James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

The Bank of Japan seems to be running its own fun-house version of monetary policy, intervening in equity markets when they fall.

Dubbed by traders the BOJ’s “1% rule,” the central bank is apparently stepping in to buy Japanese shares on days when they end the morning down 1 percent or more on the previous day’s closing price.

While the BOJ will not comment on its purchases or policies, Japanese news organization Nikkei points out that since mid-December, the central bank has bought ETFs on each of the 18 days the Topix index fell by at least 1 percent in morning trading.

While it is hard not to be sympathetic to the BOJ, which is struggling to kindle both demand and inflation after the devastating earthquake and tsunami, the tactic of buying when markets fall sharply is more of the same failed medicine, only worse.

Such an implied insurance policy for investors only further distances stock valuations from reality, makes more likely lousy allocation of capital and, ultimately, sets up the market for a nasty bout of selling if ever the BOJ ends the policy.
It is also, very possibly, a foretaste of the kind of folly that might emerge from the U.S. Federal Reserve if the current economic lull deepens into a double dip recession.

While the amounts the BOJ is spending on buying shares is small in the scheme of things, it is having an important psychological impact on traders and investors, who have grown used to official buying if the market has a bad morning.

The BOJ in October announced a new policy of buying exchange-traded funds and Japan real estate investment trusts (J-REITs). The ETFs track the Topix or Nikkei 225 indices, while the real estate trusts must be AA rated or higher. The plan was part of a larger $61 billion plan to buy up a variety of assets, including corporate debt.

There is no way of getting around it; central banks buying shares are picking winners and losers in theeconomy and are moving ever further away from their core mandate of price stability. Why on earth would anyone think a central bank has a better idea of how to allocate capital in the economy than the sum of all market forces, even given how imperfect and prone to error markets are?

Why too would a central bank want to favour large listed companies and real estate over the rest of the economy? Why not buy used cars and junk them, or simply buy up office buildings and burn them to the ground? At least those actions, deranged as they are, would have an actual impact on supply and demand in the actual economy. As it stands, at best, the BOJ’s actions simply flatter people’s ideas of how much their financial assets are worth. At worst it simply facilitates cynical buying and selling by people trying to front run the BOJ’s assumed policies.

FEEDBACK MECHANISMS SHORT-CIRCUITED

This gets to the heart of the self-defeating aspects of much monetary policy, both in Japan and in the U.S., as it has been practiced in the last 15 years. One of the main effects of all that has been done, bailing out after crises, engaging in quantitative easing, is to short-circuit the normal feedback mechanisms that should travel between financial markets and the real economy.

It is very much like pain medication; good for temporary relief but a poor long-term solution. If you have an injured knee and take opiates to mask the pain you may walk a bit more in the short term, but perhaps a lot less over the long run. We’ve been upping our dosage since about 1998, and it’s not working well anymore.

Buying up equity and property-share funds may be the most extreme and egregious example, but it is probably not the most important. That honor belongs to buying up government debt, which has helped to nullify government bond markets as a benchmark by which the world can measure risk.

In the old days, and really this is before China began buying up Treasuries as an adjunct of currency manipulation, people thought of government bond yields as a north star against which the relative risk of everything else could be gauged.

Investors really have no idea where they are anymore, and in this way all of the efforts to suppress or mask risk by intervening in asset markets have only increased the likely amount of ignorant risk we are collectively taking on. The subprime and subsequent crises are examples of this, but surely won’t be the last.

This is surely throwing up attractive opportunities for clever investors, but is not likely good public policy.
For Japan and the U.S., as difficult as their respective situations are, the best thing would be to stop supporting asset prices and let the feedback mechanisms reassert themselves. They will in the end anyway.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With QE2 set to end in five weeks and with Greece rolling downhill towards default, the world is not best placed to withstand a weakening economy.

That, however, is exactly what looks to be happening, as Asian demand is hit by a cooling China and a struggling Japan.

Let’s take a look at the evidence:

Japan’s economy shrank by 0.9 percent in the three months to March, battered by the earthquake, tsunami and ongoing nuclear fiasco.

The preliminary HSBC/Markit purchasing managers’ index for China fell to 51.1 in May from a final reading of 51.8 in April, holding in expansionary territory above 50 but amidst growing evidence that China is coming off the boil. Chinese demand for raw materials and semi-finished products has been one of the global economy’s principal supports, but now a monetary policy tightening campaign may be gaining traction.

The Chicago Fed national index, derived itself from 85 economic indicators, came in at negative 0.45 in April compared to 0.32 in March. There are numerous signals of an industrial slowdown in the U.S., while the housing market continues to weaken, threatening financial stability and consumer spending.

Finally, in Europe the euro zone composite flash PMI, an indicator combining service sector and manufacturing purchasing, fell to 55.4 from 57.8. More worryingly, the headline manufacturing index had its biggest fall since Lehman Brothers failed, falling by 3.1 points to 54.8.

“All in all it seems to us that the odds are high that a domestic and global economic slowdown is already in place.  In the U.S. the slowdown is happening with only weeks to go before the end of QE2, a program that has been a major prop for even the tepid recovery we’ve undergone so far,” said Charlie Minter of fund managers Comstock Partners in a note to clients.

“For the stock market nothing seems to matter until, suddenly, it does.”

It has begun to matter recently to the stock market, which has fallen in recent sessions after a sustained rally. The bond market has already figured this out; since mid-April U.S. 10-year yields are down more than 12 percent to 3.12 percent. Given that the U.S. debt market faces a debt showdown and the end of QE2, both factors which should theoretically send yields higher, this slide in yields shows real doubts about future growth.

CRUEL SUMMER

It is worth noting that the euro zone’s woes were not this time concentrated in the weak peripheral states; this time Germany got whacked too. That may well reflect the wrench thrown into production from Japanese plant closings, which in itself will self-correct. It is also likely reflecting a slowdown in demand for German products from China. If you believe that Chinese demand was artificially boosted by very easy credit, and that Chinese demand in turn was driving global growth, then this is an indicator of a very busy and volatile summer in financial markets.

Global markets have ignored, more or less, the euro zone’s issues for more than a year, but did so in a very supportive atmosphere. The Federal Reserve was buying up Treasuries, sending cash into risk markets in waves, while China continued to grow at a blistering pace. It may be that China is important not just because its slowdown affects demand, but because it lets investors focus on the actual prospects in the euro zone.

Will Germany and France be as willing to foot the bill for Greece if their own manufacturing bases begin to shrink? It is possible but a lot less likely.

Meanwhile the crisis both builds and spreads, with a dispute over debt reprofiling (a sort of doe-eyed default) between the European Central Bank and European officials and a fantasy plan by Greece to raise 15 billion euros through asset sales.

Greece may turn out to be a minor worry; Belgium and Italy have been threatened with credit downgrades by Fitch.

So what happens from here? A palatable outcome would be a gentle decline in economic momentum followed by a strong second half. This makes absorbing the impact from Europe easier, and makes it easier for Europe to come to terms with itself.

A less likely, perhaps, but still possible scenario is that the manufacturing slowdown gains speeds just as Europe faces a contagion from the periphery, either to parts of the core, to the banking system of the core, or both.

At this point the Federal Reserve will have an ugly choice; does it extend and expand quantitative easing to support the newly weakening economy, or does it sit tight, brace for the recession and hope something else will turn up?

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

If rebuilding after tragedies is actually good for the global economy, someone clearly forgot to tell investors.

In the days after Japan’s earthquake and tsunami and its still unfolding nuclear disaster, global stock markets have fallen sharply, as have bond yields and even energy prices, all indicators that someone, presumably someone with quite a bit of money, thinks this all will not end well.

While replacing broken windows will flatter GDP, it does not do a whole heck of a lot to increase productive capacity. The contrary argument, of course, is that Japan is suffering from a surfeit of savings and that these funds will finally be given something worthwhile to do in rebuilding.

Perhaps demand from Japan will do someone some good, but the idea that we can all grow rich by rebuilding our ruined houses seems little better than the old canard that we’ll all get rich buying each other’s houses. Both theories rest on employing more debt and both, therefore, present considerable risks.

Even beyond the idea that Japan’s plight will somehow provoke a bond crisis, of which there is no evidence yet, two factors may explain why markets are so scared; the nuclear risk and the spreading unrest in oil-producing nations in the Middle East and North Africa.

First, the events at the Fukushima nuclear plant are as unpredictable as they are frightening. Reports are confused and attempts to control the situation, such as a failed bid to dump water by helicopter, evoke images of the kind of movie happy endings we all view as far fetched.

This brings fear and that kryptonite of risk markets, uncertainty.

This cuts a much wider swath than just Japan, where nuclear power represents 29 percent of electrical generating capacity.

The truth is that nuclear power, one of the most important sources of electricity in many markets around the world, now has a very uncertain long-term and immediate future. That could have a nasty impact on energy prices, and in turn on growth and inflation.

The impact is spreading quickly; European Union energy officials agreed Tuesday to apply new stress tests on plants across the 27-nation bloc and Germany moved to switch off seven older reactors. China’s cabinet on Wednesday said it will suspend approvals for nuclear power stations to allow for a revision in safety standards, while Switzerland put on hold renewal of three of its atomic stations.

This is significant; nuclear power represents a third of Japanese electrical generating capacity, 20 percent in the U.S. and 75 percent in France.

OIL ON TROUBLED WATERS

Oil prices initially fell after the earthquake, operating on the assumption that immediate demand in Japan will fall. Prices rose on Wednesday, as fears of nuclear power rose and people worked through the implications.

This is all made even harder to predict by the unfolding path of revolts and protests in the Middle East. Libyan forces supporting Muammar Gaddafi were predicting on Wednesday the fall of rebel stronghold Benghazi within 48 hours, a development that, while ghastly, would actually help to suppress oil prices if it came to pass. That, ladies and gentlemen, is your global economy, 2011 edition, left hoping for the restitution of a vicious dictator.

Developments in the gulf state of Bahrain, which used tanks and helicopters to drive protesters from the streets on Wednesday, added to uncertainty. Bahrain has brought in troops from fellow Sunni-ruled Saudi Arabia, Qatar, Kuwait and the United Arab Emirates as it seeks to put down a largely Shi’ite-led protest movement, risking retaliation from Shi’ite-dominated Iran.

There is simply no way to know how this will work out, but financial markets look to be pricing in elevated energy prices for an extended period.

It is possible, of course, that protest is stifled, that nuclear doubts are damped and that the price of oil sinks rapidly, in which case you can expect a massive rally of risk assets and for the Federal Reserve to resume making noises about the transition away from quantitative easing.

If not, and if energy prices remain high or rise, they will be a tax on growth and consumption, all the while fanning the flames of inflation in food and energy.

It is worth noting that U.S. producer prices spiked last month, with finished foods rising 3.9 percent, the highest rate since November 1974, when President Gerald Ford was attempting to lead a “Whip Inflation Now” movement.

Tension in the Middle East, oil spikes, inflation and nuclear fears; It is all looking a bit 1970s now, and that is not something to be nostalgic about.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Photos, top to bottom: A red umbrella is seen among the ruins as survivors walk past in Kamaishi, Iwate Prefecture, days after the area was devastated by a magnitude 9.0 earthquake and tsunami March 16, 2011. REUTERS/Damir Sagolj; A Japan Self Defense Forces helicopter fights a mountain fire after a magnitude 8.9 earthquake and tsunami hit near Kamai City, Iwate Prefecture in Northern Japan March 13, 2011. REUTERS/Kyodo

Markets are busy speculating on which country might follow Egypt on the revolutionary road, but watch out for the impact on a country where bellies are full and the chances of revolt are exactly nil: Japan.

The same inflation in food and energy which fanned discontent in Tunisia and Egypt could badly hit real wages and purchasing power among Japanese citizens, potentially undermining their willingness to hang on to the debt which the government desperately needs them to own.

That’s right, deflation could actually ease in Japan and, that’s right, its demise could help tip the country into the long-awaited financing crisis.

It is not the bond market vigilantes who are likely to precipitate a debt crisis in Japan, it is Mr and Mrs Watanabe, the archetypal small saver, who have patiently held Japanese government debt in huge amounts despite very low interest rates.

It is the existence of the Watanabes (domestic holdings of Japanese debt are about 94 percent vs about 50 percent in the U.S.) who have allowed Japan to run its debt up to 196 percent of GDP, trailing only Zimbabwe. By comparison, Greece’s debt to GDP ratio is just 137 percent.

With a massive and passive domestic lending base, Japan has never faced the interest rate squeeze which its long-term outlook justifies, and unlike the U.S., is far less vulnerable to sales by foreign investors or central banks. For a country which is borrowing 50 cents of every dollar it spends, this is both a key support and a significant vulnerability.

But why have the Watanabes held on to their Japanese bonds, which are usually held through intermediaries such as via savings products? Partly it’s a matter of culture and habit, but deflation has almost certainly played a mollifying role. Japanese domestic investors hold less than 5 percent of the government bond market directly, but are much larger investors through accounts and instruments sold by financial institutions, the yield of which track government bond yields. A paltry 1.2 percent yield on a 10-year bond is a lot easier to swallow for retirees and investors if purchasing power appears to be rising as prices fall in a deflationary spiral. If prices rise sharply they may demand more.

BE CAREFUL WHAT YOU WISH FOR
But that deflationary spiral, especially as it affects households, may be coming to an end courtesy of very loose U.S. monetary policy and related strong emerging market demand.

Inflation in perishables, such as meat and fruit, hit 10.3 percent in December, and overall food prices hit an all-time record, according to Japanese data. Energy prices are moving upward as well, and are vulnerable to increasing shocks from the Middle East. Overall, and not even depending on a falling yen, Japanese consumers look to be suffering a terms of trade shock, where their ability to command wages is left far behind by rising prices of the things they must buy.

Deflation has not been that terrible for Japanese households, at least to judge by their own reports: 63.9 percent of people said they were content with their standard of living last year, as against 63.1 percent in 1989.

Ratings agency Standard & Poor’s downgraded Japan’s sovereign credit rating last week to AA- from AA, citing the difficult math of an aging population and its expectations that government debt ratios would continue to rise. Reaction was muted in bond markets, though the yen fell. The price to insure Japanese bonds against default over the next five years rose to about 0.85 percent, near highs reached last summer during the European debt crisis.

To be sure, Japan is still in deflation and even with food and energy playing a heavy part of price measure, overall prices are likely to continue to fall.

Japan doubtless has much with which to protect itself in a bond sell-off; massive overseas assets, a positive current account balance and a cohesive and biddable financial sector. That said, the following scenario is one to watch — domestic holders, stung by inflation, rapidly increase their holdings of overseas debt and other investments, cutting back on government bonds. This drives yields up and the yen down, catching the eye of foreign investors who pile on, selling Japanese bonds aggressively. Events take on a momentum of their own, and a year from now people are shaking their heads over how it was possible the Japan bond bubble lasted as long as it did.

If so, the damage globally will be profound, attention will focus on the U.S. and its heavy debts, and quantitative easing, which helped to unleash the inflation, will prove to be a powerful tool best left in its box.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  email: jamessaft@jamessaft.com)