See Jim's new portfolio to help navigate the treacherous interest-rate environment.
Jubak's Journal Recent articles: • Google and AT&T: Is bigger better?, 3/10/2006 • 10 under-the-radar blue chips, 3/8/2006 • 10 stocks that win with $60 oil, 3/7/2006 More... | Jubak's Journal Japan's gain could be your loss After 15 years, Japan's economy is growing again, which means the Bank of Japan won't be flooding global markets with free money. Say hello to higher interest rates. By Jim Jubak It's officially over. After 15 years -- yes, 15 years -- of no growth, Japan's economy is poised to grow by as much as 5% in 2006. After eight years of slowly but steadily falling prices, Japan can now smell a welcome whiff of inflation. And after years and years of 0% short-term interest rates, the Bank of Japan is widely expected to finish the year raising those same rates to 0.5%. So take a moment to cheer for the end of what has been called the lost decade in Japan. Then, buckle your seat belts. Because what's good for the Japanese investor and the Japanese CEO and the Japanese consumer isn't at all good for international financial markets. The recovery in Japan is likely to usher in hard times in financial markets and economies around the globe. And no economy is at greater risk of taking a body blow from a Japanese economic recovery than that of the United States. The problem is that during Japan's lost decade, the world has gotten hooked on ridiculously cheap Japanese cash sloshing around the financial markets.
The downward spiral The Bank of Japan pursued two strategies as it fought to bring the country out of the deflationary slump that gripped the nation after its stock market started collapsing in the 1990s.
Opening the floodgates This effort took many forms. In September 2002, for example, with the Nikkei 225 ($N225) stock index at 9,000 -- down more than 75% from its high of nearly 38,916 at the end of 1989 -- the Bank of Japan started to buy shares in troubled companies to keep the Japanese stock market from sliding even further. To keep the market for Japanese Treasury bonds functioning smoothly, the bank also bought government bonds. And in an effort to flood the financial markets with free money in the hope that somebody would borrow it if it was just cheap and plentiful enough, the Bank of Japan bought billions in short-term debt. Related news and commentary on MSN Money
Calculations by The Financial Times put the extra cash at something like six times beyond what the bank needed to put into the Japanese financial markets to get interest rates to fall to 0%. The bank's target for liquidity soared from something like $50 billion when this policy began some five years ago to something like $250 billion to $300 billion by the time the bank decided last week to end its policy of flooding the markets with cash. Until this year, pretty much nothing happened. Japanese consumers and businesses that weren't interested in borrowing $1 of free money were just as uninterested in borrowing $2 in free money, it turned out. It took a quite probably unrelated boom in exports to China and the U.S. to get the Japanese economy rolling again starting last year. So, if no one in Japan wanted to borrow all that free money the Bank of Japan was pumping into the economy, what happened to it? It went overseas -- looking for higher returns. Some was invested by Japanese savers, banks and investment companies. A favorite investment was the relatively high-yielding debt issued by the U.S. Treasury. Japanese holdings of U.S. Treasury debt climbed 115% from "just" $318 billion in December 2001 to $685 billion in December 2005. China has shown faster growth in recent years -- to $257 billion in 2005 from $79 billion in 2001. That's 225% in four years. Still, Japan remains far and away the biggest holder of U.S. Treasurys. Some of the cash was borrowed in Japan by overseas investors who used the free money to buy U.S. Treasurys, gold and mortgage-backed securities, among other assets. This carry-trade, as it's called, is extremely profitable because access to free money means that investors can leverage their own cash with borrowed money to the tune of 5 or 10 or 20 to one. The gates are going to close -- gently, one hopes On March 9, the Bank of Japan announced that it will gradually reduce the amount of free cash floating around Japan -- and, as a consequence, floating around in global financial markets. Being a responsible central bank, the Bank of Japan will try to do this gradually, so it doesn't crash financial markets. While the bank will reduce its buying of Japanese government bonds, it will continue to buy about $10 billion of government bonds each month. The worry is that if the Bank of Japan went cold turkey it would crash the market for Japanese government debt. It's not like investors are beating down the door to buy debt paying 1.6% (on 10-year notes) issued by a government whose total debt is now more than 150% of the country's gross domestic product. (By contrast, the Office of Management and Budget estimated total U.S. total debt at the end of the 2005 fiscal year at 63.7% of gross domestic product.) Global financial markets are thus looking at two big changes.
Losing our biggest lender Meanwhile, yields on 10-year U.S. Treasury notes have been on the rise -- which means prices have been falling. On March 7, the intraday yield on the 10-year note climbed to 4.781%, the highest level since June 2004. That climb in yield pretty much eliminated the inverted yield curve that had so worried investors -- and economists -- at the end of 2005 and the beginning of 2006. An inverted yield curve, a condition which results when the yield on short-term notes such as the two-year Treasury is higher than the yield on 10-year notes, is often seen as a harbinger of recession. Investors who would normally demand a higher yield to tie up their money for a longer period of time would be willing to take less in yield if they thought the economy was about to tip into recession. The economic slowdown that a recession brings usually results in falling interest rates, so investors in 10-year bonds would be taking a lower yield now in hopes of getting a good capital gain on their bonds if a recession brought interest rates down. But the end of an inverted yield curve isn't likely to provide much beyond a passing comfort to bond investors. Anything that reduces the propensity of Japanese -- and other foreign -- investors to buy U.S. Treasury bonds is a big deal in a country which will set another record for highest trade deficit in 2006. Expectations are that 2006 will break 2005's record deficit of $723 billion. When you owe this much money and you are so dependent on overseas investors to buy your debt, an announcement that your biggest creditor will start sopping up liquidity isn't exactly good news. The global debt markets are so leveraged and so dominated by complicated derivative bets that it's impossible to tell what would tank the market. My gut feeling -- and that's all it really can be, given the complexity of the markets -- is that we're not yet at the crisis point. But the Bank of Japan's good news will put more upward pressure on global and U.S. interest rates. No debtor -- whether its the homeowner with an adjustable-rate mortgage or the U.S. government -- can be happy about that. New developments on past columns Why gold stocks should go higher The Bank of Japan's March 9 decision to gradually suck the excess cash out of the financial market that it had poured in to fight deflation has sent the price of gold and other commodities down. Speculators have used money borrowed at near 0% interest in the Japanese market to make bets on everything from gold to silver to copper. And although the Bank of Japan doesn't look likely to raise interest rates until later in 2006 -- and then only to 0.5% -- some speculators have started pulling their money back so they won't be the last one out the door. That's the bad news for the prices of these commodities and of the stocks of commodity producers. The good news is that, after a relatively modest drop as speculative money pulled out, actual consumers of these commodities have stepped in to buy. For example, gold, at a two-month low near $530 an ounce, has attracted buying from jewelry makers who have been looking for exactly this kind of a price dip to rebuild their inventories. Copper and aluminum saw similar bounces on buying from industrial consumers on March 10. Right now, it looks like this physical demand will be enough to stabilize prices, although the situation demands close attention. A rally from current levels will depend on the strength of the global economy. (See the update immediately below this one.) Hard winter for the oil sector Investors who want to know when oil stocks will start to recover can take heart at recent developments in the global economy. It's starting to look like the world's economies will grow faster in 2006 than previously projected. The International Monetary Fund (IMF), for example, has indicated that it will raise its forecast for global growth this year to 4.8% from an already healthy 4.3%. As long as growth stays on track for the global economy, I think it's worth holding energy stocks through what looks like an extended version of the sector's traditional late-winter weakness. I'd only sell this sector if the global economy started to slow -- which would reduce demand and prices for oil and gas. Right now that doesn't look likely and, in fact, the numbers are starting to pile up on the side of stronger-than-expected growth. Stay tuned, though. We're dealing with projections here, and there's many a stumble possible before investors get to take projections to the bank. Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com. At the time of publication, Jim Jubak did not own or control shares in any of the equities owned or mentioned in this column. He does not own short positions in any stock mentioned in this column. | |||||||||||||||||||||||||||||
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