest rate for the following year. The interesting thing about analyzing bond prices is that bond yields contain the same information about future interest rates as the bond yield curve fully reflects the agents ‘ expectations of the economy of a Country.

To begin the analysis, a term performance must be defined; The term yield of a bond to N years, or in other words the N years interest rate is the constant annual rate that makes the current price of the bond equal to the current value of the future interests generated by this. By examining the yields of the bonds at different times, we can deduce the expectations of the financial markets on future short-term interest rates. For example, if you want to see the expectations of the financial markets in one year you should observe two-year bonds which have included expectations about the interest rate that will be at the end of the year and observe bonds to a year of maturation.

When the yield curve has a positive slope is when long-term interest rates are higher than the short-term, financial markets expect short-term interest rates to increase in the future. When the yield curve has a negative slope long-term interest rates are lower than those of the short-term, but markets expect this situation to change and short-term interest rates fall in the future. To observe market expectations during the crises of 2000, 2007 and others, it is interesting to observe the curves of the bonds of the countries that reflect the expectations of the financial markets and the decisions that were expected to be taken by the banks Central. It is important to note that the interpretation of performance curves only focuses on expectations and in most cases the decisions of banks and market agents are unpredictable. In the following two graphs you can see the bonus yield curve. In the first graph, you can see a bond of Colombia and in the second is the types of curves of yields.

Graph 7. (2017, October 10) Curva de Rentabilidad TES Tasa Fija, retrieved October 10, from https://www.grupoaval.com/wps/portal/grupo-aval/aval/portal-financiero/renta-fija/tes/curva-rentabilidad

Graph 8. Roca E. (2013 September 23). Estrategias con bonos. Retrieved October 10, 2017, from https://www.rankia.com/blog/erre/1963186-estrategias-bonos

Leaving the issue of bonds aside, the behavior and expectations of consumers and businesses will now be analyzed. These two market agents always respond to their expectations about the future. In economic models, you have a consumer who is extremely far-sighted about the future so consumers will always be thinking about what affects their consumption in the following periods. While not all consumers are like that, in reality, it is a simplification that helps to understand the formation of expectations and how they would respond to an external shock.

To understand consumption decisions, it is essential to take an intertemporal perspective because what a consumer spends and borrows today will impact their future consumption. It is assumed that individuals are rational but in the models, it is assumed that the individuals are identical to simplify the models. According to the theoretical models, consumers are very sensitive to variations in income. An explanation of this is that credit is not available to the whole population so if income disappears or decreases it will have an immediate effect on consumption as there would be liquidity restrictions. Or in another example, before the tax rate reduction is announced soon, consumers can anticipate a future increase in their income because consumption will increase at the present. These effects on consumption depend a lot on the type of agents that there are because in some countries there are more wealthy people and they do not have liquidity restrictions when compared with another country where much of the population have problems to access to credit or income is very low.

Consumption probably varies more than the current income. For example, if you have the expectations that the decrease in your income is permanent your consumption will fall in the same proportion. But if the consumer believes that the effect is transient, they will adjust their consumption less. In a recession, consumption does not adjust to the same magnitude in which the income decreases because when a rational consumer knows that it is a temporary shock and the economy will end up retaking its natural level of production. The same happens during the expansions since the rent can increase but it is not proportional to the increase of consumption because it is a momentary shock.

It should be considered that consumption probably varies, although the current income does not vary. Presidential elections, changes in Congress, or changes in people’s expectations of the performance of the economy or international relations can affect consumption without the income being affected. Even some recessions are exacerbated by people’s expectations of a crisis greater than that which exists

It will now be analyzed how companies make their decisions depending on the expectations they have. As mentioned earlier in this article investment decisions by companies depend on the real interest rate differently from the way people do in considering the nominal interest rate. Corporate decisions also depend on household consumption, sales, and expectations. A company when it is going to invest in machinery and capital to develop its activities more efficiently must make a comparison. The companies must first calculate the expected value of the benefits that the acquisition of that machinery would bring, and then compare this to the costs incurred in buying that machine.

In short, if the company believes in its expectations that the benefits in the future will be greater than the costs of its investment, then it will decide to invest. The higher the actual and expected real interest rate, the lower the expected value of benefits and this will reduce the investment the company makes. The sum of the real interest rate and depreciation is called the cost of capital use and they have adversely affected the investment decision of the companies.

If a company experiences an increase in sales that is believed to be permanent, the expected value of the benefits will also increase what will lead to an increase in investment. But it’s similar to what happens to consumption, the investment does not respond in the same magnitude as sales as the investment is not continuous as can be the consumption. Once a new technology has been implemented, the company has no incentive to continue investing beyond a certain equilibrium point. That is why it can be concluded that investment is much more volatile than consumption, although they respond in the same way to external factors such as recessions and economic booms.

If monetary expansion leads financial investors, businesses, and consumers to revise their expectations of future interest rates and future production, monetary expansion has an influence on economic output, but if the expectations do not change, central banks will not have good tools to affect production as they have small effects on the economy. If a change in monetary policy does not surprise the agents of the economy, expectations will not change and production along with other variables are not affected. The effects can be deeper or not in expectations, but it does not mean that expectations are random and erratic. Economists assume that there are rational expectations in their models and on this basis monetary policies are formulated.

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