Unexpected changes to a central bank’s reference interest rate can cause chaotic price movements. Surprise action by the Bank of Japan (BoJ) in January has driven a shift in investor beliefs. Where previously negative interest rates were not seriously considered by investors, now they are a reality.
This is an important change. The reference interest rate indicated by a reserve bank anchors the yield curve, which in turn underpins much of our notion of ‘value’. Moving the reference rate into negative territory – shortly after the BoJ said it wouldn’t – introduced a range of outcomes previously deemed unlikely.
The key question is how do investors value assets on the back of negative interest rates? When long-term interest rates become negative, it can lead some to price in a narrow range of relatively disastrous outcomes.
In these scenarios, investors often ignore attractive investment opportunities as they pay little attention to the asymmetric pricing of risk. Fear will drive investors to assets where the price they are being asked to pay neither reflects the high level of risk they are being asked to take, nor offers an appropriately high level of return. At the same time, because of the fear of loss, they will avoid investments that offer the opposite – high potential levels of return with lower levels of actual (as opposed to perceived) risk. This may well be the case in Japan where investors are willing to hold JGBs for little compensation, but unwilling to invest in equity more generally and in particular the banking stocks that are exposed to net interest income on deposits and which trade on material discounts to their book value.
When asymmetric risk is ignored, the probability of investment outcomes becomes skewed significantly towards surprises and less towards probable outcomes.
Our observations on price movements suggest that investors have shifted rapidly towards the view that ‘quantitative easing will fail’ or ’the monetary transmission mechanism is broken’. Whilst also ignoring the significant improvement seen in profit share since the nadir of 2008.
Case Study: Japanese Banks
Japanese banks feel like a natural place to observe these behaviours. Investors are now attempting to price risks in a negative interest rate world where traditional value anchors are no longer obvious. Indeed, conventional thinking would have us believe that the earnings power of financials has been permanently diminished. After all, banks placing deposits at the BoJ are now penalised by a negative 0.1% interest rate.
What we can say is that in the current environment, the path of future earnings will be considerably more volatile than investors were pricing in just a few months ago. However, this could provide profitable investment opportunities as JGB yield swings of +/-100bp will likely result in a certain amount of ‘headless chicken’ behaviour by investors.
Two key points are currently being dismissed by investors as they rush to price in disastrous outcomes. First, the banking sector has well-diversified sources of revenue; it’s not all about deposits at the BoJ. The Mitsubishi UFJ Group for example currently generates 45% of its banking revenue from net interest. However, a substantial portion of this is exposed to the US interest rate cycle.
Second, management teams have a range of measures at their disposal to offset declining net interest margins. These include introducing fees on deposits, investing in higher yielding assets, such as corporate debt and non-yen-denominated loans, or even accelerating loan growth in other countries.
At price-to-book levels of 0.5 times it seems that banks’ shares are not pricing in either a recovery in the credit cycle nor signs that demand for credit has emerged in Japan. Investors are not paying attention to the asymmetric pricing of risk.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.