|Jubak's Journal 5/23/2006
How Japan sank the U.S. market
TRYING TO MAKE sense of the global stock market sell-off that began on May 13?
Remember that old Wall Street saying, "Don't fight the Bank of Japan."
If you want to know what has rattled stock markets around the world
and when you can expect it to end, study the Bank of Japan.
What's that? You thought the saying went "Don't fight the Fed"? How
yesterday. Right now the Bank of Japan, not the U.S. Federal Reserve,
is the most important central bank in the world. It's the Bank of
Japan that's calling the tune for the world's equity markets.
Slip sliding away
For the last week, you've heard all the talking heads focus on the
U.S. Federal Reserve in their efforts to explain the sell-off that
began on May 13. The market decline, which reached a temporary
crescendo with May 17's 214-point tumble on the Dow Jones Industrial
Average, is a result of worries that U.S. inflation is in danger of
spinning out of control and that the Federal Reserve will have to
raise interest rates at its June meeting and beyond.
Core inflation -- that is inflation without volatile food and energy
prices -- hit an annual 2.3% in the April Consumer Price Index numbers
reported on May 17. That's perilously close to the 2.5% inflation rate
that many think is the top of the range that the Federal Reserve will
tolerate. After those numbers came out, the odds of a June 29
interest-rate hike, as indicated by prices in the Fed funds futures
market, climbed to 50% from 35%.
That's not a huge shift -- to 50/50 from a 35% chance. And you'd think
while the stock market wouldn't welcome another interest rate increase
-- higher interest rates, which increase the attraction of alternative
investments such as bonds, are never great for stocks -- it would have
gotten used to them by now. A rate increase in June would be the 17th
quarter-point hike since the Federal Reserve began raising short-term
interest rates in June 2004. The stock market has proven itself
perfectly capable of rallying while the Federal Reserve raises
interest rates. Before this recent sell-off, the Dow was up 12% since
the Fed began raising interest rates from 1% on June 30, 2004.
It certainly wasn't enough to send the U.S. bond market into a swoon.
Bonds actually rallied on some days when stocks were sinking. On May
18, for example, when the Dow Jones industrials fell 77 points and the
Nasdaq Composite fell to its lowest level since November 2005, the
10-year Treasury note actually climbed in price by 0.75%. The yield on
the 10-year note, which moves in the opposite direction to prices, at
5.07% on May 18 was very little changed from where it stood at 5.12%
on May 10, the day the Fed announced its latest hike in interest
Gold also behaved oddly. The metal is the classic inflation hedge, and
yet gold sold off on these inflation worries -- if that's what they
were. The metal, which had been selling at $700 an ounce on May 10,
closed at $657.50 an ounce on May 19. That's a drop of 6% when gold
should have been climbing -- if the financial markets were focused on
the U.S. Federal Reserve and heightened fears of inflation.
And finally there was the strange behavior of the U.S. dollar. If
worries centered on the U.S. Federal Reserve and concern that the Fed
and its new Chairman Ben Bernanke had lost control of U.S. inflation,
you'd expect the dollar to sink against other global trading
currencies as investors sold dollars to find safer havens in euros and
yen. But instead, the U.S. dollar has actually stayed steady against
these currencies. The U.S. dollar sold for 110.6 yen on May 10 and for
110.7 yen on May 18.
Not the Fed but the bank
This is where the Bank of Japan comes in. You can't understand why
some asset prices have tumbled and others have stayed rock solid if
you don't know what the Bank of Japan has been doing over the last few
As good as its word, the Bank of Japan has been taking huge amounts of
liquidity out of the global capital markets. In an effort to
re-inflate the Japanese economy and end the years of deflation that
had kept the country mired in a no-growth swamp, the Bank of Japan had
pumped billions into the country's banking system. Now that the
economy is finally growing again and now that prices aren't sinking
any longer, the Bank of Japan has given two cheers to the return of
inflation and has started to remove some of that cash from the
In the last two months, the bank has taken almost 16 trillion yen, or
about $140 billion, in cash deposits out of the country's banks. The
country's money supply has fallen by almost 10%. The Bank of Japan
isn't finished pumping out the liquidity that it had pumped in. That
should take a few more months. And when it is finished, the Bank of
Japan is expected to start raising short-term interest rates.
No more cheap
This sign of the return of economic and financial health to Japan is,
however, bad news to the speculators who have used cheap Japanese cash
to make big profits by buying everything from Icelandic bonds to
Indian stocks. The momentum in many of the world's riskier markets was
a result of ever increasing floods of cash -- borrowed at 1% in Japan
and multiplied by leverage as speculators turned $1 of capital into $3
or more of borrowed money.
For example, India's Mumbai stock market, up 21% in 2006 and 70% over
the last 12 months, has seen an inflow of $10 billion in overseas
money. That wouldn't be enough to move a market like the $14 trillion
(market cap) New York Stock Exchange, but it's a bigger deal on the
$742 billion Mumbai market. Although $10 billion isn't enough to move
a market by itself -- that took improving fundamentals in the Indian
economy -- it is enough to increase upside momentum once the ball is
rolling. (The Indian market's benchmark BSE index plunged 10% Monday
before trading was halted for an hour. It ended the day down 4.2%.)
New inflows of cash are needed to keep the momentum going, hot money
investors know, and it looks like the supply of money flowing into
these markets might diminish. The moves to date by the Bank of Japan
aren't enough to radically diminish global liquidity, but they are
enough so that the investors who have fed some of the world's riskier
markets understand that the trend has turned.
It's one thing to invest in five-year Indonesia government bonds
paying 12.13% when cash is flowing into the Jakarta financial markets,
keeping the rupiah strong against the dollar and pushing Indonesian
stocks ever higher. It's something else entirely when it looks like
investment flows might be drying up. Speculators aren't about to wait
until they actually see signs that cash flows are dwindling. They take
profits at the first sign that the trend may be changing. That's why
the Jakarta market can drop 5.3% in a day, as it did on May 18.
What we've witnessed since May 13 is a global flight out of more
leveraged and more speculative investments. Speculators attracted by
the momentum of the gold, copper, and silver markets have sold -- and
are still selling -- rushing to get out before other speculators could
liquidate their positions. Emerging equity markets have sold off for
the same reason: India's Bombay Sensex index dropped 6.8% on the same
day as the Jakarta market fell. High-yielding bond markets have
collapsed as prices dropped, sending yields soaring and currencies
skidding. The central bank of Iceland has raised interest rates to
12.25% in an effort to prevent the further fall of the krona as hot
money flees the country.
Risky investments look riskier
What the Bank of Japan has done is to set off a global re-setting of
investors' risk tolerance. With Japanese interest rates so low and
Japanese cash so abundant, speculators, traders, and investors have
been more and more willing in the last few years to take on risk at
increasingly low premiums.
It isn't amazing that anyone would buy Indonesian bonds. It's amazing
that they would buy them when the yield was only 12%. And given what
we know about the direction of U.S. interest rates, the likely course
of U.S. inflation and the size of the U.S. trade deficit, it was
amazing that so many investors flocked to buy 10-year U.S. Treasury
notes that they drove the yield in July 2005 to less 4%. On July 10,
the 10-year Treasury yielded 3.97%. By locking up your money for eight
fewer years in a 2-year note, you could get 3.62%. That's 0.35
percentage points in yield for taking on eight more years of risk.
Risk tolerance doesn't get reset in a day. The Bank of Japan is only
halfway through removing liquidity from its domestic and global
markets. Interest-rate hikes are likely to follow that with the first
increases coming in the second half of 2006. At the same time, the
European Central Bank is raising interest rates.
All excess liquidity has by no means been removed from the global
financial markets. But the speculators know that money is gradually
getting more expensive. Rallies can count on less hot money to fuel
their last stages. Getting out earlier in rallies starts to seem
wiser. Some risks are just not worth taking.
The correction that began on May 13 is part of the process of
resetting risk tolerance and recalibrating risk premiums. It's not
likely to last terribly long. Frankly I think the turn in this
correction isn't that far off, and it's probably time to look for a
buy or two. And it's likely to be followed at some distance by another
bout of speculative momentum, which will be followed by another
correction. Markets move from one equilibrium point to another by a
messy process of over-shooting on each extreme of the swing until they
find a new center.
That's where I think we are now, and that's what you can expect to see
for the rest of 2006 as the Bank of Japan continues to force a
recalibration of the risk tolerance of global investors. The
volatility that results can be scary, but it doesn't mark the end of
the world. It's rather just the way that, in the short term, the
financial markets adjust to new fundamental conditions, such as a
change in global liquidity.